Q3 2015 Letter

Mutoro Group Partners, LP
 

“In the search for truth there are certain questions that are not important. Of what material is the universe constructed? Is the universe eternal? Are there limits or not to the universe? What is the ideal form of organization for human society? If a man were to postpone his search and practice for Enlightenment until such questions were solved, he would die before he found the path.” – Buddha

Dear Partner,

The Fund was down 5.02 percent for the nine months through September 30, 2015. From my analysis, this is a temporary paper loss. It arises from exceptional volatility in one of our holdings, and does not suggest increased risk to our investment thesis, nor a permanent or long-term impairment of our capital. In this letter I will try to identify what led to the sharp volatility in the shares of that company and explain why we decided to accumulate more ownership of it. I will also discuss two new investments we made, and attempt to assess our prospects for the remainder of 2015 and beyond.

We own three companies currently. Because the partnership has expressed a preference for keeping our holdings private, and this letter is shared with non-partners, let us call these three Companies A, B, and C.

At the time of our last quarterly letter, Company A was our only holding. In keeping with our preference for concentration, it composed 15 percent of our portfolio, the remaining 85 percent in cash. Company A is an American media company with a highly profitable, monopoly-like position in the markets it serves. This is clear from its financials. Over the last six years, though its annual total revenue has gradually declined, Company A has averaged free cash flow of roughly $80 million a year, a 12 percent margin on its latest revenue. It has done this through cutting costs and prioritizing new revenue streams. Compare this $80 million in earning power to an equity market capitalization of $182 million at June 30th. Owning Company A at this price meant we received a 44 percent free cash flow yield to our investment. Put another way, the market was pricing Company A at 2.3 times its proven cash generation.

Why is the market pricing Company A at such a low level relative to its earning power? Company A went wrong in the same way many other businesses do: It took on too much debt. In 2005, Company A acquired a competitor, saddling itself with massive leverage just before the Great Recession. At June 30th of this year, if you added its $784 million in net debt to its equity market capitalization of $182 million, the total enterprise capitalization for Company A was $967 million. At 4.9 times its free cash flow before interest expense, this is a substantial amount of debt. But the company’s likelihood of insolvency has been greatly diminished. Following a bankruptcy in 2011 and a refinancing in 2014, all of its debt now matures after 2019, and 74 percent after 2022. And the company has safely met its covenants and reduced its debt about 20 percent since 2012. Management has repeatedly committed excess cash flows to debt repayment.

Assessing these facts, I decided we should own Company A, it having been thrown in the waste bin by investors because of past capitalist sins. The timing of this purchase at first seemed to benefit us earlier than expected: Company A was up 5 percent from the end of the first quarter to the end of the second. It then fell as much as 59 percent before partially rebounding toward the end of September. Why did Company A fall so much? At the start of August, Company A announced quarterly results that were below the prior year’s levels, though in line with earnings going back further. Equity investors are generally frightened by any trend that is not upward, and in a market already see-sawing because of concerns about the Federal Reserve and the Chinese economy, they dumped its thinly traded shares rapidly.

In moments like this, we agree with the advice of Warren Buffett, namely, “The market exists to serve you, not to inform you”. Sometimes, though, comparing different markets is informative. While equity investors in Company A panicked, the holders of its debt did not: Compared to the 59 percent fall in the price of its equity, the company’s senior secured bonds, which represent more than half of its total debt, fell just 11 percent, from 102 cents on the dollar to 91 cents, before recovering. Moreover, the largest owners of these bonds, being the company’s biggest lenders, have recently acquired shares in the company and own warrants for more shares that are exercisable at a price 54 percent above our cost basis. They have been moving down the capital structure, aligning their interests with ours.

The question I ask myself about Company A is the same question I ask about every asset considered for our portfolio: What is it worth? Despite Company A’s strong history of stable cash generation, I do not presume to know what Company A’s earnings will be at the end of the next quarter, and I am skeptical of anyone who says they do. I am similarly uncertain what its revenue will be in five or ten years. But I do know that Company A’s dominant position in the markets it serves is unlikely to be replaced, its cash generative abilities are likely to remain strong, and its debt levels are likely to be materially lower. As such, its worth has not changed much over the course of this year. So we have accumulated more of Company A in the August and September market tumult, at prices 42 percent below our initial purchase price, lowering our cost basis per share.

Investing done right isn’t about predicting the future. It’s about preparing for it. To be more exact, it’s about preparing for any one of the likeliest futures that might occur. In my previous letters, I made clear that we are, while in a present time of expensive asset prices, holding a significant cash balance to prepare for future times likely to feature falling prices. Our intent is to deploy this cash when prices fall. As they have fallen, we have done just that.

Our goal is to maintain the purchasing power of our capital over the long-term, and we are attempting to do this by focusing on the downside risk to our investments. Like Company A, Companies B and C have attractive valuations relative to their proven and probable cash generation. And they dominate the markets they serve, reflected in the high cash margins they earn on their sales. But unlike Company A, they benefit from balance sheets with little or no debt, giving them flexibility for share repurchases, opportunistic acquisitions, and other corporate actions. Company B is one of the global leaders in a small, oligopolistic software market, and Company C is an American manufacturer of key services and products for its industrial customers. We will attempt to accumulate more of Companies A, B, and C, and others, as their prices fall to levels that present us with an attractive margin of safety beneath their intrinsic values.

Between now and the long run, there will be ups and downs in our holdings. But if we focus on the fundamentals of the companies we own, rather than the market’s handwringing, I’m confident we’ll do fine.

The chart below depicts the make-up of our holdings on September 30th.

Portfolio Holdings

As of September 30, 2015

Should you have any questions or comments, please let me know.

Very truly yours,
 


Godfrey M. Bakuli
Managing Partner