1

The Five Blogs Every Investor Needs to be Reading

Close that Bloomberg tab, cancel your subscription to Barron’s, and don’t you dare even think about turning on “Mad Money.” These media outlets are comparable to drugs: they initially provide an exhilarating rush but ultimately leave us no better off than we were before. Actually, there is a good chance these financial vices are making you worse off. Consume enough mainstream financial news and you may start believing that you can profit from macro trends, currency plays, and high-flying “momo” stocks – a disastrous recipe for the average investor.

I suggest you dedicate just one week toward freeing your mind from the noise and living off a steady diet of reading material certain to improve your investment process. And for my money, nothing beats investment blogs. The ability to critique a writer’s thesis and judge their analysis as it plays out (or doesn’t…) is a valuable experience that few other mediums can offer. In this post, I’ll share the top five investment blogs that would be at the top of my reading list if I were to start over today.

1. the red corner 

If you only plan on reading one value investing blog, close your browser now – this is the one. No idea is off-limits for writer red, as he analyzes businesses from India to the UK, from obscure micro-caps to billion-dollar enterprises. Expect not an elementary analysis, but rather red ‘s uncanny ability to go beyond the reported numbers to uncover the true earning power of a business. Red puts all his picks in a portfolio tab so you can track his every move. And I highly suggest you do – since its inception in July 2012, red’s portfolio has generated a 120% after-tax return.

2. Oddballstocks 

A blog that needs no introduction in the value investing community, Oddballstocks has made its mark looking for bargains in obscure places. From African stocks to liquidating banks to companies at 1X earnings, writer Nate Tobik offers ideas you won’t find anywhere else. In addition to unknown stocks, Nate’s blog is full of investment philosophy. Be sure to check out his posts on diversification, margin of safety, and bank valuation.

3. Gannon and Hoang on Investing 

A high school dropout and self-taught investor, writer Geoff Gannon has grown to be one of the most prolific bloggers since his start in late 2005. Geoff and co-writer Haong’s posts can admittedly be lengthy, but trust me, they are well worth your time. You’ll be hard pressed to find the depth of business analysis and investment philosophy they offer. For Buffet-esque investors looking for above average businesses selling at below average prices, this blog is a must read.

4. Alpha Vulture 

A Europe-based professional poker player, writer Alpha Vulture brings a scientific and calculated approach to his investment ideas. Alpha Vulture is a master at assessing downside risk and has a sharp investment process that any investor can learn from. If you are interested in international deep-value plays, merger-arb ideas, and even a short thesis or two, be sure to add this one to your reading list.

5. Bronte Capital 

The popular Bronte Capital is the brainchild of John Hempton, an Australia-based hedge fund manager. From shorting dodgy Chinese companies to exposing fraudsters, Bronte Capital offers a skeptical eye to the markets that is both refreshing and insightful. Where this blog falls short in actionable ideas, it makes up in downright entertainment. But don’t take my word for it – read John’s now famous post on Latvian Hookers and see for yourself!

Want to get the most out of these blogs? Try reading them from start to finish. This will allow you to understand the writer’s thought process at the time and see how the investment ultimately worked out. Were their assumptions overly optimistic? Did they improperly assess downside risk? Or perhaps they were right on the money and picked a multi-bagger. The best part about this method is seeing how the writer’s investment skills are sharpened over time, something I’m looking forward to doing with my blog after it has a few years under its belt (assuming I do actually get better, that is…).

Whether you are a fan of currency arbitrage, distressed debt investing or classic bargain hunting, there is a great blog out there for you to read and learn from. Then, of course, after reading a few blogs and deciding you want to improve your own investing process, what better move than to start your own!?

