GrizzlyRock Value Partners, LP2012 Year End Investor Letter January 11 th , 2013 Fellow Partners, During 2012, GrizzlyRock Value Partners, LP (the “Fund”) returned 13.56% net of fees while averaging 55.8% net long exposure (measured at month end). The Fund’s positive performance each quarter and Sharpe ratio of 1.54 represents solid progress toward GrizzlyRock’s goal of excellent long-term risk adjusted returns. GrizzlyRock outperformed many market indices and hedge funds by maintaining a defensive posture while selecting attractive corporate investments. As an investor with 100% of my net worth in the Fund, I view the Fund’s return in 2012 as acceptable given the risk-constrained approach. Financial markets during 2012 were decidedly uncertain with investors facing various issues including slowing corporate growth, macroeconomic fears in Europe and China, and a US trifecta of questions concerning quantitative easing, the election, and the fiscal cliff. Market sentiment swung from ebullient during the first quarter to despondent during the early summer before moderating during the third and fourth quarters. Overall, corporate risk markets rallied substantially with a particular focus on yield bearing securities. A siren song of macroeconomic uncertainty adversely affected many investors in 2012. As Odysseus generations ago, GrizzlyRock’s commitment to the task at hand regardless of extraneous factors led to sound results. At GrizzlyRock, long-form analysis guides portfolio investments regardless of market sentiment or the fad du jour. GrizzlyRock’s long / short strategy focusing on dramatically mispriced assets is designed to navigate stormy and placid seas. Above: Odysseus is tempted by the Sirens on his journey back to Ithaca 2 Investment Management is Risk Management During 2012, the primacy of risk control was paramount due to macro uncertainty and robust valuations of risk assets entering the year. Early in the year, the Fund gained from specific value and credit investments while maintaining a defensive portfolio. During the second half of the year, compelling event driven situations and single name shorts justified a more aggressive approach. GrizzlyRock avoids arbitrary performance goals in order to focus on capturing opportunity as situations arise. Throughout 2012, I indicated the Fund’s conservative investment profile may provide 10% to 15% annual gains (net of fees) over the next three to five years. The current portfolio positioning likely supports returns in this range with additional upside possible from a handful of deep value investments. My belief is based on the following reasons: (1) GrizzlyRock estimates the Fund’s value equity investments as a whole are trading at 35% discount to business value. Assuming a two year holding period, a mid-teens yearly growth rate is reasonable. As GrizzlyRock does not invest thematically, equity investments are uncorrelated by risk factors and have unique catalysts. (2) Event driven opportunities remain plentiful with many spin-offs offering ex-ante return prospects of 20%+ with minimal risk. Currently, many current present an attainable path to value realization. (3) GrizzlyRock has identified a handful of overvalued businesses with low competitive advantages. Single name short positions were slightly unprofitable last year while risk markets rallied. In 2013 GrizzlyRock’s short positions are likely to return a profit based on specific company risks and extreme valuations. Given the aforementioned portfolio characteristics, now would be an excellent time to increase your investment in the Fund. Performance Attribution (see chart on page 3) GrizzlyRock’s 2012 gain of 13.56% was based on select long credit and equity positions while being slightly offset by single name short positions and market hedges. Performance for the fourth quarter was +0.80% compared to a -0.27% quarterly return for the S&P 500. Although GrizzlyRock focuses on medium and long-term asset growth, the Fund gained value during each quarter of 2012 while the S&P 500 Index declined two out of four quarters. Q1 Q2 Q3 Q4 Yearly GRVP 5.74% 2.15% 4.30% 0.80% 13.56% S&P 500 12.68% -2.67% 6.19% -0.27% 16.15% 2012 2012 Quarterly Return of GrizzlyRock and S&P 500 3 2012 GrizzlyRock Value Partners LP Performance Allocation by Investment Type 13.56% -0.52% -2.14% -0.28% +6.56% +9.94% 0% 2% 4% 6% 8% 10% 12% 14% 16% Credit Equity Short Positions Market Hedging Fees Total Comparative Performance While GrizzlyRock does not attempt to outperform certain indices or benchmarks, an analysis of comparative results sheds light on Fund performance. During 2012, the Fund provided superior absolute returns to the Dow Jones