$ARIS: Generating FCF and reinvesting it at high rates ...

This post is a look at the financials of ARIS, a company I've written about before and have followed for awhile. It's been throwing out tremendous amounts of cash and reinvesting it at high rates, a characteristic typical of a kind of investment known as "compounders".

The last 1.5 years - and most notably the last half - have shown quite spectacular results, with FCF returns on equity of +17% and FCF margins of 16%.

Using a screen, we compare the company's recent results to other stocks listed on the major US exchanges both with limited mkt caps (under $1B) and unlimited and find it to be in rare company.

Whether or not those results can be sustained is obviously most important. At $70M mkt cap it's still not in "orbit" so to speak. Over the next 2-4 quarters perhaps, investments in the business to meet growing demand, reduce churn and lower turn time will likley negatively impact margins so that's a near term headwind to sustaining current rates of return.

But if those investments ultimately return what the current business is doing - or more - it's possible to consider that this company is doing something unusual and special as it appears that it might be.

In my effort to learn more, I am seeking out knowledgeable folks with experience in small dealer markets (1-10 doors) or dealer services markets in the areas that ARIS serves: powersports, RV's, medical equipment, marine and wheel / tire. Please ping me if you or someone you know fits that bill so we can be connected for a brief chat.

***

I like it where ideas converge as recently happened here in the last two weeks ...

First I reconnected with an old friend who runs Greenlea Lane Capital and shared some ideas with him. I know few investors as focused, disciplined and patient as he and I treasure his time and counsel. Were he older, I'd perhaps call him wise but that's a sobriquet for the old and an epithet for the young, and he is young and his success to date hopefully precedes a long career ahead.

He solely seeks out compounders and while I own companies for a handful of reasons I shared with him one that I've previously written about here - $ARIS - that seemed like it fit that bill, meaning that it generates cash and reinvests it at high rates of return.

ARIS is a small software / technology company that serves the dealer markets, primarily for powersports (motorcycles and ATV's), RVs, wheel / tire and home medical equipment.

While many dealer services companies serve the back office, ARIS goes to the consumer facing side, developing websites (~50% of sales) and offering eCatalogues (~35% of sales) so that dealers with 1-10 doors can be online, showing, selling and managing product. At $4.15 it sports a $74M mkt cap / $80M EV trading at 14x TTM EBITDA, neither terribly cheap nor terribly expensive, but a discount to peers.

That idea turned the conversation towards another more mature and well known compounder - $CSU.TO - which is also a software company serving vertical markets, and got me revisiting Mark Leonard's brilliant shareholder letters, notably the most recent one about high performing conglomerates.

Independent of all this, but around the same time, someone directed me to Base Hit Investing's post on ROIIC, another great read by John Huber. The nut of that piece is how to calculate and - more importantly, internalize and understand the meaning of - returns on invested capital.

Between those concurrent events, I decided to dive more deeply into $ARIS to see how it stacks up financially against more well known compounders and to get a sense if maybe it has an opportunity to be something special.

I am a shareholder - and I don't know the future - but their recent cash flow generation has been lights out and maybe that bears out the possibility that this company could be something special. I definitely see something in the results and quality of mgmt that is unusual in a company so small.

I'll start with most recent results ...

... The 17% topline growth is ~5% organic with the rest from three acquisitions last year that enabled the company to more deeply enter the wheel / tire services space ...

TCS Technologies (Sept 2014). A dealer services company in the wheel / tire vertical that not only does websites but has an integrated point of sale / integrated inventory management piece.

TASCO Software (April 2015). Also in the wheel / tire vertical with more business mgmt / back office related offerings.

DCi (July 2015). eCatalogue in the wheel / tire / auto after market space.

... if all this sounds boring and uninteresting ("websites?"), when you look online at products for sale, you are likely looking at a picture / price / sku sourced from some kind of catalogue. In short, eCatalogues are an essential part of the infrastructure of internet commerce.

Small dealers who don't own entire catalogues essentially rent them from a company like ARIS. It is a competitive business for sure - there is no end to small companies doing it - but it is scalable, low touch, high return and - with enough subscriptions - a cash flow engine.

For ARIS, this cash flow engine has generated low dd / mid-teen FCF margins for the last 1.5 years. 

Prior to 2015, the company was working its way through an acquisition of a distressed company (50below) that created a short term blip but enabled them to substantially grow their websites business. In that case, the acquired subscribers had already paid the target company, which squandered the cash, meaning ARIS essentially acquired the liability of having to provide a service to the subscriber, but not the cash. But that is all in the past.

What is in the future?

Even as the catalogue business churns out cash the websites business is like the yin to the catalogue yan; high touch - it takes time to get a dealer website set up - and high churn - they lose about 15% of sales / year when customers jump ship to competitors or close their doors.

Just to reiterate, 15% organic growth every year is churned away. That means every basis point reduction in churn is an increase in organic growth. Reducing churn is therefore something the company is focused on though some churn is structural to the business, a factor investors should consider quite carefully.

On the most recent conf call, mgmt indicated a number of investments to speed website turnaround, reduce churn and meet growing demand. Having too much work is what I call a "high class problem" but its a problem nonetheless and the investments will be headwinds to margins.

About these investments, in their words ...

1. General investments in the business:

"As we look ahead to Q4, I want to make a few points. First, we had another quarter of strong sales bookings. This means we will continue to apply resources into translating those bookings into revenue as quickly as possible. And as such, I suspect that will continue to impact the gross margin in a way similar to what we experienced in Q3 [ie down to the high 70% / low 80% range]. 

"The flipside of that is that we are aiming to maintain organic growth rates in Q4 similar to what we experienced in Q3. Second, as I noted previously, our profit performance in the first nine months of the year has exceeded our expectations. We anticipated that there would be some investments in Q3 that would prevent us from improving upon our Q2 performance. 

"While we did make some of those investments and still improved upon our performance, some of those investments did not hit in Q3 from a timing perspective and as a result will likely materialize in Q4. These investments include, among other things, our ongoing investment in our India office, consulting fees to upgrade and optimize our data centers and the rollout and go live of our enterprise wide CRM system."

2. Platform upgrades to websites and eCatalogue:

"We have several active projects including extending and improving our core website lead gen and e-commerce platform, developing a new next-generation version of that product, and developing the next generation of our core eCatalog technology. 

"The first item extending and improving our [existing] platform is pretty obvious and has resulted in a substantial increase, in some cases a triple digit increase in leads to our dealers. These improvements have resulted in strong new bookings this year and improved churn. We remain committed to building and delivering the best platform for lead generation and e-commerce in the markets we serve. [The existing platform is internally called "endeavor" and has been around for +10 years]

"The second item is a total rewrite of that platform ... The re-write is internally code named Domino, and Domino is a product that will openly replace Endeavor. It'll be our platform for the future. It is written to be a responsive design platform. It will be much, much faster. It actually will drive much more leads. It has a tremendous amount of flexibility to be able to appeal the different vertical markets as we continue to import medical data and the entire data and other types of data. And it also is going to have significant impact on our cost structure to deliver and maintain new customers.

"... We will start porting dealers over August or September, so we will begin porting dealers over to Domino and that process will take a minimum of 12 months, it might take a little bit longer than that, but that migration effort is not going to be incremental to our cost structure today. We've had a plan to do that for a long time, and we will be porting those guys over to Domino and eventually we will retire and cut down Endeavor and all the data center that goes along with it."

"In terms of eCatalog, we have spent the last year developing the next generation publishing tools that we expect to dramatically reduce the amount of time it takes our OEM customers and our internal teams to create new content and update older content. What previously took days or weeks will now take seconds or minutes with this new platform. We developed this as a global solution from day one and designed it for use in the markets we serve as well as any other market where the equipment is complex and requires repair."