9

The Dolan Company and the True Meaning of Margin of Safety

Last week, during a leisurely morning read through the Wall Street Journal, I came across this headline:

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“Hmm,” I thought to myself, “that company sounds familiar.” Oh yeah, it was a 5% position in my portfolio just a few months ago! Now it and its equity are worth nothing. Zip. Zilch. Just like that, a stock I argued was worth $5 in a sum of parts analysis was at $.02. A picture is worth a thousand words, so let’s take a look at the stock chart along with my entry and exit points:

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How could I have been so spectacularly wrong? Well for one, my thesis lacked an adequate margin of safety. Okay, we have all heard that term before but what does “margin of safety” really mean? Let’s start with what I have learned margin of safety is NOT: the difference between the current trading price and one’s appraised value. In my original post, I valued the Dolan Company (DOLNQ) at $5 per share, which measured against the $2.75 share price at the time, implied a 45% margin of safety.

The fatal flaw in this calculation is it ignores the balance sheet and the extreme effect leverage can have in the event of an unforeseen negative development. With this in mind, I would like to propose a more complete definition of the term: margin of safety is the amount a company’s enterprise value could decline and still be greater than all of the company’s debt and the price you paid for the stock (credit Geoff Gannon). Now, when we bring Dolan’s net debt of $4.55/share (as of June 30th, 2013), our calculation looks radically different: ($5-4.55)/2.75 = 16% – yikes!

While this definition gets us closer to assessing downside risk, I believe margin of safety must be also gauged qualitatively through negative scenario stress testing. Ask yourself, what could wrong with this business? What might happen to the equity if a recession strikes and revenues decline 20%? The scenarios chosen for your analysis should be severe, yet realistic.

In Dolan’s case, their litigation service business, DiscoverReady, was the only line growing and generating steady profits – the future of the firm rested on this division. Well, DiscoverReady had extreme customer concentration with 40% of their revenues derived from one client, Bank of America. Never mind the longstanding relationship, the question must be asked – what would happen if Dolan lost BofA’s business? You can do the math, but the loss of this client would have sliced the company’s operating profit in half and put their ability to meet interest obligations in question.

We all know how this story ended. Completely unexpected, the company reported a 21% decline in revenues, including a 33% decline at DiscoverReady in their Q3 release on November 21, 2013. As It turns out, Bank of America had become concerned about the company’s financial strength and stopped sending business to DiscoverReady. Dolan’s financial condition caused their business to deteriorate, which only worsened the financial condition – a death spiral that sent the stock from $3.00 to 0 in 5 months.

I was fortunate to see the impending danger in the company’s November 6, 2013 8-K filing that revealed Dolan’s lenders were requiring the company to raise $50M through asset sales or an equity issuance. With my thesis called into question, I exited the position literally hours before the company reported their Q3 earnings and endured a 50% stock price decline. Hardly deserving of congratulations, I suffered a 25% loss in a position that could have been avoided with proper assessment of the downside risk.

Demanding a margin of safety is essential to achieving long-term investing success, and though investors are familiar with the term, it is easily misused in practice. If you want to know the true margin of safety inherent in your investments, incorporate the company’s balance sheet and stress test your thesis. A company’s debt load and customer concentration can be gleaned from a 5-minute read through the 10-K and may save you from painful losses down the road. I paid a hefty tuition for these lessons and would be glad for you to learn at my expense!

Disclosure: No position

2

ViryaNet: An Innovative Player in a Rapidly Growing Consolidation Market

After a crazy month of non-stop traveling, it’s great to be back blogging! It appears an exciting thing has happened during my brief absence: the frothy market we find ourselves in has started to show its first signs of jitters, and a number of the micro-caps I follow have sold off considerably. One such company that I believe has a good chance of doubling by this time next year is ViryaNet, the subject of today’s post. Enjoy…

ViryaNet (VRYAF, $3.55) is a mobile workforce and field service management software provider. The company has carved its niche in a booming mobile workforce management industry that remains just 25% penetrated, and is expected to grow by 40% annually for the next few years in North America. These industry tailwinds helped the company report a blowout of a fourth quarter, with earnings doubling and software license revenues increasing over 80%. Despite a 4-fold rise in 2013, I believe ViryaNet’s shares offer one of the most attractive risk/reward profiles in the market today, trading at merely 7X my estimated 2014 earnings and less than half the valuation of their larger publicly traded peers.

