The Rational Cloning: Weekly Ideas #45
1 Main Capital on KKR; Cedar Creek Partners on Harbor Diversified, Western Capital Resources, Pacific Coast Oil Trust and BM Technologies; Tweets That Make You Go… Hmm 🤔
Welcome to the 45th edition of the Rational Cloning Newsletter (Weekly Ideas Series).
Helping you discover the best ideas of others.
Happy cloning.
Weekly Investment Ideas
(1) 1 Main Capital Q2 2022 Letter
Top 5 Positions As of June 30th, the Fund’s top 5 positions were Alphabet Inc (GOOG), Basic-Fit NV ( BFIT 0.00%↑ ), KKR & Co ( KKR 0.00%↑ ), Pershing Square Holdings ( $PSH ) and RCI Hospitality ( RICK 0.00%↑ ). Together, these holdings accounted for approximately 50% of the Fund’s capital.
KKR – Doubling Down
KKR was the largest detractor to the Fund’s performance in the first half, costing us around 6%. It was our largest position coming into the year and is down nearly 40% through June. It also remains our largest position today, as I have used weakness in the company’s share price to add meaningfully to our investment. In fact, it is approximately 2x the size of our next largest holding.
KKR is an alternative asset manager that manages around $500 billion for clients. It gets paid a management fee and share of profits on much of the capital it puts to work. Importantly, KKR is very well positioned within its field.
For one, alternative asset managers (“Alts”) have been taking share from traditional strategies. On top of that, the largest of these managers have been taking share from smaller ones. Given its size, strong brand, and impressive long-term track record, KKR has been able to grow its AUM and fees at double digit CAGRs for decades and should continue capitalizing on the above trends for the foreseeable future.
Additionally, scaled Alts such as KKR enjoy meaningful operating leverage, allowing them to earn operating margins of greater than 60% on fee revenues and 40% on performance revenues.
Despite these attractive attributes, KKR and the Alts more broadly are perceived as cyclical and get hit every time the prospect of an economic slowdown enters the picture. The thinking is that their underlying portfolios are leveraged, so when the market declines their investments will be hit disproportionately, which will negatively impact performance and inevitably future fundraising.
I believe that these worries are misplaced. In fact, I believe that Alts are better positioned than any other asset manager to thrive through market volatility due to their long-term capital commitments, which allow them to not only hold onto investments during bad times, but also use their massive pools of dry powder to lean into attractive new opportunities as well.
The illiquid nature of their investments also prevents them from trying to time the market like much of active management does unsuccessfully, selling when things are scary and buying back when skies look clear, which in most cases detracts from long-term performance. In essence, the Alts plant more seeds when things are scary and harvest more crops when things look great – exactly what you want stewards of your capital to be doing for you.{
At the same time, I think KKR should be able to grow its distributable earnings (DE) per share meaningfully in the coming years. When we first bought KKR shares, it was earning less than $2 of DE per share. This year, DE is expected to exceed $4 per share. By 2026, I believe that KKR will earn more than $10 of DE per share and will trade for a higher multiple than it does today as investors get more comfortable with the Alts cycle risk.
Additionally, employees and management are highly incentivized to see KKR succeed. Insiders own a lot of stock. The compensation of the company’s investment team is heavily tied to fee and performance revenues. Lastly, the company’s recently appointed co-CEOs were each granted 7.5 million shares of KKR which fully vest when the stock reaches $136 per share (3x current levels). They each stand to make >$1 billion if they get the stock there by 2026. I think that they will.
To summarize, KKR is an extremely valuable franchise that benefits from secular tailwinds, has capable management, and generates solid earnings and cash flow. I have a tough time seeing how we lose here and can easily see us making multiples of our capital in this investment in the years to come.
(2) Cedar Creek Q2 2022 Letter
Harbor Diversified $HRBR
We purchased shares in Harbor Diversified (HRBR) during the quarter. Harbor is the holding company for Wisconsin Airlines, which has a capacity agreement with United. The attraction is the high cash balance and current profitability. The concern is the contract with United ends in 2023. Our purchases were at prices below the company’s net cash balances of $2.24 per share, and at less than 70% of book value per diluted share. Harbor earned $0.14 per share in Q1 and $0.15 in Q4 of 2021. Neither quarter benefitted from funds from the payroll support program. They should be able to earn $0.60 per share before the expiration of the capacity agreement. The stock currently trades at round $2.20 per share.
Western Capital Resources $WCRS
In addition, we increased our holdings in Western Capital Resources (WCRS) after it declined sharply due to their decision to go dark. Shares are currently under $5 per share. The company has $5.77 per share in net cash, and trailing earnings of $1.15 per share. The company repurchased shares last September at $7. It is 80% owned by Blackstreet and management. We expect the stock to end up on the expert tier or possibly not even trade at all. They did say they expect to make annual repurchase offers, but who knows what the valuation will be.
Pacific Coast Oil Trust $ROYTL
Pacific Coast Oil Trust (ROYTL) is an expert market stock. It is one of the more complicated and interesting stories we have come across. It is an oil and gas trust that was sold to the public in 2012 at $20 per unit. The trust gives unit holders the right to 80% of cashflow after the payment of production and development costs for oil fields located in Los Angeles and Santa Barbara counties. At the time it went public the seller, Pacific Coast Energy Company (PCEC), formerly BreitBurn Energy, was retaining 52% of the trust units and selling 48% to the public.