3. Opening an office in New Delhi

"We continue to build out capacity in the US and India to lower our backlog and cost structure. While our overall numbers for the quarter were quite good, our revenues would have been even higher had we been able to deliver all customers in under 30 days which is our target.

"As we discussed in the last call, one of those initiatives resulted in opening an office in New Delhi, India. Almost a year ago we assigned a senior operation resource to investigate building additional capacity in India, we conducted a comprehensive review of the options and hired a VP General Manager in November and have continued to add staff. We now have an operations team up and running in India, the leader of that team was trained in our Duluth office for three weeks and one of our senior US resources is in New Delhi now completing that team’s training. We expect this team to start working on our backlog in the next few weeks.

The nut of these investments means on the plus side, they are investing in their business to upgrade their platform and reduce churn ...

... but on the negative side, near term margin impact and with the distraction of platform upgrades and ERP / CRM systems rollouts, I'm sure we've all seen how that can get off the rails pretty quickly. Again, things investors need to consider.

How the company manages the transition will be critical to the next years results and that's really the most important thing, despite prior year results that have been exceptionally impressive. I have been focusing on how to gain insight and comfort with these changes and if anyone has networks into dealer services software that I could chat with for 15 minutes, that would be most helpful. 

Back to recent results, here is a summary of TTM figures ...

... growth, margin expansion and FCF generation.

Putting it all together with some balance sheet data gives a sense of returns on capital ...

... 17% FCF return on equity and 12% return on total cap seem impressive to me.

As BHI discussed in his post, some use in the return denominator Total Capital less Goodwill & Intang (53% on TTM FCF) and others just use Tang Capital (89% return on TTM FCF). I don't think it's appropriate to exclude goodwill / intang for acquisitive companies b/c it is an essential element of deployed capital, even as it just sits there.

I've seen a table recently that showed how an index of "compounders" generates FCF return on equity in the 19% range vs the MSCI index in the 14% range, so ARIS is somewhere between the two.

Are these exceptional results?

I try not to get bogged down in parsing return numbers so finely. What matters to me is consistent and long term growth in BVPS and cash flow generation as proof that mgmt is adding value.

In ARIS case, a lot of the growth is through acquisition and in the past they've definitely overused stock for acqs, but at 17M shares outstanding it hasn't been inappropriate given the need to expand liquidity and especially when at one point there were paying as high as 14% interest on debt. Based on a prior correspondence with the company, I believe they will be much more parsimonious with using stock for future acqs.

As for how they compare to other companies, I created a screen to see who else might fit the bill. (I think I shared a version of it on screener.co called "Companites that look like ARIS"). I used the following parameters that shared the same recent dynamics as ARIS ...

TTM Rev Growth > 20% 
( total revenue(i) + total revenue(i-1) + total revenue(i-2) + total revenue(i-3) ) / ( total revenue(i-4) + total revenue(i-5) + total revenue(i-6) + total revenue(i-7) ) > 1.2

TTM EBITDA / Total Cap > 15% / 14% / 13% for last three quarters
( ebitda(i) + ebitda(i-1) + ebitda(i-2) + ebitda(i-3) ) / ( Total Debt(I) + Total Stockholder Equity(I) ) > 0.15

( ebitda(i-4) + ebitda(i-1) + ebitda(i-2) + ebitda(i-3) ) / ( Total Debt(I-1) + Total Stockholder Equity(I-1) ) > 0.14

( ebitda(i-4) + ebitda(i-5) + ebitda(i-2) + ebitda(i-3) ) / ( Total Debt(I-2) + Total Stockholder Equity(I-2) ) > 0.13

EV / LTM EBITDA < 14
built in parameter

FCF margin > 20% / 10% for last two quarters
( Total Operating Cash Flow(I) - Capital Expenditures(I) ) / total revenue(i) > 0.16

( Total Operating Cash Flow(I-1) - Capital Expenditures(I-1) ) / total revenue(i-1) > 0.1

** note that in my model, I appropriately calculate free cash flow net of capitalized software development, but screener doesn't have that parameter, so the comp margins are higher ** 

... and there are 13 US-listed companies not based in China with $1M > mkt caps > $1B. If you look at the screen you won't see ARIS there - strangely enough - and when I looked at the raw financial data noticed it didn't match the Q. This of course begs a whole host of other questions ... but that age old complain "until I can afford to get FactSet, its all I got to work with here".

Casting a wider net, when I lower the rev growth rate hurdle to 10%, raise the valuation hurdle to 20x and expand the market cap to $500B (also a shared screen "All cap blog screen"), the list grows to ~125 companies with a list of compounders that will be much more familiar to investors, topped by GOOG:, GILD, RAI, PYPL and ORLY to name a few.

That is good company to keep.

-- END -- 

THIS IS NOT A SOLICITATION FOR BUSINESS OR A RECOMMENDATION TO BUY OR SELL SECURITIES. I OWN ARIS FOR MYSELF AND CLIENTS. DO YOUR OWN HOMEWORK OR CONSULT WITH AN ADVISER BEFORE MAKING INVESTMENT DECISIONS AND DO TRY TO IDENTIFY AND STAY WITHIN YOUR CIRCLE OF COMPETENCE. TRY TO EXPAND IT INCREMENTALLY AND OVER TIME.

The robot selling investments; brief thoughts on a trend

Summary bullet points:

• No one likes being sold to. Poor selling - especially of financial products - feels condescending and judgmental. 

• And in an environment where a generic Financial Adviser at a generic bank charges 1% to do essentially the same thing as a robot, it makes sense to choose the lower priced, self directed option. 

• Robo-investing painlessly resolves the conflict a lot of people feel about investing, that they should know more about the market but they've never found that foothold on which to engage it. The various online robo-options provide non-judgmental, non-condescending ways of allowing people to engage the markets. 

• But is it the best option? An undifferentiated approach to investing is now the most popular but it is not necessarily right for everyone. It reflects a misreading of academic studies as well as the lazy (and greedy) aspects of the mutual fund industry, which has become good at aggregating AUM yet can't possibly allocate it efficiently in an active style. This "race to the bottom" of AUM aggregation - not robo-investing - is hurting the industry. 

• The underperformance by funds is not only "The Paradox of Success" (raising too much money) but it reflects a lack of creativity in allocating asset. Everyone is crowding into the same trades. 

• Selling differentiated aspects of active investing without compromising integrity or returns on capital seems the best and most attractive option to me as I try to grow a nascent asset management business. 

I recently attended an event where a lobbyist spoke for three minutes of prolonged insincere, smarmy-ness, and towards the tail end - concluding with an awkward introduction to the event's organizer - I had this revelation: No one likes being sold to.

It got me reflecting on the generational shift in attitudes around selling and how much the avoidance of salespeople and "being sold to" might factor into shopping online.

Personally, I still enjoy the occasional face to face shopping experiences and the guided journey towards a better product. But online shopping is such a better alternative.

Ironically, the entire online experience is made possible by constant shuk-like efforts to sell me stuff I just bought. Despite the ubiquity of those efforts (not on this blog, mind you), the intrusiveness is algorithmic and therefore feels impersonal and "just sort of there", like billboards in the city.

I imagine the current batch of 20-somethings - the first generation to grow up exclusively with online shopping - is super experienced with the self-driven, yelp driven, review driven process whose independence makes the dopamine rush at its completion that much more of an accomplishment.