Business

Companies in field service intensive industries, such as utilities and telecoms, rely on ViryaNet’s solutions to optimize their mobile workforce and respond to real-time scheduling changes. The company’s core product, ViryaNet G4, provides web-based solutions, optimizing the full lifecycle of field service operations. This software allows service intensive companies to perform critical tasks, including creating work orders, scheduling and dispatching field personnel, and receiving real-time reports from the field.

As anyone with Comcast experience knows, poor service provided by field technicians can be a prime cause of customer attrition. A recent survey conducted by TechValidate showed that ViryaNet’s software proved effective in finding a solution to these issues, with over 75% of customers reporting improved field technician efficiency, on-time arrival, and workforce utilization. This value proposition has allowed the company to achieve nearly 100% client retention rates and a blue-chip customer base rarely experienced by a company of ViryaNet’s size:

Blue Chip VRYAF

Up to now, ViryaNet’s solutions have been primarily deployed through an on-premise model with up-front licenses (ranging from $300-500K to a few million) and recurring maintenance contracts priced at ~20% of the up-front license fee. A key feature of the ViryaNet sales strategy is the utilization of channel partners that “white-label” the company’s software and sell it as their own mobile workforce management solution. Accounting for roughly 30% of the company’s sales, channel partners include household names such as GE Energy and Vodafone.

Industry Overview

Over 70% of the world’s economy is comprised of service businesses and they’re continuing to grow in share. Gartner estimates the field service management market is valued at $1.5B annually, with software sales making up $329M of that total (ViryaNet February 2014 Investor Presentation). Most importantly, the market remains underpenetrated and is expected to grow at a rapid pace; research by Frost and Sullivan points to a 40% CAGR in North America through 2018 (source).

The mobile workforce management market is highly fragmented and consists of a large number of niche players in addition to that traditional ERP and CRM software vendors. ViryaNet’s primary competitors are ClickSoftware Technologies (CKSW), Astea International (ATEA), TOA Technologies, and ServiceMax. Despite the competitive landscape, the company has found its niche and been recognized as an innovator in the industry. Lately, ViryaNet’s markets have been in a heavy consolidation phase with two of the company’s primary competitors acquired in just the last three years: Ventyx (acquired in 2010 by ABB Ltd.) and Metrix LLC (acquired by IFS in 2012).

Financials

Below is a summary of the company’s financial performance over the past seven years:

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Note: The company’s 2013 10-K was not filed at the time of this writing so CFO for that year has been excluded.

ViryaNet’s recurring business has kept revenues stable, and a rationalizing of the cost base brought the company to profitable operations over 2008-9, which it has since maintained. The company experienced a breakthrough year in 2013 with record revenues, operating income, and a large jump in shareholder’s equity as debt was paid down. A closer look at the company’s quarterly financials reveals that the business accelerated in the fourth quarter of last year:

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The company’s maintenance and service revenues have remained stable over the last seven quarters, but a surge in software licensing revenue doubled operating income and put it at a record 27% margin. This outsized effect can be attributed to software licensing gross margins, which – at approximately 95% – are far higher than the 60% margins associated with services revenue. The company accredits the strong licensing revenue to the performance of their channel partners, particularly GE Energy, which have become increasingly adept at selling their product as these relationships have matured.

Valuation

Here is where ViryaNet’s valuation stands in relation to their larger publicly traded competitor, ClickSoftware Technologies:

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As seen above, ViryaNet trades at just over 1X revenues and 8.8X TTM EBITDA – a modest valuation for a software company that grew EBITDA 38% y/y. The market has awarded ViryaNet less than half the revenue multiple of Clicksoftware, which was not even profitable and experienced a decline in revenues. Recent transactions in this space also illuminate ViryaNet’s undervaluation, with Metrix LLC being acquired at 2.2X revenues in 2010, and the larger Ventyx being acquired at 4X revenues in 2012.

