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Underperformance is UGLY

July 1, 2017

Over the past seven months I have added seven new positions, 6 long and 1 (ouch) short. Now, you know, I’m not one for looking at short-term performance but sometimes you have to look in the mirror and acknowledge just how ugly you are even in the short run… and that’s certainly the case here! Of the seven positions, two have positive returns, one is about even, and the remaining 4 are down between 8% and 40%. That’s not pretty when compared to the S&P 500; up some 11% since December 1, 2016. Undoubtedly throwing darts at a list of stock names would have resulted in better stock selection. So lets take a look what went wrong. As usual, I’ll ignore the investments with positive returns and focus on those that are down. There is no better way to improve your investing skills than dissecting your mistakes (if indeed they are mistakes!). So here goes.

Share Price
Company Purchase Current Change $2.09 $2.33 11%
Regency Affiliates $8.95 $6.95 -22%
Tropicana Entertainment $31.63 $42.60 35%
Glassbridge Enterprises $6.59 $3.96 -40%
Rite Aid Corp $4.70 $2.95 -37%
Awilco Drilling $3.76 $3.52 -6%
Netflix $138.00 $149.41 -8%

Regency Affiliates
Shares are down about 20% since I purchased. The story here is simple. One of the company’s three assets became irremediably impaired just after I invested; the company has a 50% interest in a cogeneration plant at a Kimberly-Clark facility in Alabama with a 15 year contract due to expire in 2019. The renewal was being renegotiated when I invested. With no forewarning (or at least none that I was aware of) it was announced in April that Kimberly Clark had decided to build their own cogeneration facility and thus not renew the contract! This rather surprised me as I don’t understand how it could be cheaper to build a new facility than renegotiate a better rate with the existing facility (but then again my engineering expertise is rather limited, I will admit). Furthermore Regency management gave no indication that the negotiations were going against them, or that, in fact, the decision would be made so soon. Once the existing contract expires in April of 2019 Regency will own an interest in a cogeneration plant that, from what I can understand, will have practically zero residual value. And this after management did a dog and pony show last Fall about how the company was so undervalued! So, either management was blindsided by the non-renewal or they were not quite honest with the investment community in their presentation. I’ll opt for the first, giving management the benefit of the doubt. But that still leaves me questioning the soundness of Regency management’s judgment. Did they underestimate the possibility that the contract would not be renewed and thus not dedicate enough effort to the renewal process or was it simply out of their control? We’ll likely never know.
So where does that leave us in terms of our investment? The Oct. 2016 management presentation put a ‘sum-of-the-parts’ valuation on the company of $14.63-$21.64 per share. Their value for the interest in the cogeneration plant was $10-$28 million, or $2.09-$5.86 per share. So a revised per share value might now be in the range of $12.54-$15.78 assuming no residual value for the cogeneration plant. It is interesting to note how much of the total upside the interest in the co-generation plant was in their Fall presentation! In any case, today’s price of $6.95/share is still a substantial discount to the company’s estimated ‘conservative value’; about a 45% discount to the conservative valuation. There remains another risk however; the company’s primary asset, a 50% interest in the buildings housing certain primary Social Security Administration offices, is under a lease that expires in 2018. Should the SSA not renew the lease this asset might have to be revalued downward. Notwithstanding this, I will continue to hold and see what happens during the lease negotiations. If the lease is renewed I expect that the underlying mortgage will be refinanced and the company should receive a large cash payment; how management handles this cash will determine whether I continue to hold thereafter or not.

Was it a mistake to buy when I did? or could I have made a better decision? The only thing I really fault myself for is being too optimistic about management. They did have some trouble with self-dealing about 10 years ago which I kind of ignored. Not sure, though, that my decision making was faulty as much as the timing inauspicious.

Glassbridge Enterprises
OK, I got this one ALL wrong. The transition from Imation as an operating company to Glassbridge as an asset manager sent the company’s financial statements into total turmoil. When I invested, the company was in the middle of the transition; financials were at best hard to interpret. It appeared to me that at my entry point of $6.59 per share I was getting more than the share price in cash on the balance sheet. However, when year-end 2016 financials were filed a couple of months later some of that cash and a good bit of book value had disappeared into the vortex; cash dropped from $50 million to $32 million, but more worrisome, book value dropped from ($.78) per share to ($5.29) per share. Just another case where I feel that management was somehow conspiring against us investors; new management also awarded itself 1.5 million shares against the right to invest funds in the now-parent company’s asset management business. And before you downplay this, remember that the company, after its January 10:1 reverse stock split, had only 5 million shares outstanding (including 5/6 of the grant). That 1.5 million shares represents more than 1/4 of the company!
It’s interesting to note how volatile the share price has been recently, trading down to almost $3.00 on basically no news, then popping back up to the $4-$5 range. I interpret this as investors having a rather disparate view of how the company should be valued. In fact, I’m a bit unclear myself as to how to value the business. With the share price down 40% from my entry point is it time to double down?
To a large extent I think the value of the Glassbridge’s asset management business is dependent on what The Clinton Group wants it to be worth. I’m assuming they want to do something with this ‘vehicle’. So if the shares dip into the $3.00 range again I’ll probably be doubling down.

In this case, I can clearly see that the investment process was faulty; I invested with incomplete information, knowing full well that it was incomplete. The hubris was in thinking that I could decipher what balance sheet information there was better than other investors WITH THE SAME INFORMATION! Note to self.. YOU’VE GOT TO BE KIDDING!