Concurrently, I think every generation has their enlightenment, and if my experience in my 20's is any guide, it involves some recognition that whatever we've learned up until that point is propaganda and hypocrisy, and there's ample room for improvement to make things a bit better, more honest and real.

With that frame of reference, I'm conflicted about the trend in "robo-investing", the simple, self guided, asset allocation method of online investing targeting today's 20-somethings.

On one hand, of course they're investing online. The only people surprised by this are traditional financial advisers.

On the other hand, I have a hard time understanding why the same person who might spend 20-minutes trying to find the right restaurant, glasses or sweater, might spend less time buying the least differentiated product with likely larger sums of money and more limited information.

I struggle with this "dichotomy" (whatever that means).

I have this nascent business - an investment management firm - focused on well-researched, patient ownership of terrific small businesses trading for discounts to my sense of what they're worth, and with enough integrity to avoid companies that despoil the environment and drop bombs on people's heads, (ie the roughly 30% of the S&P tied to energy, commodities, dirty power, and aerospace / defense).

And I'm trying to come up with a good questionnaire to help clients better establish an awareness of how they think about money and investing so they can better understand themselves (what's more important than that?) and also so I can better understand if it makes sense for us to work together.

So here I am exploring various ways of framing surveys to engage people in their attitudes about investing, when a friend suggested I was overthinking this and perhaps I should check out how a robo-investor establishes suitability.

On Wealthfront I was asked TWO questions, quoted directly below ...

1. When deciding how to invest your money, which do you care about more?
Maximing gains
Minimizing losses
Both equally

2. The global stock market is often volatile. If your entire investment portfolio lost 10% of its value in a month during a market decline, what would you do?
Sell all
Sell some
Keep all
Buy more

... and based on those two questions I was given a portfolio of Vanguard ETF's.

In an environment where a generic Financial Adviser at a generic bank charges 1% to do essentially the same thing, I can see how it makes sense to use the robo-adviser. Undifferentiated AUM aggregation is a race to the bottom.

And in an environment where a shady salesperson might ask only one question for appropriateness: "Do you want to invest? Perfect, I have the right product for you" the robot is certainly a better option (and the client won't feel dirty).

And somewhere in the middle is the traditional FA who might unconsciously talk down to clients: "I know it's hard to understand, let me do this for you."

In all of these worlds, I can also see how the robo-option painlessly resolves the conflict a lot of people feel about investing, that they should know more about the market - they hear about it everywhere - but they've never found that foothold on which to engage it. These robots - like online ads - provide a non-judgmental, non-condescending way of selling.

But I also think: "Wow, Wall Street has gotten really good at separating people from their money."

Because on one hand, if you want an undifferentiated approach, of course you should just take the cheapest alternative. But on the other hand, why should anyone accept an undifferentiated approach?

We've taken these academic studies about how a long held passive index fund will outperform the "average active investor after fees" and turned it into an undisciplined mantra, as if its a solution to everyone's needs. Average the shady salesperson racing for AUM against an honest investor with sound judgment, and after fees you'll probably return below the market. 

But find someone knowledgeable, trustworthy and good at this, and you might, for not much more money, become a shareholder in terrific business that you're proud to own, and some might turn out to be great returns on capital. 

I'm framing this from my own bias as an active investor, where index ETFs seem like the investment analogy of a glory hole; it gets the job done at the lowest cost possible, just don't ask what's on the other side. (For the super-rich, secretive hedge funds fill the same void and at much higher costs, because the rich person's burden is the need to pay more).

If you do ask what's on the other side, you'll find that it's a mass of businesses, and businesses within businesses, some too big to fail, others too big to succeed, which overall should grow at or near GDP, and whose value depends largely on interest rates and the comparative value of alternatives.

This is "the market" - mentioned every 15 minutes on the radio, etc. in the form of "The Dow" or "The S&P" - and the huge propaganda machine that says we should invest in it absorbs people into doing things they wouldn't normally do, like wagering their retirement and savings on it, day in and day out.

I think due to misinterpreted studies, people think the markets are less risky than individual businesses so they throw their retirement savings and 401k's and money at them. I can't wrap my head around that. Would you rather own a handful of things you know, want and like, or bags full of random things, including those that aren't necessarily good for you, that pollute, that despoil, that kill?

I'd prefer to invest in actual businesses I (and my clients) won't feel dirty owning and that can provide meaningful returns on capital over time, no matter what "the market" does.

There are lots of people out there investing this way. Like some of them, I aim to be an open book, a guided journey through investments and analysis, providing clients with exposure to individual businesses that generally aren't in the indexes, that are well managed, generate cash, seem inexpensive and over time could grow materially faster than GDP so that perhaps at some point - if things work out and the value is realized - ownership in these businesses can compound capital faster than the market. 

And I do this without exposure to companies that drop bombs on people's heads or despoil the environment b/c my clients capital should have as much integrity as they do.

It makes so much more sense to me than the undifferentiated approach. Maybe I just need to find the right robot to sell it?

-- END --

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

$WELX: An investment in Beatles history and nostalgia

As readers of this blog know, owning stock makes you a part owner of a business. This is why owning shares in tiny $7.8M market cap pink sheet listed company Winland Electronics (WELX) makes shareholders part owner of Beatles history and nostalgia.

I'll explain ...  

WELX has a day job selling remote sensing equipment used to monitor (track, log and alert) temperature, humidity, water leaks and power changes within buildings. Their products include the WaterBug, TempAlert, PowerAlert and top of the line, EnviroAlert800-ip, which has inputs for up to 12 sensors and requires a subscription to a cloud based monitoring service, their entry into IoT.

Here's the product catalog. 

I've seen these products in the closets / mechanical rooms of rental buildings, but they are also in commercial refrigerators, food or pharma plants and other industrial processing that requires certain environmental monitoring. They are not fancy like the Nest but work out of the box. 

There's a lot to like about that tiny little business though its not for every investor; revenues are highly concentrated and at 4x book, etc. it's trading at nosebleed valuations.

The valuation reflects (obviously) a desire by some to own the stock for among other reasons that the company has transitioned from a manufacturer, to an asset light model, and some expect even possibly to an investment vehicle for its two Co-Chairmen: Thomas Braziel and Matthew Houk.

You've probably not heard of them but they've had some success investing, Thomas through his firm BE Capital and Matthew through his work at Horizon Asset Management.

Houk, one would presume, is good at what he does since his boss at Horizon, Murray Stahl, acquired 15% of WELX in late 2014, which is another reason for the valuation, given Stahl's fame as a "guru" in the investment world.

In short, this is really about putting money on two young jockeys (so to speak), and alongside Stahl.

A lesson I learned a long time ago is that if you have a chance to meet a CEO or Chairman and you find them to be terrific capital allocators with high integrity and great ideas on long term shareholder value, sometimes its best to just make an investment in them and let them do their thing, even if "that thing" is not totally known ahead of time.

Some might say this is investing with your eyes closed, misunderstanding everything you see, b/c another lesson I learned even longer ago is not to blindly follow what you read online or promises you hear from someone with an angle. Saying "no" a lot - A LOT - and the ability to separate the "A" ideas from the rest is the hallmark of the best investors.

But unless you're building something yourself, investing is ultimately about entrusting your capital with the best capital allocators you can find, whether its a coffeeshop owner (entrusting them to build the right space that attracts customers), an industrial company (entrusting mgmt to anticipate the right product mix), etc., and at a price and with the right concentration so that the inevitable blips and bumps don't hurt you.

The problem of course is how to find good capital allocators. I think my brief experience as a PI helps with that, though I might be overstating its benefits.