While the valuation gap has closed over the last six months, it will have a long way to go if the company delivers another record performance in 2014. ViryaNet’s business is notoriously lumpy, so, let’s consider three potential 2014 scenarios. For the base case, we will assume the company continues its high single-digit revenue growth rate and achieves operating leverage with a greater mix of software licensing revenues. The bear case will have licensing revenue trending back to the levels of 2012, and we will annualize the company’s blowout fourth quarter performance to form a bull case. Put together, here are the scenarios:

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Note: The company has a large amount of NOL carry-forwards ($35M for parent company, $62M for US subsidiary) that although valuable, have not been considered in the valuation.

In the base case, I believe that the company is capable of putting $.50/share toward the bottom line, which would put the valuation at a paltry 7X earnings. Assuming the company holds its current 10X EV/EBIT multiple, shares would then rise to $5 in the base case and provide nearly 40% upside from current levels. Should business continue to accelerate, shares could easily be valued at $7 and offer investors well over 100% upside. Considering the company revealed a multi-million dollar service order shifted from Q4 of last year to Q1 of this year, and just launched a cloud-based version of their flagship software, I feel there is plenty of upside to the scenarios I have outlined.

Catalysts

I see a number of near-term catalysts that could drive shares to new highs in 2014:

  1. Launch of ViryaNet G4 Cloud Offering – the company only began offering cloud-based deployment in November of last year and has already indicated strong demand. ViryaNet’s solution had previously been offered as a cloud model by only a couple of channel partners, but now the company is offering it to their entire direct customer base. The new cloud service should appeal to small- and medium-sized businesses that are weary of making a large up-front investment in the software, and will provide valuable source of recurring revenues.
  2. Acquisition Potential – as discussed previously, the field service and mobile workforce management markets have been consolidating rapidly. Management attributes it to the difficulty involved in building this complex software, which took ViryaNet over a decade with over $100M in paid-in capital. As the mobile workforce management market expands, I believe large software vendors look to ViryaNet as one of the few niche players left on the market – and with recent transactions occurring in the 2-4X revenue range, this scenario could result in a big payday for investors.
  3. Exchange Up-listing – with ViryaNet’s stock rising well above $1 in 2013 and the shareholder equity now at $2.5M, the company is in a good position to improve the liquidity of their shares by up-listing to an exchange such as the NASDAQ. With only a couple million shares in the float and the average daily trading volume at just over $50K, many interested investors are likely waiting on the sidelines for improved liquidity. Though management has not set a timetable, I believe an up-listing could occur as early as year-end, which should increase interest among institutional investors and assist in closing the valuation gap.

Risks

ViryaNet faces customer concentration risks, with four customers accounting for roughly a third of their revenues. The company is also dependent on the channel partners that have fueled their recent growth. Should ViryaNet experience the loss of a large customer or one of their partners find a replacement solution, the company would likely be faced with operating losses until new business is won.

ViryaNet also operates in a highly competitive and emerging industry characterized by rapid technological obsolesce. Should they be unable to keep pace with new innovations and industry trends, like cloud-based delivery, the business might face declining sales and an eroding competitive position.

Insiders

ViryaNet is a closely held company, with insiders collectively owning over 47% of the shares outstanding. Both CEO Memy Ish-Shalom and Chairman Samuel HaCohen have individual stakes standing at over 10%. Acting as true owners, management has done an excellent job achieving consistent profitability, organically growing the business, and moving the company toward a debt-free position.

Also of note, management has built their stakes with open-market purchases. In March of last year, Memy Ish-Shalom purchased 135,000 shares at $0.52 each, which increased his holdings by 50% to 10% of the company. I will point out that following the rapid rise in share price over the last six months, some insider selling has occurred – but, as Peter Lynch says, insiders sell for a variety of reasons and I don’t believe these actions are tied to management’s view of the company’s future.

Conclusion

ViryaNet’s position is enviable, with a blue-chip customer base and an innovative solution that is gaining traction in the rapidly growing mobile workforce management industry.  Investors have the opportunity to partner with a highly incentivized management team that has consistently delivered on product innovations and sales growth, at a price that is less than half of where comparable companies trade. With the company’s new cloud offering, up-list potential, and attraction as an acquisition target, I predict 2014 will be another breakout year and shares could climb a long way as more investors learn about this hidden gem.

