Friday, June 29, 2018

Mid Year 2018 Portfolio Review

It's halfway through 2018 already, time to check the scoreboard, and its not pretty, during the first half of the year my personal account dropped -6.44% compared to a positive 2.56% for the S&P 500.  I have nothing too insightful to say, made some mistakes, waiting on a few situations to fully play out and just going to keep moving forward.
Updated Thoughts:
  • Green Brick Partners (GRBK) looks pretty cheap again.  To recap, Green Brick is a homebuilder that did a reverse merger with an NOL shell in 2014, its essentially controlled by Greenlight Capital and is run by veteran Dallas based developer Jim Brickman, who is a close business friend of David Einhorn.  To begin 2018, Green Brick had only $67MM in NOLs remaining and will likely come close to burning it off this year, if not early 2019.  Once the NOL is gone, the reason GBRK exists as a public entity will cease and restrictions around its ownership will no longer limit the company's strategic options to either be acquired or use its stock and merge with another homebuilder.  Third Point, who had owned ~17% of the company, recently did a secondary to sell their position and the news took GRBK's stock down from the low-to-mid $12s to the low-to-mid $9s.  Initially the company planned to raise capital alongside Third Point, but then reversed that idea when the secondary priced at $9.50.  Why the company would want to raise equity capital is a bit of a head scratcher, every quarter management puts out a slide showing how their leverage is lower than everyone elses and how they plan to add leverage but that curiously never happens.  Green Brick will earn at least $1/share (GAAP) this year and likely more, meaning the shares trade at a sub 10 P/E despite a high growth rate, strong balance sheet, and operating in blistering hot job markets.  It doesn't seem that Jim Brickman is ready to retire for a second time, but given Greenlight's performance woes, they might need a win and push the company to be sold once the NOLs are gone.  One lesson learned here so far, stay away from NOL shells that are trying to become the next mini-Berkshire and instead look for ones that make one acquisition that instantly generates taxable income.
  • Earlier this year iStar (STAR) made what looked like a weak effort at evaluating strategic options and has opted to accelerate the divestment of their more liquid legacy assets and continue to grow their core businesses of CRE loans and net leases (which is basically status quo, but with more effort!).  The one interesting thing to note is they've all but announced a dividend, stating several times that they're evaluating one and even amended their bank debt to remove previous dividend restrictions.  iStar has been disappointing so far, CEO Jay Sugarman seems overly distracted by their ground lease vehicle SAFE which only makes up a small fraction of iStar but seemingly takes up far more of his time.  Additionally, we've gone through a couple CFOs over the past two years and disclosures remain opaque making it hard for the market to value their assets.  It's still stupid cheap on a sum of the parts basis, but hard to know when that narrative will change, I thought it would by now, but we could be in the same situation in another 2-3 years still talking about monetization of legacy assets.
  • I've owned Dell Technologies Class V (DVMT) shares, which are meant to track VMWare (VMW), since Dell completed the purchase of EMC in 2016.  In early February, news broke that Dell was considering its either going public itself or doing a complicated merger with VMware that might or might not include the DVMT tracking shares.  The market reaction was all over the place, the craziness fired up my animal spirits and I bought some July options that will likely expire without much fanfare as the negotiation drags out between Dell, VMW and DVMT holders on how the tracker discount will get divided up.  I'd still fall on the side of Dell being somewhat fair to DVMT holders (maybe a 20% discount to VMW) as his reputation and that of is his PE partners is still important, plus you've got activists lining up on both sides of the DVMT/VMW trade ready to sue if either side feels too much pain.