In any case, the "investing in a jockey" theme isn't some new ground breaking idea. I doubt most people understand at all what's going on at Berkshire but a few own BRK b/c Mssrs Buffett and Munger are "terrific capital allocators with high integrity and great ideas on long term shareholder value." It is why I own WELX.

The aspect of being a part owner of Beatles history came later and is just the sugar in my coffee. 

***

Many museums don't have budgets to put on one-off special shows so companies like Exhibits Development Group (EDG) create shows, sell them as a turnkey solution and - if the shows are successful and desirable - keep selling it over and over, presumably collecting some % of ticket sales.

Its an easy model to comprehend; build the exhibit and resell it over and over. The incremental cost after the first show is ostensibly zero, the rent in theory is zero since the museums host, the material is probably part of someone else's collection, insurance might even be carried by the museum. The point is, in theory its a tremendous business that requires little capital and if things go well, generates cash.

One new show that EDG is putting on is a collection of Beatles memorabilia titled "The Magical History Tour", whose world premiere was at the Pacific National Exhibition, in Vancouver, BC in August 2015 and just opened at the Ford Museum in Dearborn, MI to good reviews. Other venues to host the exhibit include the Chicago History Museum, Chicago, IL; Putnam Museum of History & Science, Quad Cities, IA; and Minnesota History Center, St. Paul, MN.

To put on this show, created an entity called EDG-PMA LLC, reflecting the partnership between EDG and Peter Miniaci & Associates, the group of four Beatles collectors who supplied items for the show.

WELX, through an investment vehicle I'll explain below, currently owns 14% of an investment in this LLC but it won't be long 'til more belongs to them b/c - if everything works out - that investment will eventually convert into a 25% stake.

Here's how the investment was put together: Two investment groups - WELX and FRMO Corp an unnamed third party* - created an investment vehicle called Northumberland with initial investments of $200K and $1M, respectively and owned proportionally. Thus, WELX owns 17% of Northumberland and an unnamed third party owns the rest. [* i'd previously thought FRMO was this unnamed third party but can't find my source for this info, so i've edited that out as of August 2018. it's not financially material but transparency has value for its own sake]. 

Northumberland invested this $1.2M to EDG-PMA LLC. It looks like a loan but acts like a convertible preferred equity. In return for the loan investment, EDG will pay interest at an irregular dividend of 10% and once the loan  the investment is repaid - this is key - Northumberland will own 30% of the LLC putting on the show.

Furthermore, when the investment converts to equity, WELX will end up owning 83.33% of Northumberland meaning it will own 25% of the LLC. (30% * 83.33% = 25%). I reckon its set up this way to utilize WELX's NOL's, so the profit they take might equal the profit they make without sharing it with the taxman (rim shot).

The Beatles I hear, are pretty popular and if this ownership continues indefinitely and the show can continue, it should generate solid cash flow for as long as the LLC has access to the pieces in the show.

Obviously, all investment carries risk as does this one, and of course, if you really want to own Paul McCartney's pick or George Harrison's notebook, eBay or other venues might be most appropriate. The value of Beatles memorabilia might even be enhanced as a result of the new show, which I hear is worth a visit if you're passing through Dearborn.

Full text of the investment language follows.

"On Friday, July 10, 2015, the Company completed an investment of $200,000 in Northumberland IX LLC (“Northumberland”), an entity formed with another third party to invest a total of $1.2 million in EDG-PMA, LLC (“EDG-PMA”), itself an entity formed in cooperation with Exhibits Development Group, LLC (“EDG”) to develop, design, construct, market, place, own, and operate a traveling museum exhibition presently known as The Magical History Tour: A Beatles Memorabilia Exhibition. 

"Northumberland’s investment in EDG-PMA is effectively structured as convertible preferred equity. 

"The convertible preferred equity pays an irregular preferred dividend at a rate of 10 percent per annum on any outstanding principal balance and is immediately convertible into 30 percent of EDG-PMA common equity upon repayment of Northumberland’s $1.2 million principal amount, the timing of such repayment being dependent on the distributable cash flow of EDG-PMA." 

"Until repayment of Northumberland’s $1.2 million principal amount, the convertible preferred equity is entitled to the entirety of EDG-PMA distributable cash flow. Prior to the repayment of principal, the Company’s interest in Northumberland is proportionate to its $200,000 investment. Following the repayment of principal, the Company’s interest in Northumberland shall be 83.33 percent." 

-- END --

This is not a solicitation for business or a recommendation to buy the stock just something unusual about a stock that I thought readers would appreciate. It is based on public filings but I can't vouch for the accuracy of those filings or of this blog post.. This "safe harbor" statement is meant to cover my ass and to remind readers they are responsible for their own research and investment decisions. At the time of this writing, I own some of the stock. All investing carries risk particularly small cap equities and that risk includes the potential for a total loss of capital.

Kicking around a new idea: $PSSR Inexpensive and Independent Airspace Technology Company

Summary bullet points:

• $PSSR is a micro-cap with long operating history in aerospace technology and improving balance sheet.

• Book of business is growing with recurring revenue subscriptions and the tailwind of long term industry trends.

• Trading at inexpensive 5x EBITDA despite visibility into continued revenue growth.

In a recent article in the WSJ about a successful test using blockchains (ie bitcoin technology) to record transactions in the credit default swap market, I read the following quote ...

"Some may be reluctant to make changes that threaten their own market share or introduce new complexity to current systems that have been tested and refined over the years."

... and it struck me as something that could have been written about any industry, at any point in time in history.

This post is about technological change in the aerospace industry, NextGEN, and a tiny company called PASSUR Aerospace (PSSR) that until 15 years ago had a niche in "old technology" but is evolving with the "new technology" and could have an opportunity - given its established space in the industry, its slate of solutions that support NextGEN and recent hires - to grow revenues, maintain margins and thereby expand ROE and ROA back towards double digits.

The "old technology" is locating airplanes on a map, once essential, soon to be ubiquitous. The "new technology" is helping their customers - airlines, airports and ATC's - analyze, understand and make sense of enormous amounts of information to make better, faster and more efficient decisions around airspace and airport operations; scheduling, on the ground asset management, and routing.

Many larger companies are focused on using algorithms to provide better information for these customers. PSSR says its competitive advantage is +20 years of data analysis tracking its own and other information for more accurate predictive software.

I see another advantage as the stickiness of real estate in the enterprise, in the airport and ATC - the company has been there for more than 30 years - combined with finding solutions for airline customers that actually improves efficiency (a member of the board Kurt Ekert says he was formerly a sr employee at Continental Airlines when he found the company as a customer and fell in love with the product).

If ...the industry continues to modernize and evolve, if ... the product continues to improve and if ... the company continues to focus on meeting needs of existing customers, the stock could be attractive - revenues have grown recently and deferred revenues (a measure of subscriptions) imply continued growth - while the current valuation of of 5x trailing EBITDA seems to discount much in the way of a positive outcome.

I don't make price targets or predictions but I can imagine a future where continued and consistent steady growth and cash flow justify a higher valuation off of a larger pool of profit, while the balance sheet continues to delever, implying the potential perhaps for material growth to shareholders. Or not?  I am still trying to learn more; continued study and patience will be key.

PASSUR was founded in 1967 and has been publicly traded for more than three decades.

For most of this time, it operated under the awful / awesome name “Megadata” until 2008, when it changed its name eponymously to the pronunciation of the acronym of its heritage product, “Passive Secondary Surveillance Radar”.

Underlying PSSR – the acronym – are fixed radar sites – currently 185 in all - the largest passive commercial radar network in the world - at or near airports mostly in the US but also in Europe and Asia - that provide faster and more accurate position updates to airline operations control and ATC's. (These are the spinning radars that are used as establishing shots in movies, typically followed by skidding wheels on the runway).