Disclosure: Long VRYAF

1

Avante Logixx Update: A High-End Security Roll-up in the Making

Since my initial post on Avante Logixx in November, a number of positive developments have occurred that I believe have helped set the stage for new highs in 2014. Shares have risen over 50% since my write-up, however, I believe they have the potential to continue their move and reach $.80+ on the heels of the company’s emerging growth strategy.

First up, on January 17th the company reported their latest financials for the third fiscal quarter (possibly the fastest preparation of a financial report in the history of micro-caps). Results showed continued organic growth across all lines of business, with revenues up 32% and gross profits up 48% – though growth has decelerated over the course of the last few quarters. Below you will find Avante’s financials from the last seven quarters and updated valuation:

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The decelerating revenue growth and the 300 bp decline in the EBITDA margin are concerning but don’t illustrate the entire story. The margin hit was driven primarily by increases in staffing and the company’s vehicle fleet, both of which are necessary to support the company’s growth in the future. And as co-CEO George Rossolatos explains in Avante’s MicroCapClub Invitational Presentation, prospects for future growth are good, based on the company’s plan to utilize a targeted advertising campaign to market their services for the first time in its history. Impressively enough, the company has grown for decades strictly by word of mouth. With an advertising campaign and new products in development to cross-sell, I believe the core business will be capable of growing by at least 15-20% in the foreseeable future.

In my opinion, an even more important development arose on February 26th with the issue of this press release:

AVANTE LOGIXX INC. ANNOUNCES $5 MILLION “BOUGHT DEAL” PRIVATE PLACEMENT FINANCING

“February 26, 2014 – Avante Logixx Inc. (TSXV:XX) (“XX” or “the Company”) is pleased to announce that it has entered into an agreement with a syndicate of underwriters co-led by Cormark Securities Inc. and Mackie Research Capital Corp. (collectively, the “Underwriters”), pursuant to which the Underwriters have agreed to purchase, on a bought deal private placement basis, 15,625,000 common shares (the “Shares”) of the Company at a purchase price of $0.32 per Share (the “Offering Price”), for gross proceeds to the Company of $5,000,000 (the “Offering”).

Note: No affiliation with Mackie Research Capital Corp.

 So, what is a negative working capital business with $1.5M in cash on the balance sheet doing diluting shareholders nearly 30% with a $5M equity raise? The company clues us in later in the press release:

“Avante believes there is a significant opportunity to execute strategic and accretive acquisitions in the fragmented premium security services and monitoring markets.”

In order to gauge the attractiveness of this strategy, we need to take a closer look at George Rossolatos’ background. Here are some key highlights of his history from Avante’s January 2014 Investor Presentation:

  • Prior to Avante, George founded Riverdale Capital with the intent of developing a business in which he could take on a senior operational role to drive value creation.
  • Prior to Riverdale, he co-founded private equity firm TorQuest Partners with Brent Belzberg in 2002.
    • From 2002 to 2009, George and his TorQuest partners raised and invested two funds of $180 million and $550 million respectively.
    • TorQuest’s overall IRR from exited investments was in excess of 60%.
  •  Recognized in 2007 as one of Canada’s Top 40 under 40.

This is a successful private equity veteran who sought a business in which he could take on a leading operational role and help shore up. Since using his own funds to buy into Avante just 3 years ago, George has:

  1. Ended a risky technology development program, reduced headcount.
  2. Rationalized the cost structure, restored the business to profitability.
  3. Drove double-digit organic growth through new product development and cross-selling

The next logical step in the Avante’s evolution would be to accelerate growth through accretive acquisitions. George carries over a decade of private equity experience and has the expertise necessary for the company to be successful in this effort. The security services and monitoring markets are also fertile grounds for a roll-up strategy due to the amount of synergies and cross-selling that can be reaped through acquisitions. With all monitoring conducted from the central headquarters in Toronto, new clients and product offerings can be added at minimal incremental cost.