  • Earlier in June, the SEC approved a rule that will change the default notification option for mutual fund investors from physical mail to email starting in 2021 (sounds further away than it is in reality).  Donnelley Financial Solutions (DFIN) is one of the largest printers of mutual fund materials and stands to lose a fair amount of business once this rule takes effect, its not unexpected as it was discussed in detail at their recent analyst day (guided to a ~$12MM hit to EBITDA if the rule passed), but its just another in a series of setbacks for this spinoff as they try to stabilize themselves as a standalone company.  Shortly after, Groveland Capital and Denali Investors appeared on the scene with strikingly similar letters (here and here) to the board of directors asking DFIN to explore strategic alternatives as the market is valuing DFIN at a 6x EBITDA multiple.  October 1st will mark the two year anniversary of the spinoff, opening up a few more options for DFIN, but I'm skeptical anything will happen as management seems set on pursuing (attempting?) the difficult print to SaaS company transition.
Closed Positions:
  • Exantas Capital (XAN), formerly known as Resource Capital (RSO), was one of my favorite ideas for a while but the more I tried to do the math, the less confident I became that XAN could trade at book value, at least anytime soon.  XAN's manager, C-III, also did a couple of unfriendly things with their management agreement: 1) they locked in a fixed base management fee for 2018 after redeeming the preferred shares and 2) they reset the incentive fee hurdle which was previously all but out of reach. The base management fee reverts back to a bps calculation at the end of 2018 does put a little fire under management, they've changed the corporate name, are out there giving investor presentations and have a new CRE CLO in warehouse.  But I still struggle with how this gets close to a 10% ROE at its current size given the risk profile of their assets and the expense drag, I recently sold.
  • La Quinta Holdings (LQ) worked out almost perfectly as expected, I sold the REIT spinoff CorePoint Lodging (CPLG) the day following the spin at $28, only wish I would have sized this idea up more and look forward to what Wyndham Hotels & Resorts (WH) can do with the LQ brand -- I'm still very optimistic on both WH and WYND despite them trading poorly after the spinoff (maybe S&P 500 selling pressure?).
  • I sold LGL Group (LGL), they hinted at an acquisition of their operating business around the same time as the rights offering, that didn't come to pass and their disclosures around the process seemed woefully absent, so I sold for about my cost basis.  This is hopefully my last "micro cap NOL shell that's pursuing acquisitions to utilize their tax asset" idea, seen enough of these flounder to have had enough.
  • Along with being 'done' with NOL shells, I think the same could be said for reverse morris trusts (RMTs), I was originally attracted to Entercom Communications (ETM) for the RMT and related discount through CBS, but stayed for the free cash flow story management was spinning along with the incredible insider buying that continues to this day by the founding Field family.  But I don't actively listen to terrestrial radio, if I do its a much more passive experience, with streaming/podcasting options I'm getting exactly what I want which is what makes it more valuable to advertisers.  Even with sports or news, many will point to this being an issue in today's divisive society, but I can listen to a podcast that matches my view, whether its a sports team or a political view, that kind of targeting is hard to compete with in traditional radio.  I should have stuck with my gut on it and sold after the deal was completed, but instead I got punished by thesis drift, this is a heavily levered company that will likely report poor earnings again for Q2, might be more interesting to re-enter then?  But yes, RMTs, less attractive than spinoffs, they seem to be even more levered that spins as they need to keep the 51/49 ownership structure and then a common misconception seems to be that former CBS holders are indiscriminately selling here but CBS holders elected to take ETM stock, it didn't just appear in their account like a normal spinoff.  Entercom might turn out well, but I decided to sell and move on to other opportunities.
  • VICI Properties (VICI) is a the REIT that was created out of the Caesar's Entertainment (CZR) bankruptcy, my thesis was simple, it traded slightly cheap to gaming REIT peers because it was listed over-the-counter and wasn't yet paying a dividend.  Both of those have changed and its bounced around a bit to actually trading expensive to peers do to its perceived independence compared to MGP which is controlled by MGM.  I made out with a small profit.
  • The management buyout of ZAIS Group (ZAIS) was completed and I was cashed out of that position for a nice profit.  
Current Holdings:
*Additionally I have CVRs related to GNVC, MRLB and INNL 
Disclosure: Table above is my blog/hobby portfolio, I don't manage outside money, its a taxable account, and only a portion of my overall assets.  The use of margin debt/options/concentration doesn't represent my true risk tolerance.