The company once sold the machines, then sold the information from the machines as a subscription service. This fixed asset - and the service from it - gave PASSUR its name in the industry for solving the problem of locating an airplane and putting it on a map. As an example of this legacy, after the 1996 crash of TWA Flight 800, its radar network helped establish the precise location of the airplane at the moment it exploded and also the locations of other airplanes in the vicinity that might have witnessed it.

For several decades that legacy business was niche, yet essential and unique in busy airspaces. But new technology - notably ADS-B - is disrupting that position. By 2020 all airplanes flying in US airspace are required to have ADS-B - whether or not this actually happens is unknown - but it would make passive secondary surveillance radar a redundancy.

However PSSR is evolving ... and this brings us to NextGEN 

If you read the newspapers you've heard of NextGEN, perhaps as a bloated and expensive, FAA program; a failure; a plodding success; an over-promised and under-delivered program to - depending on your viewpoint - upgrade airspace technology to improve efficiency and safety in US airspace; or to simply force all the air traffic controllers out of work.

But NextGEN's over riding ambition is to modernize the US aviation system "... to improve the operational performance of the national airspace system."

Because of the collaborative nature of the US airspace, the benefits of any modernization at one airport or in one airplane isn't effective unless surrounding regional airports and airplanes using those airports also upgrade.

In the simplest least complicated explanation of NextGen, it is an effort by the FAA to "quarterback" the collaboration required between the primary agents in the industry ...

Airlines (ie operators)
Airports
Air Traffic Control Towers

... in order to modernize the US airspace.

The whole plan unfolds in a tough politicized environment where there is reluctance to change "... or introduce new complexity to current systems that have been tested and refined over the years" as per the introductory quote.

Big contracts. Government agencies. Modernization. It's all very complicated, long term and likely to benefit the large industry players, right?

The RTCA (Radio Technical Commission for Aeronautics) is an industry advisory committee used by the FAA as a "Public-Private Partnership venue for developing consensus among diverse, competing interests on critical aviation modernization issues in an increasingly global enterprise."

And here - among many places - is where PASSUR plays a part; despite their small size they are trusted, independent and known in the industry, so they have a seat at the table helping to develop, implement and track NextGEN priorities as well as participate in opportunities to improve operating efficiencies in the industry.

Furthermore, their "last generation" technology isn't so last generation; they continue to roll out new SSR systems at airports, as backups and redundancies.

And finally, they have been generating meaningful - and it seems recurring - revenue growth helping airlines and airports use the enormous quantities of data available to airlines from a variety of sources to solve one of three general problems that occur primarily when weather disrupts flights ...

• Better ETA’s and ETD’s to airlines improve on time performance and better prepare for arrivals and departures.

• Better on-the-ground airport information (ie “surface management”) to improve – among other things - turnaround times and on-ground performance.

• Better air-traffic management to safely accommodate increased overall capacity in the airspace and airports.

... in predictable environments these things on their own are not terribly complex but throw in diversions associated (most frequently) with poor weather and non-linear problems around availability of runways, gates, crew time, surface equipment, etc. begin to escalate.

This is where PSSR's service / solution / revenue generation comes in. The company integrates its own sources (PSSR) with other available data sources (ADS-B, ASDE-X, Mode S, En Route Radar, Airline OOOI data, ACARS, fleet databases, etc) as a data feed to flight and airspace information, then runs the data through its own algorithms and uses it to provide better analysis for predictions and performance, which ultimately supports better decision making by its customers.

It sells services and software systems via subscriptions that provide more efficiency in various aspects of the airline industry. Large material customers include $LUV and $JBLU in their most congested regions that experience weather.

I hate to rely on cliches and jargon but this where I'll throw out the term "big data" with a link to an HBR article about how PSSR - and Sears Holding (lol) - are using "big data" to improve operations. (take it FWIW, I felt I had to reference the article).

A key question here when we reflect on the world of big data is why aren't other people doing it, why is PSSR still independent, why aren't revenues higher, etc? 

On the face of it, having better resources to solve these problems sounds like a “no-brainer”. However, based on our research and our understanding of the industry, there are headwinds to customer adoption of both solutions.

• On ETA / ETD, it’s not generally seen as a complicated problem where the benefits of shrinking the ETA / ATA gap is seen as critical. When a plane leaves late it can fly faster, weather remains an acceptable excuse for delays and with the exception of the most congested airports, “good enough is good enough”.

• On on-ground performance and turnaround times, the biggest factor is planing and deplaning customers. A subscription service that improves on ground performance without improving that process does not appear to be a problem customers feel need solving

• And finally, reference the quote at the beginning of this post. A source I spoke with at a competing company who said the PANYNJ, which manages some of the busiest airspace in the world, is a huge obstacle to investment in new technology for reasons as simple as "turf battles".

In light of these obstacles, the answer to selling a customer a solution to a problem they don’t feel they have and in a crowded and competitive field is to increase and improve selling and marketing function. PSSR is doing this, it appears with early initial success albeit with some degradation of margins (EBITDA margins now 28% down from the mid- 30% range; we'll get to this in a minute).

But the investment thesis that underlies the opportunity for material long term gains is that there will be an evolution in how these problems are viewed by the customers.

We have seen examples in other markets and industries where marginal improvements were deemed unimportant and unnecessary until eventually they became essential and ubiquitous.

That is the path to a maximal and exciting return. For the patient investor, if that evolution occurs and customers are willing to pay, there could be material gains. In the meantime, you're getting some solid "blocking and tackling" at a low multiple.

FINANCIAL PERFORMANCE
We see a company growing revenues and backlog, this as a decent cash flow generating growing business trading for a low multiple at today’s prices.

Revenue and Subscription (aka backlog) Growth
The evidence demonstrates that since losing contracts in 2012/2013, quarterly revenues have been growing through 1Q16 (quarter ending 1/31/16) with pronounced sequential and y/y over growth over the last four quarters. The company indicated the "lost contract" was not a recurring revenue "core" program but a one-off for DHS.

This chart tells the current growth story (revenues) as well as the future growth through two balance sheet items that capture the equivalent of “backlog” (ie subscriptions); they are deferred revenue netted against accounts receivables. Higher levels of subscriptions should lead to continued higher levels of revenues over the next 12-months leading to potential growth acceleration.

Balance Sheet Improvement 
When we think about a business and its all-in consistency, we look for companies with good balance sheet management as reflected in growth in shareholder equity. Here the improvement since 2012 has been slow and steady . The bulk of improvement prior to that came via a partial recapitalization / debt to equity conversion in 2012. The company’s primary shareholder GS Beckwith Gilbert owns 4M shares (53%) and is also the note holder on the $3.5M in outstanding debt.

High EBITDA Margins, but Investments in SG&A a Headwind
Until recently, EBITDA has largely kept pace with the growth in revenues. However, new hires in the last 12 months have absorbed a greater share of expenses.

The new hires that impact SG&A include back office talent as well as customer facing talent:

• David Brukman, CTO.
• David Henderson, CFO
• Leo Prusak. Former FAA Deputy Director to head airport operations
• Bob Junge, formerly head of JFK airport operations, to sell airport solutions
• Howie King, formerly of competitor Saab Sensis, to be a director in business development

Other evangelists for the product include …

Jim Barry, CEO
Tom White, head of product
Chris Maccarone, airline performance

The impact of these new hires might be evident in future revenue growth but it is certainly evident in current SG&A which at 1Q16 had increased 38% to $1.6M; it is as high as its ever been and is now up to 48% of revenues, up from the 38% average in the prior five years.