Based on my  research, estimates show that the smaller companies in Avante’s target industry can be acquired at valuations of 3-5X EBITDA. Additionally, the 15X EBITDA multiple Avante is currently commanding represents a powerful valuation arbitrage that George has at his disposal. To elaborate on the significance, let’s consider a sensitivity analysis for Avante’s price target across a range of valuation scenarios:

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Let’s assume that $5M is earmarked for acquisitions and that the company’s current cash balance both covers the underwriting fee and supports organic growth. The placement will increase the shares outstanding ~30% and bring the fully diluted count up to just over 75M. On the downside, if Avante overpays for acquisitions and experiences multiple contraction, shares could retreat to $.26, around the level when I initially presented the company. Alternatively, if Avante’s valuation holds steady, acquisitions within my estimated price range would bring shares to $.47-$.61, and afford investors  ~20-50% upside from current levels.

As attractive as this upside is, I have ignored three things that could potentially drive shares even higher than my estimated target range:

  1. Synergies from acquisitions, lowering the effective purchase price.
  2. Organic growth from marketing and new products/services.
  3. Multiple expansion to 20X+ EBITDA, in-line with peers.

Note: Keep in mind Avante’s business model allows them to convert 90%+ of EBITDA to FCF. A 20X EBITDA valuation  is more reasonable for Avante than for most other companies.

In my opinion, synergies are highly likely given the co-CEO’s private equity expertise, and multiple expansion will likely follow assuming the company proves to successfully integrate their first acquisition. Security technology companies often trade at lofty multiples and the appendix slide from Avante’s Investor Presentation shows that EV/EBITDA multiples far above 15X are possible. If you combine these factors, the $.80 valuation from the bull case in my analysis should be achievable. Additionally, if the company executes on all fronts, a share price of $1.00+ would not be out of the question either.

Finally, the financing “bought deal” structure involves Cormark and Mackie Research, the underwriters, taking responsibility for the placing and guarantee of financing. They will act as principals and be responsible for placing a sizeable amount of relatively illiquid shares following this transaction. I find it highly unlikely that the underwriters would structure a deal this way unless they were highly confident in the company’s prospects and investor appetite for shares. The underwriters and institutions involved with the deal will be incentivized to see their holdings appreciate, which is likely to manifest itself through analyst coverage, published research, and other media promotion – all of which are capable of helping to convey the story to the investing community.

There are clearly risks in the financing and acquisition strategy, but I believe the company has mitigated them by making the commitment to start small and search for targets locally in order to minimize integration risk. George has the expertise necessary to execute a roll-up strategy and his large stake in the business will ensure that he minimizes dilution risk and only pursues sensible deals. With Avante beginning the next phase of its evolution, look for accretive acquisitions, continued organic growth, and institutional buy-ins to all help make 2014 a break out year for the company.

9

OptimizeRx – A Little Company in the Sweet Spot of a Massive Industry

The pharmaceutical business is a $350 billion market that faces unprecedented challenges. According to IMS Health, drug companies spend over $6 billion per year promoting their drugs to physicians only to lose ground to low-cost generics. With doctors barring drug reps and shifting their business to e-Prescribing, pharmaceutical companies face the daunting task of reaching the physician’s workflow. At the center of all this is OptimizeRx (OPRX, $1.60), a tiny company with a novel solution.

Business

OptimizeRx, through its SampleMD software, provides a platform that allows doctors to print and electronically distribute sample vouchers and co-pay coupons for prescriptions. Launched only in 2008, SampleMD has already been integrated into 350 electronic health record (EHR) systems and supports a portfolio of over 65 leading drugs from the likes of Pzier, Lilly, and Sanofi Aventis. These drug companies pay OPRX $4-5 every time a coupon is printed from their platform, making the model massively scalable.

SampleMD has a value proposition that appeals to all parties in the prescribing process:

Pharmaceutical companies – SampleMD offers a solution to replace the pharmaceutical industry’s legacy system of maintaining a drug rep staff to deliver coupons and promote drugs to doctors. These drug reps were expensive, each averaging $200K/yr, and have increasingly become viewed as a nuisance by doctors. It should come as no surprise then that the industry has been downsizing their sales force, to 75,000 reps in 2012 from a peak of 105,000 in 2007.

