*This is my monthly letter to investors summarizing the month of November.
The full PDF version of the summary, including managed account performance data as well as a few added components is only available via email.
Return data will no longer be published as a part of the summary.
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Largest winning position in December: WMIH +145.22%
Largest losing position in December: CIDM -12.17%
New additions to portfolio: None
New liquidations in portfolio: EVOL
Portfolio exposure as of December 31st: 93% long/7% cash
Top 3 winning positions in 2013: WMIH +236% (unrealized), IWSY +165% (realized), SPNS +44% (realized)
Top 3 losing positions in 2013: PRXI -16% (realized), MITL -6% (realized), PTGI -3% (realized)
Portfolio Highlights For December
WMIH experienced an extraordinary month of gains following an announcement early in December that renowned private equity firm KKR would make a strategic investment in the company. This announcement created a gain of 145% for shares of WMIH during the month of December.
The KKR deal, assuming it is fully-consummated over the coming weeks, immediately alleviates a number of pressing issues for the company:
1. It takes away the possibility of any further discounts in the value of the WMIH NOL shell, accompanied by WMMRC (reinsurance entity), due to fears of equity somehow being shelved in a future deal that puts equity holders at a severe disadvantage. The structure of the deal between KKR and WMIH provides, among other things, a hefty grant of 5 year warrants collectively totaling 61.4 million shares of WMIH common stock at an average exercise price of 1.36. KKR upon exercise of the warrants becomes a significant shareholder in WMIH, therefore removing the risk of any devious, underhanded type deals that will diminish or exclude the upside for equity holders.
2. It confirms that the NOL shell, with a reinsurance company attached, that is WMIH will more than likely be cultivated into an entity within the financial arena that is substantial in nature. Companies like KKR and Blackstone, not to mention the all star board of directors that has been assembled, do not come together in this manner to simply put up lemonade stands seeking profits that are inconsequential in nature. These are home run hitters. They seek out situations that in 2, 3 or 5 years can provide profits of an exponential nature. The modus operandi here is to seek out opportunities where relatively small amounts of capital are deployed, leveraged and cultivated into large amounts of gains. That will be the goal with WMIH, with details emerging throughout 2014.
The eventual shape the company will take is still up for debate. I have thought since the very first day I purchased shares in July 2012 that the reinsurance entity (WMMRC) contained within the holding company was a more valuable commodity than investors were giving it credit for. It is this investors opinion that KKR will merge WMIH into a company that is insurance related, with the reinsurance entity playing a role in the future creation of value for shareholders, alongside the tax advantaged profit potential that the NOLs bring.
Whatever shape WMIH takes going forward, the company now needs to be valued on the basis of future earnings potential as opposed to purely looking at it from the standpoint of a company that is an NOL shell. The value of the NOLs was a reference point for valuing the shares when only Blackstone was involved, without any type of leveraged structure that promised the shell would be turned into a revenue producing entity. With the involvement of KKR, given the structure of the deal, we now have grounds for assuming capitalization and a vague, initial idea of what size company we will be dealing with going forward.
With that said, future models of valuation should look at WMIH from a multiple to possible earnings standpoint considering both the value of the NOLs and the structure of the KKR deal.
Finally, it should be noted that our investment in WMIH has now yielded a total profit of near 500% since being initiated in July 2012.
BFCF finished the month of December with a gain nearing 20%. There are some issues of clarity that will be dealt with during the first half of 2014. Namely, the SEC suit versus Alan Levan pertaining to his role at BBX during the financial crisis. In any case, the company is setup to deal with the eventualities of life with or without Levan moving forward. Any action taken by the SEC against Levan won't discount what BFCF has under its umbrella. It will only be once the merger with BBX takes place, followed by a listing on either the NYSE or Nasdaq, that transparency into the the parts that make up this opportunity take place, followed by the appropriate creation of value.
DRII is the closest comparison we have to the free cash flow generating (formerly BXG:NYSE) monster contained within BFCF. DRII is growing revs at a 30% clip this year, trading at a 1.5 bil mkt cap on est. $800 mil revs for 2013. Last numbers we have on BXG were nearly $400 mil in revs 2012. Assuming similar growth that bumps up to $500 mil for 2013. Combined post-merger mkt cap for BBX/BFCF is 400-450 mil. That puts the value of BFCF at less than 1 times sales (BXG alone) post-merger. Value proposition? Yes. Actually it is an extreme value proposition when you look at the value of BFCF based on the BXG unit as a multiple to free cash flow. But, there are other opportunities out there that deliver attractive free cash multiples within growing companies.
I’m not a value guy. I’m a hidden/misunderstood asset guy. And BFCF is the equivalent of a Wall Street grab bag of goodies. The only issue is you have to stick your hand into the bag blindfolded because we don’t know exactly what is contained in the bag. But that is perfectly fine. Why? We have the BXG unit within BFCF that is the birthday cake. Whatever we get from the grab bag are just extra goodies to make this party legendary.
The distressed RE assets that were gained through foreclosure through the FAR unit of BFCF are impossible to value correctly. This is due to two reasons:
1. We don’t know how extensive they the RE assets are apart from the fact that the CEO has referred to the assets as a “gold mine.”
2. We don’t know the extent of development that will take place on these properties, making them all the more valuable under the guidance of real estate veteran Alan Levan. But Mr. Levan has said:
“This is land that is ripe for development now and for which we are lining up partners to develop that land with us today”
“In a non-banking environment you can work the real estate to its highest and best value,” when referring to the reasoning behind stripping away their bank charter.