Rite Aid
What can I say here except that my belief was that management of Walgreens would tough it out and consummate the take-over? Well, they didn’t. At the 12th hour they struck a new, completely different deal; they agreed to purchase a little less than half of the Rite Aid locations for $5.8 billion, adjusted for working capital, and also give Rite Aid a $385 million breakup fee. From what I can garner, there are a number of varying opinions about what this means for Rite Aid shareholders. Will the stump company be able to make a go of it in their downsized form? or is there some other end game? It seems hard to understand the Rite Aid strategy in this new deal; most chains are trying to GROW and benefit from ECONOMIES OF SCALE. So what’s the scoop? I sure as heck don’t know. The new Rite Aid will be much less levered (the net $5.2 billion in cash they receive will go toward paying down LT debt of $7.2 billion). But savings of $300 million in interest payments doesn’t seem enough to ‘right the ship’, especially because they will be LOSING the effects of economies of scale on SG&A costs. We also have no idea WHICH locations they are selling to Walgreens; Are they selling the MOST profitable or the LEAST? So lets just take a step back and look at the big picture. Walgreens was willing to pay $6.9 billion for all of the Rite Aid equity ($6.50 a share), including the 4600 store locations and assumption of all liabilities (LT debt of $7.3 billion). Yes, they were going to have to sell off 1,000 or more locations to Freds but the compensation was still going to accrue to Walgreens. So, from a per store perspective, the buy-out deal valued each location at about $3 million ($14.2 billion/4,600 locations). Under the current store-purchase deal Rite Aid will be left with 2,400 locations. If we valued these locations based on the Walgreens revised buyout offer price of $6.50 a share they would be worth $7.4 billion. The shareholder equity would then be worth $5.2 billion (the $7.4 billion EV less the debt of $2.2 billion). With about 1.1 billion shares outstanding that would come to about $4.75/share. This is clearly worse for Rite Aid shareholders than the Walgreens original offer. But that simple calculation points out the several factors that WE DONT KNOW and which are ESSENTIAL for a more precise valuation; which store locations were sold off (the best or the worst?), whether SG&A can be shrunk commensurate with the shrinking of the store locations and what other efficiencies, in the form of sourcing benefits, the current store-purchase deal holds for Rite Aid.

I don’t think my (or anyone else’s) valuation of the post-deal Rite Aid can be very accurate with the information we currently have. I kind of laugh when Evercore comes out with a target price of $2.50 per Rite Aid share, but perhaps they know a lot more than I do. Instead, I want to focus on another aspect of the deal; Rite Aid management was in the mental mode of being ‘bought out’ over the past 18 months. I’m sure operations suffered because of the uncertainties surrounding the acquisition. I’ve worked for a company that was the target of an acquisition and I can assure you it’s not a pleasant experience; everyone is looking for their next job. So, transitioning from that mindset to one based on reorganizing a downsized corporate structure? good luck! My inclination here is to believe that some other deal is in the works or will be in the works shortly. It is difficult to move from one mindset to another so swiftly especially after such a long ‘gestation’ period. So my totally UNINFORMED prediction is that the stub company gets sold within the next 18 months as well. It may be that management will need the Walgreens purchase to be approved before another ‘deal’ can be announced, but I think those investors who wait it out will see a tender in the $5-7/share range sometime in the next two years. Of course, I could be totally off base; Rite Aid management might have an acquisition (like Freds?) in their sights instead. Or they could just be happy to maintain their high paying management jobs and run the company into the ground (never underestimate self-interest!); it’s not easy to ascribe intelligent asset allocation to management. In any case, I am hoping to double down on my position at around $2.50/share. I was surprised at the price resilience yesterday as it was the last day of the quarter and I thought there might be some ‘forced’ selling for those funds that didn’t want to show a position in Rite Aid at the end of the quarter.

On the investment process: the jury is still out. Need to see how this plays out over the next year or two.

Awilco Drilling
Shares of Awilco, after accounting for the $.20 dividend paid in June, are currently priced right about where I purchased them. I expect the share price to remain in a rather narrow range until we get closer to contract-end next April or oil prices make a significant move up (or down!). I think there is kind of binary outcome for these shares based on what happens to the price of oil.

Ditto as above: the thesis still has to play out.

OH BOY WAS I EARLY ON THIS! shares are now only 8% higher than when I sold short but in the meantime they have been as high as $165 (-20% on my position). My original investment thesis was that the shares were priced for perfection at $138, but, as someone once said, the market can stay irrational far longer than I can stay solvent. I almost bailed on this position several times but because it is small relative to the overall portfolio I ended up hanging in there. I still think Netflix shares should be priced in the $50-$75 range. Will they ever get there? I don’t know. But what I believe the general investing populace is forgetting is that this disrupter can get disrupted too! Who is to say that Amazon or Google won’t invest billions to create original programming? Then it would just be an ‘arms race’; who can spend the most and develop the biggest guns (the best programming). There really is no enduring moat in this race; just look at the broadcast networks! And they had a 30 year head start! New technology is the disrupter and Netflix just happens to be at the crest of the wave at this moment.
As I noted in my last post, I’m still about 50% in cash and look to stay that way until I can find a $.20 dollar. Given my slothful state I really don’t think that’s going to happen until the market corrects ever so slightly. In the meantime I’m trying to build up a wish list of great companies that I might be tempted by at 50%. 40% or, better yet, 25% of their current price.

The investment process: remember 2 things.. 1) do not short shares; trading is not your strength and 2) don’t forget… DO NOT SHORT NO MATTER WHAT! GOT THAT? This position may still play out positively, but it will just be pure dumb LUCK (something we hope for in investing but know not to count on).

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