Industrial Average with less volatility. Compared to the S&P 500, GrizzlyRock outperformed on a risk-adjusted basis (as measured by the Sharpe Ratio) while not quite reaching the Index’s total advance. GrizzlyRock’s performance was bolstered via high yield credit exposure and individual security selection slightly offset by low average net exposure to risk assets and relatively less investment in well performing sectors such as autos, finance, and technology. As shown below, GrizzlyRock also posted superior returns when compared to many other hedge funds. Per Hedge Fund Research, the HFRI Fund Weighted Composite Index returned 6.16%. The HFRX Equity Hedge: Fundamental Value Index, comprised of funds with similar strategies to GrizzlyRock, generated a +5.88% return during 2012. While a risk-adjusted comparison is not possible as index component net exposure levels are unknown, GrizzlyRock’s 2012 returns were successful. 2012 GrizzlyRock Returns Compared to Equity and Hedge Fund Indices Fund / Index 2012 Return Standard Deviation Sharpe Ratio Net Long Exposure (1) GrizzlyRock Alpha (2) GrizzlyRock Value Partners, LP 13.56% 8.7% 1.54 55.8 N/A Dow Jones Industrial Average 10.20% 9.6% 1.06 100% 7.87% S&P 500 Index 16.15% 10.5% 1.52 100% 4.55% HFRX Fundamental Value Index 5.88% 2.9% 2.02 Unknown N/A (1) Average gross long investments minus short positions as a percentage of NAV as assessed at month end. (2) GrizzlyRock Alpha = GrizzlyRock Return – (Index Return x GrizzlyRock Net Long Exposure) 4 Yearly Portfolio Review GRVP Allocation at Month End March 2012 June 2012 September 2012 December 2012 Long Exposure 72% 52% 63% 78% Short Exposure 15% 10% 12% 15% Gross Exposure 87% 62% 74% 92% Net Exposure 58% 43% 51% 63% Beginning the year, the portfolio was composed primarily of high yield credit as well as venerable (yet inexpensively-priced) businesses such as Berkshire Hathaway, Lowe’s (the home improvement retailer), Visa, and Fairfax Financial. Market turmoil during fall of 2011 presented an opportunity to purchase excellent companies with strong balance sheets and competitive advantages for discount prices. Following Buffett’s mantra “be fearful when others are greedy and greedy when other as fearful” I reduced net long portfolio exposure during the spring as market prices increased. As a result, the Fund gained during the second quarter driven by several short positions and market hedges while risk markets declined. During the summer and fall, my focus was on intriguing event driven and short positions. In December, I added two deep value investments which have highly asymmetric risk-return prospects and significant positive skew. These businesses are in quality industries with incentivized management teams and have clear catalysts for value realization. (Next section highlights one) At the individual security level results were broadly strong with a few misses. The Fund’s largest position during the year rallied 65% yet remains undervalued. My biggest mistake during the year was clear: selling Visa Inc. (NYSE:V) in June for $120 as prevailing market prices neared my initial valuation estimation. While the Fund netted a 62.7% profit taxable at long-term rates on the sale, Visa was selling for about ~$150 per share at year end 2012. After accurate analysis and prescient investment (see GrizzlyRock’s Q2 letter for more detail), I sold Visa as the Fund captured the “low hanging fruit” yet the market continued to increase Visa’s price. Great businesses compound valuation as they grow and I neglected to adequately account for this phenomenon when I sold Visa. I have incorporated this lesson into my sell methodology and plan not to repeat the error. Performance for the rest of the portfolio was as follows: Most long positions gained in value. A few short positions made money, a few broke even, and one short impacted performance. Event driven positions were broadly positive although certain catalysts expected during the year are now likely 2013 events. 