The question of course is, can the revenues scale these new hires? The evidence from recent revenue and subscription growth is that it is on the way.

COMPETITION / CONCLUSION
Current competitors that sell “data driven” solutions tied to weather diversions, on ground performance and operations systems management include SAAB Sensis, Navtech (an airspace technology company recently acquired by Airbus) and IBM / weather channel, but none are as narrow and focused as PSSR.

The risk associated with competition should include the question: "When does google get into this space"? In some respects, though the degrees of complexity are different, the evolution of NextGen is not materially different from the evolution towards self driving cars. Many of us already use devices for routing, ETA management, etc when driving. I would argue its easier to penetrate the automobile since there's no "gatekeeper" (or union) advocating obstacles to automated driving the way there is keeping it out of the ATC or cockpit.

To this aspect, I see the company's legacy through the lens of that initial quote as a benefit. The company's real estate in the cockpit, ATC, and operating control room has value; the company is trusted and present. Best of all, they have been evolving slowly and successfully in the right direction.

As I've dug into this industry, I've been surprised with how "old fashioned" it is. On the front end, the customer interface seems to have leapt forward with ticket ordering and boarding pass apps and the evidence shows that overall safety has improved as well.

However, on the back end, based on what I've learned, many companies continue to operate inefficiently - and more critically - airports, municipal authorities and ATC's are as well. As someone told me recently, "the air traffic control system in this country is so antiquated, it would scare the shit out of you if you knew about it."

Because airlines, airports and ATC's are all partners in the industry ecosystem, the full benefits of an improvement by one agent - an airline say - in on time arrival might not result in faster turnarounds if the airport or ATC doesn't improve efficiency and a gate isn't available. Again, this is the reason for NextGEN.

It makes for an interesting investment quandry, because the situation can go on indefinitely. Ultimately however, my investment thesis is driven by the view that while improvements in efficiency can be overlooked and ignored eventually they became essential and ubiquitous. And in the meantime, you're getting a company that has a long history of quality management,

RISKS

There are obvious risks with investing in general, nano-cap specifically and in particular companies - like this one - with ownership concentrated in the hands of one person.

Beckwith Gilbert owns ~53% of the equity of the company (4.1M shares) plus the $3.5M note paying 6% interest. He is by many accounts committed to the success of the company and was willing to stand by when it had financial difficulties but it is unclear he is committed to returning shareholder value and that's made me cautious on this position in my portfolio.

Two issues specifically give me pause:

1. His compensation. Mr Gilbert is paid  $300k / year for his role as the Chairman, which is as much as the CEO, Jim Barry, who does most of the heavy lifting. I have no view on what Mr Gilbert does to earn his compensation but it is in addition to the interest he receives on his $3.5M in debt to the company. Viewing that $300k comp as a form of interest expense on the debt, the implied rate on the debt is closer to 16%, which is well in excess of junk yields.

At face value, perhaps it should be viewed as an indication of the speculativeness of the investment with as high a degree of risk as a junk bond.

2. A comment to me about his goals for the company. I recently attended the shareholder meeting and followed up with questions after digesting what I'd learned. A final question of mine, which I like to know from all executives of all my investments, is what are the goals for company, or in short: "why"? Why be in business? Why do this? Often its just lip service but sometimes there's a commitment to customers, to employees, to shareholders, etc.

In this case, when asked why they're still independent (given that some have rolled up and been acquired) his answer was along the lines of "b/c it's more fun to be independent and take on the big boys."

And when I asked about the long term goals for the company, where they expected to be, etc. there was no comment beyond "having fun".

I don't think that's untrue - there is something refreshing about that - but what does it mean for shareholders and maybe even about the employees who don't have the same financial independence as he has.

I think its much more fun to have winning investments. 

ABBREVIATED GLOSSARY OF AIRLINE TERMS
ADS-B. Automatic Dependent Surveillance - Broadcast

ASDE-X. Airport Surface Detection Equipment, Model X


ERAM. En Route Automation Modernization.

TAMR. Terminal Automation Modernization and Replacement. "The TAMR program is upgrading air traffic control systems at terminal radar approach control (TRACON) facilities across the national air space (NAS) with the Standard Terminal Automation Replacement System (STARS) platform."

TRACON. Terminal Radar Approach Control

STARS. Standard Terminal Automation Replacement System

-- END --

ALL RIGHTS RESERVED. THIS IS NOT A RECOMMENDATION TO BUY OR SELL SECURITIES IT IS MY OPEN BOOK / EDUCATION OF A SINGLE COMPANY THAT LCA AND / OR ITS CLIENTS MAY OR MAY NOT OWN AT ANY GIVEN TIME. THIS IS NOT A SOLICITATION FOR BUSINESS. DO YOUR  OWN HOMEWORK.

"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. 

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

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:

On page four, another Buffett quote / reference AND Howard Marks. 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.

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

There's a cognitive dissonance in the letter that might be lost on someone who doesn't follow sports but the record shows that over the last three seasons Hinkie's 76ers have won just 47 games out of a total of 242 played. That's a 0.24 winning percentage.

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. And he's leaving before he can really test his capabilities.

The whole thing is funny to me almost in the way it would be funny for a passenger to learn that his pilot studied from the greats, but never learned how to land.

To his credit, and as Hinkie's letter points out, the team's plan all along was 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 looking at the record alone isn't fair to Hinkie. But his resignation tells another story.

Although changes in the executive suite resulted in his having to share power with more traditional basketball minds (Bryan Colangelo) 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. 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."

Talent evaluation and stock picking are bound by the same science of projecting and valuing some unknown future.

Today's investors are told to punt on stock picking and just buy a diversified portfolio. Hinkie does the same by accumulating a volume of assets instead of focusing his efforts on finding the right ones. Again, this is the un-Buffett approach.

Is Hinkie a good talent evaluator? It takes at least three years to known 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).

Maybe Hinkie knew the edge of his competence so he compensated for it by accumulating a volume of picks so he could diversify. This would explain his penchant for accumulating 2nd round picks. Or maybe the Sixers execs compensated by bringing in someone they felt was a better talent evaluator. either way, Hinkie won't be around to conclude what he started and it may be awhile before he finds another job in the NBA.

***

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

why i screen and what i screen for ...

"At a certain season of our life we are accustomed to consider every spot as the possible site of a house ... "

So begins Henry David Thoreau's famous essay "Where I Lived and What I Lived For" the title of which I've stolen for this post. In repayment, I might as well copy the whole first paragraph, which speaks lyrically of investing ones imagination and ends with a most famous and beautiful proverb:  

"... I have thus surveyed the country on every side within a dozen miles of where I live. In imagination I have bought all the farms in succession, for all were to be bought, and I knew their price. I walked over each farmer's premises, tasted his wild apples, discoursed on husbandry with him, took his farm at his price, at any price, mortgaging it to him in my mind; even put a higher price on it — took everything but a deed of it — took his word for his deed, for I dearly love to talk — cultivated it, and him too to some extent, I trust, and withdrew when I had enjoyed it long enough, leaving him to carry it on. This experience entitled me to be regarded as a sort of real-estate broker by my friends. Wherever I sat, there I might live, and the landscape radiated from me accordingly. What is a house but a sedes, a seat? — better if a country seat. I discovered many a site for a house not likely to be soon improved, which some might have thought too far from the village, but to my eyes the village was too far from it. Well, there I might live, I said; and there I did live, for an hour, a summer and a winter life; saw how I could let the years run off, buffet the winter through, and see the spring come in. The future inhabitants of this region, wherever they may place their houses, may be sure that they have been anticipated. An afternoon sufficed to lay out the land into orchard, wood-lot, and pasture, and to decide what fine oaks or pines should be left to stand before the door, and whence each blasted tree could be seen to the best advantage; and then I let it lie, fallow, perchance, for a man is rich in proportion to the number of things which he can afford to let alone."