Portfolio Lowlights For December
CIDM was the biggest drain on performance during the month December, posting a decline of 12%. It should be noted that for the quarter, after this decline, CIDM did manage to gain more than 30%. You can then classify the December pullback as simple profit taking following the steep gains of the past couple months.
I expect CIDM to be a highly-profitable investment during 2014. The transformation of the company has literally just been fully completed following a multi-year process that has seen the company transform itself from a business model dependent on cinema deployment to a leader in entertainment content distribution.
The acquisition of Gaiam's entertainment unit adds to CIDM's industry clout given the visibility and strength of the licensing deals under Gaiam's umbrella. Given their already extensive library of film content, along with partnerships involving nearly every major retailer from Amazon to Wal-Mart, the potential for a recurring stream of high-margin, unencumbered, growing revenue is tremendous over a 2-3 year time frame.
In terms of comparisons into entertainment content companies that have traveled down this same path, a look into LGF is highly appropriate as CIDM management has referred to numerous time in the past. I understand that LGF has the highly successful “Hunger Games” franchise under its belt, which will automatically command a premium to EBITDA. But when you look at the fact that LGF is trading at 15X EBITDA and CIDM at close to 2X forward, full year EBITDA then you begin to understand the value proposition taking place within the transformed model.
It is simply up to management now to execute on the pieces they have assembled AND to leverage their growing industry clout to gain access to greater opportunities in content. I have no doubt given management's extensive industry experience that the results going forward will match the vision detailed over the past 12 months.
KCG finished flat for the month of December in what can only be classified as a narrow, sideways trading range. I'm perfectly fine with this as we did manage to gain 20% on the investment within just a couple of weeks of initiating the position in November.
As cash continues to find its way into the developed global equity markets I expect liquidity providers, such as KCG to be a prime beneficiary. As detailed in the research report published in November, well established liquidity providers such as CBOE, CME and the recently acquired NYX have already seen a premium attached to their share price given the growing acceptance of a friendly investment environment over the long-term.
The only reason KCG has remained undervalued relative to industry peers is because of the distressed situation that company faced following the software error that nearly sunk the company in 2012.
The reorganized KCG is a highly efficient, well capitalized, cash flow monster that is being overlooked due to issues of the past.
Upside here remains tremendous long-term.
EVOL was liquidated from the portfolios for a modest gain since initiating the position in July. The total profit here was less than 10%. While I believe the company will do well in 2014, I feel that I understand the above listed opportunities much better than I do EVOL at this moment.
Looking Ahead To January
Us equity types have had it easy in 2013. We haven’t suffered much of any pullback whatsoever. Bears have been disparaged, dissected and pilfered from to the point that they populate a small leper colony surrounded by dying weeds and various reptilian lifeforms. The nouveau rich investors of the social media sector abound as whatever is related to the sector bounces up in ways that are only comparable to the mid-cycle of the 1990s bull.
With 2014 upon us, the comfort with which bulls operate has been growing. With that growth has come a certain confidence in the form of increasing bullish forecasts. Gone are the days of low single digit growth forecasts. Investors are demanding a certain level of chutzpah from their local, neighborhood analyst.
You must realize by now that Wall Street forecasts are only an articulate, analytically driven reflection of the popular sentiment of the time. In other words, what Wall Street analysts do is gift wrap what investors are feeling in pretty words and a colorful bouquet of statistics, passing it off as original thinking. It is, in fact, group thinking that only serves the purpose of driving trends. Wall Street will never tell investors to be bearish in a soaring (think 2000) bull market. And it will never tell investors to be bullish in a brutal (think 2009) bear market.
I won’t be alone with my bullish forecast, no doubt. I am bullish on 2014, despite the fact that I have more company than I have become used to over the past few years. All that means is that we are mid-cycle in a bull market. There is really nothing more to read into it than that. All the knee jerk sentiment analysts that simply believe that bullish talk equals a reversion to the mean forget that markets do tend to reward investors at times. Markets are not always as difficult as 2000-2010. There are loyal, angelic markets. And there are demonic, nefarious markets. An investors job is to know which type of market we are in and act accordingly.
Where will the surprises be in 2014? I think in two places:
1. 2014 will not be as smooth and effortless for bulls as 2013 was. After Q1 up until about August, a window opens for a relatively sharp, precipitous and unexpected pullback that will be brutal. It will likely be called a mini-crash by investors. Probably to the tune of 10% plus on the downside within a couple of weeks. It will likely be macro driven, with Fed policy being cited as a key reason for the violent reaction of the markets.
2. The markets will end 2014 substantially higher than most are expecting. This becomes especially true following the events outlined in #1, which will cause many to abandon the bull case suddenly. The upside in S&P into year end is to roughly 2200. From August to year end the markets should absolutely rip. The first half of the year, from February into July will be pretty volatile and generally disruptive in nature.
The S&P 500 ended 2013 with a gain in excess of 25%. This type of gain has happened 8 times over the past 30 years. The average gain following a 25% up year in the S&P has been 15%, with only one year (1990) finishing negative. In fact, only 1992 saw a single digit percentage gain for the S&P following a 25% plus gain. Every other time the S&P 500 experienced a double digit percentage gain in the year following a 25% gain in the markets since 1982.
2014 will not be as lubricated a path towards success as 2013 was for investors. However, the impetus to avoid exposure because of the simple fear of heights should be avoided. We are in the middle (it can certainly be argued early) stage of a secular bull market. The meat and potatoes in terms of investor gains comes in the late stages, which are still years away.
In the meantime, volatility will increase both on the upside AND the downside, with 2014 being a preview of the kind of awe inspiring, short-term bearish cataclysm that awaits investors who are over-leveraged or exposed to the wrong sectors at the wrong time.
Regards,
Ali Meshkati