5 2012 Lessons Learned Reviewing annual portfolio gains and losses is an excellent time to reflect on decisions and strategy. Investment markets often dole out humbling lessons as well as rewards for prescient analysis. Here are a few lessons learned in 2012: (1) Not All Balance Sheets Are Equal In early 2012, GrizzlyRock purchased a consortium of early stage precious metal mining businesses well below book value. The summer swoon of gold prices lead to poor market economics and book value plummeted while the discount from share price to book value of equity remained. Discounts to book value can lead to attractive returns yet book values themselves must remain robust. (2) Don’t Fight the Market – Wait For The Right Time To Express A Position This lesson was predicated by the Fund’s on-again, off-again short of Salesforce.com (NYSE:CRM). Without a lengthy expose, Salesforce.com has been increasing revenue growth by signing less economic contracts with customers in exchange for long contract terms while attempting to convince Wall Street that sales compensation is not a cost! All Wall Street recognized was revenue growth regardless of Salesforce’s inability to generate earnings or fair free cash flow. After much consternation, GrizzlyRock returns from Salesforce.com were flat in 2012. (3) Markets Overpay For Growth and Certainty (Reminder of Fundamental GrizzlyRock Belief) Pricing inefficiencies are often created by investors who abandon positions as growth wanes or outlook clouds. GrizzlyRock purchased Ituran Location and Control (NASDAQ:ITRN) for well below intrinsic value last summer as ancillary noise regarding growth rates depressed share prices. GrizzlyRock paid just 10.7x earnings and 3.9x EV to EBITDA for a monopoly business in Israel (50% of revenue) generating immense free cash flow and a growing Brazilian unit (40% of revenue) with a new, exclusive contract with Chevrolet and positive forthcoming regulation. Ituran gains to date are ~26%. In early October, the stock price of Alliant Techsystems (NYSE:ATK) languished as market participants focused on macroeconomic fears of impending sequestration of military spending and a potential decline in defense spending by a second term Obama administration. GrizzlyRock purchased Alliant at 7.4x earnings and 4.5x EV to EBITDA for a technologically advanced business which just received a 10 year renewal of its largest military contract. Alliant Techsystems gains to date are 23%. By the time business economics are clearly visible the price will be clearly reflected. As such GrizzlyRock desires to be a net seller of businesses with clearly priced-in economics. 6 Current Fund Investment: Liberator Medical (PINK:LBMH) Late in December, I invested Fund capital in a small direct-to-consumer medical supply distribution business with a straightforward business model, experienced management with large equity ownership, excellent industry dynamics, and rock-bottom valuation. Liberator Medical is the market leader in selling urological (i.e. catheters) and ostonomy products to Medicare eligible seniors through direct response advertising. Liberator’s high ROI model works as follows: Liberator purchases direct response advertisements (primarily on TV and online) which generate incoming leads. After customers are qualified through insurance and medical documentation, Liberator has added a customer for highly necessary recurring products at 60% gross margin. GrizzlyRock estimates Liberator retains customers at a ~85% yearly rate while management indicates customers are retained for up to 10 years. CEO Mark Libratore founded the company in 2007 after noting the urological product (78% of 2011 sales) market as highly attractive given the sensitive nature of the product, low cost per unit, industry demographic trends, and underpenetrated market. Management is recreating their previous success at Liberty Medical (the largest direct-to-consumer distributor of diabetes supplies) in an adjacent market. Industry growth rates should average 6% annually based primarily on US demographic trends. Medicare pays about three quarters of product cost with the remaining amount paid by secondary insurance and consumer self-pay. Although some investors view Medicare reimbursement risk as plausible, this risk is mitigated by the following reasons: (1) In 2008, Medicare increased total catheters available for Medicare seniors from 4 per month to 200. Moving from self-sterilization to providing disposable catheters decreased total spending per patient due to a lower incidence of infection and costly hospitalization. (2) In 2012, Medicare raised reimbursement rate prices of Liberator’s urological products by 2.4%. Further, urological products were not included in the last round of competitive bidding. (3) Catheters are a low cost, commoditized product necessary for many seniors with proven overall cost effectiveness. While Medicare budgets are under pressure on all sides, catheters most likely will not be the place for Medicare to reduce expenditures. Why is the Opportunity in Liberator Shares Exist? (1) 3.2% revenue growth during the nine months from October 2011 through June 2012 Prior to this time period, Liberator had been growing revenue over 20% per year. In fiscal 2011 (ending 9/30/11) Liberator advertised more than any previous year yet customer acquisition was less effective than in years