Thoreau established an early precedent on the great american obsession with real estate.

***

The catalyst to this post is a response to a recent one on the popular microcap blog "oddball stocks" about whether or not screening has any value.

I unabashedly use screens and believe they have tremendous value for narrowing the spots one might consider the site of a house, or for the type of house one might consider building, to paraphrase Thoreau.

***

The goal here is to write about why I use screens, investigate their strengths and weaknesses, explore some that I use and describe the kinds of companies that turn up.

To lay out expectations, I am a fundamental equity analyst and I use screens to look for ideas and narrow my universe. This is not a quantitative guide where one can read a random investing blog and learn "a guaranteed way to make a lot of money without doing any work". I guarantee this is not that.

As with other posts here, I hope readers will walk away with new ways of thinking about companies in general, or investing in general, or a new specific idea to think about on their own or a new arrow for the quiver when it comes to screening stocks.

***

Screens in my view are best for creating "idea funnels" that - when paired with substantial fundamental research - helps uncover some compelling investment ideas.

Pairing screens with fundamental research offsets their two biggest weaknesses:

1. Screens - and arguably all financial data - is backward looking while the present value of an asset is its future streams of cash flow discounted back. The work with investing is "knowing the future" - or estimating it to some degree of probability - and screens don't help with that but fundamental research can.

2. Screens are dumb quantitative tools if used to blindly buy stocks that fit certain fundamental operating parameters (not price or valuation related). But when paired with a qualitative process it can be an exceptional tool of winnowing and categorizing great companies and potential ideas.

I'm not someone pursuing an algorithmic trading mechanism based on bell curves and least squares. I aim to become a part owner of a few sustainable well managed businesses, to own them for long periods, and to buy them at a price that will result in outsize returns should my very realistic expectations for the future work out as expected, and with multiple paths to success. I think screens help identify such opportunities.

***

As an example of how this all works together, a month or two back I ran a screen that kicked out among a short list, $GEOS, a company that at the time had good recent financial results, a long history of "value creation" (ie growing bvps) but was trading at its 52-week low.

$GEOS is a technology company that makes undersea seismographic equipment for mapping the seafloor and is used in the offshore energy exploration industry. Very cool stuff.

My research into the company illustrates my two points above.

1. Backward looking results reflected a backward looking operating environment. The bust in oil prices meant last year's results are no model for this year and next.

2. As a dumb tool it would have lead to a dumb outcome but paired with qualitative work, it helped identify an interesting idea.

Digging into the $GEOS financials, it was easy to identify that the company has been around for more than 20-years and most incredibly, with largely the same management team intact, providing a significant sample size from which to make assessments.

The success of management through several cycles became an important data point for me. Due to acquisitions the deep past wasn't a perfect proxy financially but given the long tenure of management paired with 20 years of public filings, it was quick work to extrapolate patterns of successful behavior, notably making hay during strong energy cycles and exiting those cycles with clean balance sheets, limited capital intensity and a focus on new product development.

All of this is a very simplified way (I put several hours of work into the idea) of saying a patient investor could (and perhaps still can) buy the stock at a point where the market is discounting a bleak future provided they are willing to hold until prices rebound. The beauty of this vs other energy companies in my opinion is the low capital intensity.

So here's in brief a situation where a screen operated successfully as a funnel and when paired with the fundamental research indicated meaningful information that exposed  a long rich history where just the recent past would've provided false comfort.

Incidentally, it's the kind of history that can't be screened for.

That said, ultimately, we deemed the $GEOS idea inappropriate for our clients. At Long Cast Advisers, we believe that capital should have as much integrity as our clients missions. Seeing that $GEOS makes equipment onerous to marine mammals - apparently it disrupts their ability to hear - it failed our firm's "integrity of capital" mission, but the effort illustrates the strengths and weaknesses of screening and how it works best paired with a qualitative process.

***

I've lagged since my last post and have been taking a long time on this b/c I've been working on a handful of home projects. The most time consuming was rehabbing two large pieces of furniture I found at my in-laws house to use as a dresser, desk and storage combo for my kids.

The work involved wasn't that intensive - sanding, priming, paining and replacing the hardware - but due to space constraints, I had to work on each piece separately, so it was like two projects in one.

The boredom of priming / painting was overcome by listening to Marc Maron's WTF podcasts. If you're not familiar with him, he interviews entertainment folk comedians, writers, actors, directors and producers (and occasionally heads of state) in the entertainment business from his studio garage.

I listened to, among others: Sacha Baron Cohen, Charlie Kaufman, Brian Grazer, Crispin Glover, Todd Haynes, Sarah Silverman, Eric Bogosian and the two brothers who make the HBO show "Togetherness".

These are all folks that have hustled hard and endured a lot of failure for their craft and I couldn't help but find similar - nearly identical - dynamics between investing / starting an investment business and the "creative" pursuits of these performers.

I found many analogs b/t the two professions, and specific to this topic, they all filter their material through some sort of screen to determine if a joke is funny or an idea is good.

To an investor, an investment screen is simply an automated form of one of these filters. Other non-financial filters investors use - consciously or not - include the bullshit filter (if it sounds like bullshit, it probably is), the sleep filter (does it keep you up at night?), the exercise filter (how you think about the stock when you're working out), the shower filter, etc.

Are these filters the same for everyone? Investing is one of the most personal exercises and we should all learn to develop and trust our own filters. What I find to be a good idea might be very different from what other people think and - by its nature - is often very different than what the rest of the market thinks.

Just as an artist needs to be comfortable with their filters to engage in original work, so do stock pickers have to comfortable with their own filters to find and invest in good ideas.

As we all mature and improve with our work - in the arts or investing - we can better discover the source of good material and hopefully tap it more frequently. As with the arts and investing, veritas vos liberabit.

***

For my screens, I use screener.co. I have no affiliation with the company other than as a customer. Were I to have any choice, I'd go back to Factset, which I used when I worked on the sell side, but it's wildly expensive for this startup investment manager and Screener.co is a good alternative plus the trial period cost (free) is unbeatable.

Now, for an investor seeking quantitative screens under the familiar academic models, save time and simply go to oldschoolvalue and it will provide a variety of stocks that fit various magic formulae.

I've never really dug into these formulaes (until now) but based on what I'm reading on investopedia, the Piotroski method seems to be the sort of thing I tend to look for with a certain type of investing: book value growth, positive cash flow, and no dilution. That's as good a starting point as any.

However, the beauty of the screener vs OSV is that you can start with those methods and layer on top of it any number of factors to further narrow the field.

Some traditional simple screens I use include ...

recent rev growth + operating margin expansion
long term growth in shareholder equity
stocks trading near 52-week highs or 52-week lows
stocks out / under performing the S&P by more than 20%

... those former two are driven by quarterly results and won't change week to week or between reporting periods while the latter two are price driven and will change daily.

Some more complex screens I've used include ...

receivables growing faster than revenues
inventory growing faster than COGS
recent decline in revs + operating margin compression but growth in operating cash flow, etc etc

... I can easily spend hours tweaking inputs to test different theories of business drivers even if it only results in a handful of new ideas.

Considering the options available in a screen, it can be overwhelming to a novice, but a great jumping off point for thinking about screens is Howard Schillit's classic, "Financial Shenanigans", some of whose pages are taped to the wall by my desk.

