Cove Avenue Capital Q3 2023 Letter To Shareholders

GREETINGS FELLOW SHAREHOLDER

The calendar third quarter of 2023 was general a messy one for monetary markets at giant, and never notably enjoyable for CSC shareholders as we gave again a few of our first half positive aspects each on a relative and absolute foundation. Nonetheless, we’re fairly happy with our yr so far outcomes.

Earlier than we get to our stock-by-stock evaluation, our general view of life stays pretty constant. Rising rates of interest function negatively on most property and the financial system at giant with a lag. These modifications usually are not “momentary”, and there might be attention-grabbing and painful penalties that naturally befall a world that coasted for over a decade on low charges and free cash.

Our strategy is focused on “handfuls” of particular firms, at particular values, run by particular individuals. No, we’re not resistant to the “tides’ within the brief run, but when our work is correct over the long term, we are able to zig whereas the market zags as we’re seeing this yr.

We are saying round Cove Avenue Capital: sure issues can solely be defined as “off spreadsheet” occasions. That Viasat (VSAT) launched the primary of its 3 satellite tv for pc community flawlessly solely to have a Northrop (NOC) antenna fail – the primary failure in 13 deployments- was not a part of our funding narrative. Whereas most prices are totally insured, the mathematics on the precise cashflow produced by an enormous improve in service capability is pushed out to the appropriate by no less than 18 months. That’s not an excellent factor. Now what are the percentages that Inmarsat, which lately merged into Viasat, suffered what’s more likely to be a complete failure after launch – the primary in its 40- yr historical past? Once more, the satellite tv for pc was insured for prices, however the delays clearly delayed a cashflow inflection level and thus decreased our current worth.

Sure, we did improve our place and made Viasat our largest place prior to those launches. And sure, we bought 30% of the place in between launches to mirror a change within the time worth of our cash, and it grew to become merely a “High Ten” place.

And sure, the inventory is silly, silly low cost with immense strategic worth in a world of “extra space.” The inventory wakes up daily with out reminiscence and seeks to low cost the long run…and thus we endeavor to research the long run in a probabilistic manner, and weight positions appropriately given the chance / return steadiness. We expect Viasat is an excellent wager from right here, simply not our greatest, highest-conviction wager. Now we have taken tax losses in taxable accounts, however you will note this place again in portfolios once more shortly after month finish.

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Additionally below “off spreadsheet,” we didn’t mannequin for an enormous cyber-hack of MGM Resorts (MGM), of which our holding IAC Inc. (IAC) owns 18% – their largest worth driver. The cybersecurity breach froze MGM’s reservation system late in September 2023, usually making a mangle of issues. Each shares dropped accordingly. Angi (ANGI), of which IAC owns 85%, reported a year-over-year income decline as Joey Levin (now full-time CEO of each IAC and Angi) focuses the corporate on extra worthwhile enterprise and retention…a lot to our delight. Dotdash Meredith stays mired in an advert recession because it continues its work onboarding the Meredith print properties to its digital monetization machine.

We view these challenges as annoying however momentary and the present market response as overly punitive. IAC at the moment trades $125m above the mixed worth of its money, MGM, and Angi positions. On the present worth, you “get” 31% of car-sharing market TURO, the fairness of publishing big Dotdash Meredith, Care.com, Vivian Well being, and different IAC firms for…$125m. Sure, now we have taken this chance so as to add to our place.

E.W. Scripps (SSP) was a detractor within the quarter on issues in regards to the basic financial system and advert market, in addition to the world of “strikes” which may have an effect on the need of auto firms to promote and the power to supply “scripted” tv and films. We expect all these points outline “cyclical and momentary”, and we aggressively added to our place to make this a High 5 place. Scripps has performed a really good job of positioning itself to capitalize on the evolution of the media business. We expect “legacy” TV has for much longer life to it than “fancy discuss” suggests, and regardless of apparent publicity to the cyclicality of the promoting enterprise at giant, Scripps is a money gusher that’s quickly paying down debt from a sequence of acquisitions that had been enabled below the prior administration. Decide your favourite math, however ours means that free cashflow to pay down debt is creating 30% annualized will increase in fairness worth at present ranges. Now we have had totally different exposures to SSP during the last decade – starting from zero to our present High 5 place.

Whereas the core choices of Viemed Healthcare (VMD) allow an environment friendly, at-home service to more and more unwell sufferers that facilitates respiration and permits them to keep away from visits to the ER. That apparently is a not view shared by some giant Medicare Benefit (MA) plans. Specifically, there was a latest development in direction of elevated denial charges for non-invasive air flow (NIV), as excessive as mid-80s for below one giant MA plan and the mid- 60s for a pair different giant MA plans. These charges are aggressive relative to many different MA plans which have as little as mid-teens denial charges. Within the short- time period, these denial charges have put some strain on the inventory, however regardless of these points, Viemed continues to profitably develop in addition to purchase different NIV suppliers.

Lifecore Biomedical (LFCR) stays “below wraps” in a strategic overview course of being led by Morgan Stanley. We bought our widespread inventory place close to 2023 highs to threat alter our publicity. We retained the popular shares, which proceed to pay-in-kind. We anticipate an affordable end result to be introduced this calendar yr.

Ecovyst (ECVT) took a short-term hit because it introduced earnings that had been frankly a bit extra unstable than we…and different buyers…had been anticipating. As a distinct segment particular chemical enterprise, ECVT is topic to the whims and ordering patterns of a lot bigger international gamers within the brief run. We expect the a number of utilized to this high-margin stream of free cashflow is absurdly low and it stays a High 5 place.