past. GrizzlyRock believes this spend was weighted disproportionately towards secondary product categories including ostonomy and mastectomy as opposed to the core urological 7 market. Liberator reaccelerated their sales growth in the fiscal 4 th quarter of 2012 with the highest ever quarterly sales of $16.5 million (over 10% growth quarter over quarter). (2) Liberator does not have a natural buyer of minority shares With a market capitalization of $37.1 million, Liberator flies under the radar for funds investing large amounts of capital. The natural buyer of this business is a strategic medical device manufacturer or a private equity firm who would take control of the business and leverage the customer list and distribution channels. Liberator is a predictable, growing business with discernible economies of scale that could support financial leverage. This combination is highly attractive to control buyers. GrizzlyRock views a buyout as a highly likely catalyst for Liberator. (3) Current GAAP financials do not reflect Liberator Medical’s economic reality Liberator has been investing significant amounts in operating staff to aid business growth. These SG&A expenses have obscured Liberator’s margin potential. Liberator management is not running the business for Wall Street; they are focusing on developing a robust, scalable business. (4) Liberator has not been a historical producer of free cash flow Liberator is at an inflection point of free cash flow generation. The company has historically been a net user of cash as they invested $45 million over the past five years to acquire recurring customer relationships. After spending $15.2 million on advertising in fiscal 2011 and $13.1 million in fiscal 2012, management is projecting a decline in 2013. A decline in ad expenditures coupled with absolute revenue growth will significantly bolster free cash flow in 2013 which may provide a catalyst for share price appreciation. Valuation & Conclusion Liberator is currently trading at 10.5x 2013 earnings, 0.6x sales, and 5.6x EBITDA for a business GrizzlyRock expects to grow high single digits while increasing operating margins in 2013. These metrics are drastically undervalued for the largest business in a growing industry. Liberator’s undervaluation is conferred by the September 2012 sales of 180 Medical, the second largest market participant, for 4.7x sales and 13x pro forma EBITDA. GrizzlyRock conservatively estimates Liberator’s base case valuation to be approximately $80 million which implies 100%+ equity upside for the share price over a few years. The upside case implies equity price appreciation of 200%+ from the current share price predicated on Liberator’s purchase by a middle- market private equity business or strategic medical product distribution firm. A sale to a larger entity (such as a private equity backed roll-up of similar distributors) would allow Liberator to remove significant costs from their operating structure. Further, the inherent stability of cash flows could allow a purchaser to 8 include modest financial leverage in the transaction. The combination of operating and financial leverage for a business growing in the mid-single digits per year would be highly valuable to an acquirer. As return potential is inconsequential without considering potential investment downside, what is Liberator’s value in a stress scenario? Assuming below industry growth rates and EBITDA margins less than half of management’s projection for a flat case GrizzlyRock values the business at ~$30 million which implies a ~20% decline in share price. GrizzlyRock considers the base or upside case much more likely than the stress case. Regardless, even if the base case has a 50% probability of 100% gain and the stress case has a 50% probability of 20% loss Liberator is a highly attractive investment. Assuming three years for value realization, GrizzlyRock projects a probabilistic ~25% yearly return on Liberator. (For further information on Liberator contact me – yet be prepared to receive a 20+ page analysis!) Fourth Quarter Closed Positions Review (organized alphabetically) The below briefly reviews investments exited during the fourth quarter. • EnCana Corporation (realized gain of 26.6% from position inception): A large-cap oil and natural gas firm, I purchased EnCana in April of 2012 as fears regarding industry oversupply in the US natural gas market adversely affected stock prices. As a robust company which will earn economic profits under most plausible scenarios in the unfolding natural gas industry, EnCana was priced considerably below its true worth in April 2012. EnCana’s sale was predicated on a significant increase of market