The SampleMD platform also allows pharmaceutical companies to better gauge their return on promotional spending, which has become critical as competition from generics has intensified. The platform allows drug companies to know their coupons are actually reaching patients and not collecting dust in a doctor’s drawer. Drug companies can also use the platform to target their promotions to a demographic and communicate product information in real-time, right within the doctor’s workflow.

Patients/Doctors – patients receive the benefit of co-pay savings, which can be upwards of 80% for a typical $20 voucher on a $25 co-pay. These savings increases the likelihood patients will adhere to their medication regimen and thus lead to better treatment outcomes. The link between co-pay price and drug adherence was demonstrated by a recent study, which found that patients who received a $35 voucher on a $60 co-pay adhered to their regimen 35% longer than those that did not receive a coupon. Better outcomes are also becoming a key focus for doctors in response to new incentive systems outlined under ObamaCare.

EHRs – To entice EHRs to integrate SampleMD into their system, OptimzeRx offers the EHR a share of their coupon revenue, typically 40-50%. By integrating SampleMD, EHRs solidify their product while gaining a high-margin revenue stream. OptimizeRx has made much progress on this front, forging partnerships with some of the country’s largest EHRs – Allscripts, DrFirst, and Nexgen to name a few.

In addition to scalability, OptimizeRx’s business is recurring in nature – once a physician becomes familiar with the platform and benefits of e-couponing, it is very likely it will become a core part of his/her practice. The platform also benefits from high switching costs afforded by the time and effort required for integration onto EHRs.

Financials

Since launching SampleMD in 2008, OPRX has experienced exponential revenue growth:

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Note: A recent change in accounting policy will require OPRX to show revenue share as it is accrued rather than when it is paid. This change will likely have them showing a GAAP loss over the most recent period.

As expected, the company has not required additional infrastructure for growth and operating expenses have remained stable. This has allowed the business to scale and reach an inflection point this year, achieving positive cash flow for the first time.

To appreciate the acceleration of OPRX’s business, we can get a more granular view from the company’s quarterly financials:

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Note: The Q4 annualized figures reflect the recent accounting change whereas the historical quarterly results do not.

The key driver for OPRX’s revenue is the number of coupon distributions, which has increased in each of the last 7 quarters and driven triple-digit revenue growth. Most importantly, the company became comfortably profitable in the fourth quarter even after considering the revenue share accounting change. Given the recurring nature of the business, we can annualize the fourth quarter numbers to get a feel for OPRX’s run-rate operating income.

Examining OPRX’s valuation is a bit complicated due to a large number of preferred shares and warrants held by an early investor in the company, Vicis Capital. Vicis has been winding down their operations and has in place a securities redemption agreement with the company, which gives OPRX until March 31st of this year to raise $6M for the buyout. The firm has been accommodative, recently extending the deadline and lowering the redemption price from $9M, but the lack of a fundraising plan has caused distress in the investor community.  To work up a fully diluted share count, we will assume they issue 4.5M shares @ $1.60 and have to issue 2.25M warrants @ $2.40. Our valuation then looks like this:

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At the current run-rate, OPRX has a valuation of nearly 5X sales and 30X EBIT – rich by any standards. However, once considering the operating leverage inherent in OPRX’s business model and the catalysts set to drive distributions higher, it becomes clear this company remains deeply undervalued.

Modeling / Valuation

Modeling OPRX is challenging and is sensitive to two key inputs: the number of users on the platform and the average distribution frequency of each user. Fortunately, management has provided us a starting point by setting the goal of achieving a 1M quarterly distribution run-rate by 3Q 2014. By haircutting this goal and assuming it takes until the end of 2014 to achieve, we can get a glimpse of what the next few years should look like for OPRX:

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The business model requires little additional overhead to scale, but I have erred on the conservative side considering the company will be hiring a full-time CEO in the near future. Using an average pay-out of $4.50 per coupon, we find this business would do $18MM in revenues and nearly $6MM in EBIT under this scenario.