Hallador Power (HNRG), which was our prime contributor within the quarter, continues to carry out strongly, because the inherent worth in “previous carbon” continues to regain some grudging appreciation in monetary markets. We proceed to suppose that is an funding with “legs” given the troublesome provide/demand points inherent in any type of a “inexperienced” transition. However importantly, we proceed to threat weight the inventory as a basic commodity and are web sellers to keep up a 2.5% place.

Equally, CNX Sources (CNX) was a contributor for most of the identical causes, plus the considerably shocking announcement that the Biden administration signed off on a invoice that’s permitting the completion of the Mountain Valley Pipeline mission. The mission is a multi-billion greenback endeavor that’s 95% full that can improve the takeaway of pure fuel from core Marcellus fuel reserves to individuals who want it within the Southeast. Typically good issues occur off spreadsheet.

Heritage Crystal Clear (HCCI) was bought to personal fairness for $45.50 per share. Our unique buy worth on the agency was within the teenagers practically a decade in the past. That is the unicorn model of how funding life ought to work: discover a good enterprise that grows, discover a good CEO who understands worth per share math, after which maintain on for pricey life it doesn’t matter what the nonsense d’jure is within the headlines. That’s clearly a simplistic model of life (in any case Heritage has a phase that defines earnings volatility), but it surely’s fairly near our expertise with HCCI (that’s an excellent factor).

DLH Holdings Corp. (DLHC) is a advisor that gives a variety of public well being and life sciences companies to varied Federal well being companies such because the Veterans Administration and Facilities for Illness Management. It has added excessive margin cybersecurity capabilities by way of its acquisition of Grove Sources final yr. That is an asset-lite, excessive free money flowing enterprise with usually sticky 3 to 5- yr contracts. This firm trades at a reduction to its friends—regardless of having greatest at school margins— largely as a consequence of an overhang for a excessive income however low margin contract that comes up for renewal within the coming months. Our analysis signifies the inventory is priced for a “worst case” situation with respect to this renewal, and different doubtless outcomes current a high-upside case. Moreover, administration has been astutely utilizing money to amass smaller gamers in adjoining capabilities— equivalent to Grove—to diversify income throughout extra contracts. CEO Zach Parker got here in seven years in the past when the corporate was doing $2m in EBITDA; they’ll generate someplace between $30m to $35m this yr. DLHC was a prime performer within the third quarter because the administration staff continues to execute on its technique and positions the corporate to be bought to a bigger participant.

We initiated a place in American Software program, Inc. (AMSWA), the proprietor of provide chain planning software program Logility. This software program allows digital provide chain optimization with the most well-liked use case in product demand planning and primarily companies shopper items, meals and beverage, and retail clients who’re managing business-to-consumer (B2C) provide chains. This enterprise generates masses of cash, boasts excessive returns on invested capital (ROIC), and could be very sticky – when you prepare your staff on the software program and have all of your related inputs embedded in this system, you might be unlikely to modify.

This enterprise trades at a reduction to its peer set for causes that stem from the founder’s controlling B- class shares within the firm. He’s 88 years previous. The corporate has been overly conservative with its steadiness sheet, under-investing in development and dragging its ft on acquisitions. Demand for provide chain software program has surged following Covid, and but this firm continues to pay a dividend. Moreover, the area of interest that Logility companies goes via a items recession. They’re seeing gross sales cycles elongate whereas they’re attempting to maneuver clients to the cloud. The funding group has punished the inventory to this point in 2023.

We see a catalyst to resolving these points as the corporate publicly said that they’re conducting a course of to transform the B shares of Founder Jim Edenfield into A shares. Now we have engaged with administration on the best way to conduct the method and consider the decision of this share conversion will eradicate a big overhang on the inventory and allow a way more environment friendly use of capital going ahead. We’re already seeing indicators of progress with a latest acquisition, a divestiture of a non-core enterprise, and the adoption of a 10b5-1 buying and selling plan for a share repurchase program. This firm finally operates in a dynamic and quick rising business that’s consolidating. With the removing of Edenfield’s management, we see a sale to a bigger participant as a possible end result.

We…and administration… bought Chase (CCF) to Non-public Fairness in a lately introduced acquisition. The worth was “truthful” for a pleasant assortment of companies.

CommVault Methods (CVLT) has a market- main place within the backup and restoration house for enterprises, providing on-premises storage, a hybrid personal/public cloud resolution, and a cloud- based mostly resolution known as Metallic. After we first invested in CommVault in 2019, the corporate suffered from “Founders Syndrome,” which was overcome by quite a few Board modifications and the hiring of a brand new CEO, Sanjay Mirchandani. Mr. Mirchandani has performed as we hoped and righted the legacy enterprise’s price construction whereas efficiently launching and rising their cloud product Metallic. CVLT reached above what we consider to be truthful worth and we bought the inventory.

Our world in public small cap equities has not been a popular asset class and has not been the recipient of big flows of {dollars}. That has created actual alternatives in actual companies with actual values which are much less affected by the fads of the day. Now we have a lot to do and see plenty of alternative however are being appropriately cautious and picky.

Thanks acquire to your partnership.

Finest Regards,

Jeffrey Bronchick, CFA

Principal, Portfolio Supervisor Shareholder | Cove Avenue Capital Small Cap Worth Fund

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Editor’s Notice: The abstract bullets for this text had been chosen by In search of Alpha editors.

Editor’s Notice: This text covers a number of microcap shares. Please concentrate on the dangers related to these shares.