Fast forward a few years, oil prices had declined from $100 per barrel to $60 and production had declined from 3,400 barrels per day to 2,200 resulting in sharply lower distributions. By 2018 the trust was trading between $2 and $2.50 per unit and paying roughly $0.30 per unit annually. In September 2019 PCEC was acquired by NewBridge Resources. Just a few weeks later, in October 2019 PricewaterhouseCoopers (PwC), the trust’s auditors resigned. In the 8-K filing on October 4, 2019 it stated, “PwC advised the Trust that information had come to PwC’s attention that causes PwC to be unwilling to be associated with the Trust’s financial statements in the future.” You don’t see that every day. The November 13, 2019 8-K notes that a 50% owner of NewBridge was or may have been affiliated with a company that filed for bankruptcy in 2015. Clearly there was more to the story. We have read unconfirmed reports that allege the buyers have criminal records that include embezzlement and insider trading. Talk about messy. Yet we aren’t actually done yet. That is only the who and the what, it is the how and the why that complete the picture.
In the same November filing, PCEC notified the trust that PCEC intended to deduct future plugging and abandonment costs (also known as asset retirement obligations, or ARO) from the amounts otherwise payable to the Trust under its Net Profits Interest beginning January 2020. The amount of estimated cost was $56.7 million. Annual payout from the trust at the time was about $10-11 million. The costs were not expected to occur for a number of years. Some wells were expected to be exhausted within five years, while for other wells it would be thirty years or more into the future. The assessment would result in no payments to unit holders for a number of years, which would trigger a clause forcing sale of the trust.
The trustee must have pushed back because PCEC commissioned Moss Adams to assist in determining the estimated asset retirement obligation (ARO). Moss Adams calculated it at $45.7 million, which was $11 million lower than before but would still trigger an eventual sale. The trust commissioned their own study by Martindale and came up with $28.7 million and communicated that the trust conveyance permits the amount to be accrued versus how PCEC wanted to treat it (all up front). It seems that the new owners of PCEC wanted to charge it up front knowing it would force sale of the trust in two years, and give PCEC all the cash flows in the interim. 4 The trustee wanted to amortize the ARO over five years believing that was most equitable to unit holders, which was logical, but probably not consistent with GAAP (generally accepted accounted principles) which would require recognizing the present value of the liability immediately.
The prospect of no further distributions sent the unit prices plummeting to 30 cents. No quarterly or annual filings were filed as there was no auditor. Unit holders did get monthly updates via press releases and 8-K filings from the trustee on production, revenues, expenses, operating income and the 80% net profit interest. Then COVID hit and oil plummeted from $60 per barrel to near $0 before resettling around $30 and slowly climbing back toward $60 by fall 2021. Due to COVID PCEC shut some production in. In July 2020 a unitholder filed suit. Unit prices fell to around 10 cents. Then it got even stranger. PCEC’s CEO who had the troubled past was ousted and supposedly blew the whistle in court. To make a long story a bit shorter. The court granted standing and prohibited dissolution of the trust. That eventually led to a three person arbitration panel that decided for PCEC, but that decision is still on hold pending settlement discussions. Units are currently trading around $0.32 per unit. So why did we buy units? We came to the conclusion that there were only a few likely outcomes:
Worst case – Unitholders have to pay full ARO and it leads to Dissolution of Trust. The two years of no payments by the trust has already occurred (from spring 2019 to spring 2021), and assuming court decisions all go against unitholders it would lead to an auction of the interests, where after payment of what remains of the ARO the remaining balance of the proceeds would go to unitholders. In this scenario time is our friend, particularly now that oil has risen to around $100 per barrel. As of May 2022, the higher estimate of the ARO remaining was $14.3 million and the balance was declining at about $1.5 million per month. By the time of an auction it could be paid off or nearly so. With oil at $100 the trust is generating roughly $4.5 million per quarter or $0.12 per unit. What would an investor pay for the that? Assuming a conservative three-year payback for the buyer comes to $1.50, and a 5x return for the fund from current prices. If the buyer assumes oil averages $80 per barrel, then cash flow is $12 million per year, or $0.32 per unit, and a three-year payback valuation comes to $1 per unit or 3x the current price.
Some kind of settlement where PCEC buys out unitholders or agrees to amortize the ARO. A buyout would likely have a similar valuation of the worst case scenario. A settlement about ARO treatment would result in the trust continuing in existence and unit holders receiving monthly payments. With oil at $100, the trust would earn $0.12 per unit per quarter. What is that worth in the (expert) market if the ARO issue is settled? We think more than the worst case.
Bonanza – somehow the court finds PCEC acted inappropriately, or it finds that a major portion of the ARO has already been assessed. We noted to the group filing suit that the original prospectus noted that $22.3 million of ARO had already been accrued before the trust was created.5 Thus we think it is possible, if not likely, that PCEC is charging something that was already (partially) accrued for. If so, that is $0.66 per unit based on 38 million units outstanding. The value of the units could be near $2 or more.
The bottom line is we don’t know precisely what the units are worth, but our analysis concluded that it is likely more than the current price. We made it a 4% position in the fund. Hopefully we are not missing a key issue. Time will tell.
Tweets That Make You Go… Hmm 🤔