It's one of the most important books I've ever read on investing. The proximate reason is that it identifies how companies tend to hide weak performance but ultimately its about how business operations translates into accounting, and accounting is the language investors engage with in their work.

It's a book that helps investor identify the weave in the fabric as opposed to the billow of the flag.

***

I consider screening as an essential tool for investors. There are those that bash screening, I imagine b/c of the weaknesses I mentioned above, since a corollary to those weaknesses are that it doesn't identify companies in turnaround or with undervalued assets on their balance sheets.

Fair enough. But as with all tools, their usefulness varies with the inputs and in whose hands they are used.

Another project I recently worked on was the repair of an old writing table with an unusually arched and severed leg whose repair would make a handsome desk for my office.

I figured to make a spline joint for the repair and consulted with a neighbor who repairs old pipe organs for a living. He suggested I use a chisel and forstner bit to carve out the space for the spline, two things I'd never used before (I'd intended to use an inelegant dremel) and in retrospect I think his advice was driven by his passions as a purist and mine to learn new tools and techniques.

It was a soft wood, and the chiseling was easy ... but imprecise ... and when I was finished and gluing up the pieces it was like holding an overflowing double Shake Shack burger with the sauces oozing out everywhere. It was a total mess. In last minute desperation I salvaged the work with two small cross dowels to lock in the spline and called it a day. I work atop the desk now as I write.

The point is that a chisel and forstner bit, like a stock screener, are only as useful as the experience of the person wielding them. Though I'm a novice at woodworking, I have a lot of experience with screens and I aim to show here a few useful methods to open up and share with others information I use for myself and find helpful in my work.

***

What parameters are important for screening? That's up to investors to decide. And it might change with the cycle or interest or desire to diversify types of investments.

I think a great way for investors to think about this is to start with a favorite company, identify a few trends or financial items deemed material to its success, plug those trends into a screen and see what other companies share that dynamic. I am sure there will be a few surprises.

Sophisticated quantitative investors use this same method - I think they call it multivariate regression analysis - to identify both what is "material" and what other companies share those dynamics, but you can do the same with a very modest amount of effort.

*** 

How often should one screen?

At Long Cast Advisers if we can find 5-10 good ideas a year, we are good shape. So we don't screen every day and when we do screen, we spend a long time honing ideas and parameters.

When filling the ideas funnel, we just follow where it takes us, and sometimes it leads nowhere, or to ideas that might lead to corollaries to other ideas down the road. It opens the door to the imagination and creativity required in investing, thinking broadly about what inputs have lead to said results, how they might be changing, who else might be impacted by them, etc.

Ironically, the screening process is almost the antithesis of the investment process, which is highly regimented, structured, and process / checklist oriented.

On top of the fundamental screens we look at, you can easily layer a parameter for stocks that are down more than 50% in the last 52-weeks, or making new highs / lows, to capture companies that  have sold off / moved up for reasons that the market is wont to do every now and then.

***

Since Long Cast Advisers focuses on small cap stocks, we start by narrowing the pool by market cap and geography and types of companies. There's a video here that explains how to use screener to narrow the pool by a variety of standard or basic functions. (That video helped me to scale the "screener" learning curve).

So here's the basic screen I use most of the time before I start adding parameters ...

I start by narrowing markets to: NASDAQ, NYSE, OTC and unlisted securities.
>> Click on "markets" upper left and add the ones I want to use

Then I narrow search by market cap (>$1M but <$500M) and eliminate companies domiciled in China and industries that don't interest me. (note that i use "create free form condition" for all of these inputs)
Market capitalization <= 500000000
Market capitalization >= 1000000
Country located in != "China"
Industry != "Banks" ...
Industry != "Investment Trusts"

Industry != "Closed End Funds" 

Obviously, you can narrow / expand this however you want; I know many colleagues who think I'm too narrow and love the overseas screening tool, I just haven't gotten there yet.

... then I think about what drives shareholder value, what evidence exists of it, and what kinds of companies I'm looking for at any moment in time.

A simple screen to look for something like this is simply looking for consistent at least 10% annual growth in shareholder equity where net assets exceed liabilities by 10% exceed without debt and acquisitions ...

( Total Stockholder Equity(A) / Total Stockholder Equity(A-1) ) > 1.1
( ( total assets(a) - Goodwill(A) ) / Total Liabilities(A) ) > 1.1

... and then repeat that comparing A-1 to A-2, etc.

A few things to note with these basics:
The time periods like "A", "A-1", "Q", "Q-1" follow the terms without spaces
Spaces are required between operators " / " or " > "
Spaces are required for parenthesis marks that group operators

... you get the hang of it after awhile and i've found the screener founder to be highly responsive to questions about formulae.

something a little more complicated I was thinking about recently is  a screen for companies growing organic revs and operating margin while generating positive EPS. My thinking here was to add a parameter that eliminated companies that had grown goodwill to avoid acquisitive growth.

Step by step:

Look for revenue growth mrq > 5%
( Total Revenue(i) / Total Revenue(i-4) ) > 1.05

Looking for goodwill to be relatively flat over that same period
( goodwill(i) / goodwill(i-4) ) < 1.05

Looking for OpInc margin growth mrq > 10%
( ( Operating Income(i) / Total Revenue(i) ) / ( Operating Income(i-4) / Total Revenue(i-4) ) ) > 1.1

And positive EPS mrq
Diluted EPS(i) > 0

... that resulted in 45 companies under $500M mkt cap that had those parameters as of the recent quarter. But I wanted to look for trends, so I rolled all the same parameters back one quarter ...

Revenue growth LAST quarter > 5%
( Total Revenue(i-1) / Total Revenue(i-5) ) > 1.05

again, goodwill relatively flat LAST quarter
( goodwill(i-1) / goodwill(i-5) ) < 1.05

OpInc margin growth last quarter > 10%
( ( Operating Income(i-1) / Total Revenue(i-1) ) / ( Operating Income(i-5) / Total Revenue(i-5) ) ) > 1.1

And positive EPS LAST quarter
Diluted EPS(i-1) > 0

... and now i'm down to 12 small companies.

Within this list are two I already know fairly well: OTCM, which I've long owned and REIS, which I've looked at a long time but have remained on the sidelines for a variety of reasons. CSCD is also on the list but is getting acquired so not interesting to me.

Now, I'm down to 9 companies that share dynamics with two that I already know really well.

Screener has a nice tool called "company profile" where you can click on the results of your screen and call up a quick chart, description, and summary I/S, B/S and C/F qrtrly or annually and that's where the qualitative filtering starts

the gobbledeegook filter >> does the company describe itself in clear simple language

the balance sheet quick filter >> are there any wild jumps (sequential and y/y) or smooth trends in basic balance sheet items like cash, a/r, inv, payables. I like to see total assets growing without growth in goodwill, and especially shareholder equity trending upwards b/c that's where mgmt is adding value.

From this screen, I get two ideas to go into the ideas funnel - $DLHC and $GV - b/c I've analyzed and understand the staffing and engineering / construction industries very well.

***

I was initially thinking I'd add a variety more screens but I realize it's a bigger topic than I anticipated and this was just my introduction. In the future I'll write about other screens I use without this long intro and I'll also provide readers with a little more of the fundamental process I use as well to analyze the companies.

I think pulling back the screen and defining the process on how I work has so many benefits. And in this day and age of free flowing information, how to add value to the commodity of information is the most essential aspect of knowledge.

-- END --

ALL RIGHTS RESERVED. THIS IS NOT A SOLICITATION FOR BUSINESS. INVESTING INVOLVES RISKS AND UNCERTAINTIES. IF YOU'VE READ THIS FAR, THANK YOU FOR YOUR INTEREST.