price towards intrinsic business value. • Potash Corporation (realized loss of 4.2% from position inception): A large cap owner of valuation potash, phosphate, and nitrogen reserves which sells into an oligopolistic market, Potash was purchased during Q1 2012. Sale during the fourth quarter was predicated upon a less favorable industry outlook. • Short Media General / Long Sinclair Broadcasting Pairs Trade (realized gain of 22.4% on net exposure): During Q4 2012, I shorted Media General (NYSE:MEG) given drastic overvaluation relative to broadcasting peers. Sinclair Broadcasting (NASDAQ:SBGI) was purchased to neutralize industry exposure. Media General declined and the position was liquidated for a 7% gain while Sinclair rose and generated an 8% return. Media General declined as expected yet the rise of Sinclair’s stock price was fortuitous. (Note: GrizzlyRock maintains a long-term investment in an undervalued broadcaster with excellent prospects.) 9 Current Portfolio Update At year end, the Fund had 17 long investments: three credit positions, four event driven positions, and ten value equity positions. The Fund also contained five short positions that reduced net long exposure to 58.8%. Geographically, Fund investments are primarily in the US, Canada, and Western Europe with some exposure to developed Asian countries, Israel, and Brazil. GrizzlyRock Outlook Moving forward into 2013, the environment for GrizzlyRock remains constructive. Yet, many risk classes are fully valued and offer few compelling opportunities. Certain European and Japanese companies appear inexpensive yet contain a macroeconomic sword of Damocles. Current Fund value equity investments, when considered as a whole, are priced roughly 35% below true business value and present sound ex-ante prospects. The most salient current opportunities exist in US event driven and long / short equity positions focused on company specific factors. High yield credit is near full valuation with little Fund investment focused on the asset class recently. High yield bonds are currently priced to return as little as 6% per year for leveraged firms. Current market terms are attractive for corporate issuers yet fail to adequately compensate investors such as GrizzlyRock for the myriad of associated risks. When you speak with corporate CFOs give them some advice from the esteemed Steve Miller “Go on, take the money and run!” Until market conditions improve, GrizzlyRock will focus elsewhere for mispriced assets. Two industries producing interesting short opportunities currently are enterprise software (primarily software-as-a-service) and retail. Both industries offer high priced companies which are growing revenue rapidly yet not materializing profits nor sustainable competitive advantages. I will comment on company specifics as short positions are closed. Credit 17.3% Value Equity 45.7% Event Driven Equity 14.1% Short Positions 8.5% Market Hedges 6.5% Cash 7.9% GrizzlyRock Investment Allocation at Year End 2012 10 Conclusion GrizzlyRock is designed to earn attractive risk-adjusted returns in corporate securities over the medium and long-term. By increasing Fund value each quarter during 2012 we achieved this goal on an interim basis. The current portfolio is designed to profit regardless of market direction and I look forward to updating you on investment progress throughout 2013. As an emerging fund, GrizzlyRock Capital is actively seeking additional investors. I continue to share GrizzlyRock’s value proposition to investors who are interested in a risk-constrained, “best ideas” approach to corporate investing. If you are satisfied with performance and process to date, consider sharing the GrizzlyRock story with fellow investors. As always, feel free to reach out to me to discuss any aspect of Fund operations. Best wishes in 2013! Sincerely, Kyle Mowery Managing Partner GrizzlyRock Capital, LLC www.grizzlyrockcapital.com (773) 278-9609 |
[email protected] Legal Disclaimer: This is not an offering or the solicitation of an offer to purchase an interest in GrizzlyRock Value Partners, LP (the “Fund”). Any such offer or solicitation will be made only to qualified investors by means of a Confidential Private Placement Memorandum and only in those jurisdictions where permitted by law. The Fund’s investment strategy does not track the S&P 500 nor any other index. Comparison shown for informational purposes only. No assurance can be given that the investment objective will be achieved or that an investor will receive a return of all or part of his or her investment. Investment results may vary substantially over any given time period. Past performance not indicative of future results.