Friday, June 8, 2018

Perspecta: DXC Government Services Spin, CSRA 2.0

On 6/1, DXC Technology (DXC) completed the spinoff of its U.S. government services business and merged it with Vencore and KeyPoint, two PE owned government services businesses, to form Perspecta (PRSP).  There's been a lot of M&A in this industry, DXC was formed in 2017 via the combination of Computer Services (CSC) and Hewlett Packard Enterprise's (HPE) services business, prior to that merger, CSC had spun off its government services business as CSRA in November 2015 only to re-enter the business via the HPE deal.  Then in February, General Dynamics (GD) came in bought CSRA at a rich 12x EBITDA or 18x earnings multiple. Now once again DXC/CSC is returning to the same playbook and spun off its government services business.

Several years ago I profiled and owned several of the government spins (EGL, XLS, VEC, CSRA, LDOS), large defense contractors were dealing with the draw down of troops in the Middle East and sequestration started pinching Federal budgets by spinning off their lower growth and lower margin services businesses.  Now that the Federal budget is in growth mode again, projected at 1.5-2.0% annually through 2022, government services multiples are on the rise and you're seeing the opposite M&A trend taking place with GD buying CSRA.

If anyone in the industry reads this they'll likely cringe, but from an investment standpoint, most of these government services are very similar with nearly indistinguishable strategies making them fairly straight forward to value.  This kind of M&A in any industry would likely be disruptive to clients, but here deal teams work on individual government contracts and have more of an identity with the contract than the cute name currently on their business card.  It's a very competitive business where valuation multiples should converge over time as its nearly impossible for a firm to have a clear competitive advantage.  The nature of the business also makes these firms a bit of black box, many of their contracts are classified and its hard for the average investor to shift through the contract re-compete pipeline.

Perspecta is pitching their margin profile as their differentiating factor due to their heavy weight towards firm-fixed price contracts compared to peers.  This is partially the nature of the IT services business, CSRA featured similar EBITDA margins.
Fixed contracts are where the government and the contracting firm agree upfront on a price/value of a given engagement and its up to the contracting firm to make it profitable.  These types of contracts are potentially more lucrative if a management team can squeeze costs out as those savings don't have to be shared with the government (at least until the next re-compete).  But this can cut both ways, if Perspecta were to run into issues with cost overruns and or just flat out misprice a fixed-price contract in a competitive bid (animal spirits can get the best of anyone) then they could be stuck in a negative margin position unable to get out for several years.  Whereas the cost-plus contracts are safer, but with lower more predictable margins, as the contracting firm and the government agree on a specified margin upfront and the total value fluctuates with expenses (think timeshare resort management or Nacco's coal mining operating agreements).

As mentioned, all these independent government service providers trade in a pretty tight range, Perspecta has moved up a bit this week, but still remains at the bottom of the table on both an EV/EBITDA and P/E basis.
Perspecta has one large contract with the U.S. Navy servicing their intranet and related communication needs ("NGEN") that is coming up for re-compete, its a $3.5B 5-year contract, or roughly 17% of Perspecta's pro-forma $4.1B annual revenue base.  They're the incumbent on the contract through predecessor firms (was DXC, before that HPE, before that EDS) since the program was established in 2000.  The Navy is splitting the contract into two, one will be the services and the other the equipment side of the contract, Perspecta is likely to give up some of this revenue either by adding additional subcontractors to the team, or losing one side or the other, and then just general competitive pressures will decrease the profitability of NGEN through the re-compete process.  They're projecting flat revenue growth over the next year, given the healthy budget backdrop, I'm guessing its less the integration/new public company focus they've stated, and more an acknowledgment that NGEN will be rolled back for them this time around.  In the Form 10, the old DXC government services business ("USPS") had a 90% historical re-compete win rate and Vencore has a 97% historical re-compete win rate.  It's unlikely that the Navy would move completely away from Perspecta, incumbents are hard to beat, but that headline risk is out there and is potentially a reason why the stock is cheap.  I don't think the market is intentionally doing this but if you were to back out the NGEN contract entirely, Perspecta is trading for roughly the same multiple as its peers.

Perspecta has 165.6 million shares (old DXC shareholders own 86% of the company) and net debt of $2.7B, if it were to trade at a peer multiple of 12x EBITDA, the shares are worth $33/share versus the $24.25/share they trade at today.

Other thoughts:
  • DXC is a S&P 500 constituent, I haven't seen an announcement kicking PRSP out, presumably because there's nothing to announce if PRSP is just simply not added to the S&P, but we've likely seen some forced selling by index funds since the 6/1 spinoff.
  • Mike Lawrie is the CEO and Chairman at DXC, he'll be the Chairman at PRSP, since taking over CSC a few years ago he's done a tremendous job for shareholders in both creative M&A and operating performance.  Good manager that is worth following.
  • One thing about NGEN that feels a bit wrong to me, it's barely mentioned in the Form 10, and not in the risk section for concentration risk, despite being a material 17% of revenue.  Could be an intentional oversight because the risk of losing the contract is minimal, or a bit deceptive, I'm not entirely sure which?
  • Perspecta's leverage will be a little higher than peers to begin with which is pretty typical for spinoffs, the company is projecting $1.5B in operating cash flow over the next three years and have slated 35% of that to pay down debt which would get them to the lower end of their target range of 3 to 3.5x EBITDA.
  • Vencore filed an S-1 last year before pulling the IPO, the S-1 is worth reading, Vencore is more of a mission services business versus the IT services at DXC's old USPS business.  KeyPoint, the smallest of the three being merged together, is the leader in background checks and security clearance, good little niche.  Perspecta believes they can go after contracts they previously weren't qualified for now that they've merged the three entities (combining mission and IT services), that's possible, but doubt it moves the needle much.
Disclosure: I own shares of PRSP