And a fair multiple for a scalable, recurring-revenue business growing at triple-digit rates? At the absolute minimum I’d argue for 15X, but realistically 20-25X would not be out of the question. Taking our low-end valuation and discounting back, we arrive at a valuation around $3.30, over double the current price.

Now all this begs the question: is management’s goal realistic? For a sense check, we can look to a revenue sensitivity analysis across the two key drivers, number of users and frequency:

edcfb70e81cfd144a59d922f42a5300a

SampleMD averaged around 100K users over the last quarter, which means that each user distributed a coupon once per three weeks on average. Following a number of key integrations currently taking place, notably with Nexgen and Allscripts, OPRX will have a base of approximately 150K users. This means achieving management’s goal will require each user’s frequency to increase to once every other week – hardly a stretch considering the secular trends in e-prescribing.

The sensitivity analysis can also be used to demonstrate the potential of OPRX’s business. There are roughly 700K prescribers in the United States and I believe the company could eventually reach a 50% penetration rate through further EHR partnerships. It is also possible that with growth in e-prescribing, the platform’s user frequency could reach twice per week, which would still be a small percentage of the 15 prescriptions an average doctor writes per day. Put these potential scenarios together and this is a business that could do $150+ MM in revenues and be worth 10-20X the current price.

Insiders

OptimizeRx is a closely held company with founder Dave Harrell holding nearly 16% of the shares outstanding on a diluted basis. Mr. Harrell was an ex-drug rep himself and started the company in 2006 as a portal for consumers to learn more about available drug coupons. Supporting Mr. Harrell are David Lester, COO, and Terry Hamilton, VP of Sales, both of which have extensive pharmaceutical and marketing experience. All executives’ interests are well aligned with shareholders, with Mr. Hamilton and Mr. Lester owning 4% and 2% of the company, respectively.

Risks

While OptimizeRx’s business model makes for a compelling thesis, there are a number of risks that have weighted on the stock recently.

Financing – as discussed above, the company will need to raise $6MM in next two months to buy out Vicis Capital. This will require the company to issue a significant amount of equity and holds them hostage to their stock price in the near-term. The stock has found itself in limbo whereby not communicating options for the raise, the stock has languished, which only reduces the company’s leverage in negotiating a deal.

Management Execution – in March 2013, the company brought on Shad Shastney, the founder of Vicis Capital, to serve as CEO and presumably craft a buyout deal from his old fund. Uncertainty caused by Mr. Stastney’s indictment with the SEC for securities fraud and resignation from the company sent the stock tumbling, even though such issues long pre-dated his involvement with the company. Founder Dave Harrell stepped in as CEO and although he has excelled at building the business, he has limited experience in managing a public company. The company is searching for an industry veteran to take the helm, but the question of who will be leading this company going forward is a major concern for investors.

Catalysts

OptimizeRx stands to benefit substantially from secular trends in the e-Prescribing industry:

1)     EHR Integration/Future Partnerships – SampleMD is currently being integrated into the Nexgen and Allscripts platform, which itself has over 100,000 users and a dominant share of the e-prescribing market. The company also recently an announced a partnership with Physicians Desk Reference (PDR) to bring SampleMD to PDR’s extensive network of EHRs. Considering SampleMD will reach only 20% of the country’s prescriber base following these integrations, more partnerships could be on the horizon in 2014.

2)     New Drug Additions to the Platform – SampleMD currently features 65 leading drug brands (up from 46 at the end of 2011), having recently added blockbusters like Viagra. Given the enticing ROI SampleMD offers drug companies on their promotions, the company could soon be given entire portfolios of drugs to support on their platform.

3)     Growth in the e-Prescribing Industry – According to Surescripts, the leading U.S health information network, e-Prescribing has been growing at a rapid pace, increasing from 326M to 570M prescriptions over 2011 alone. Driven by government incentives and desire for operational efficiencies, the total number of e-Prescriptions is predicted to reach 2 billion in 2016 (of which ~30% will be branded drugs). To put this market opportunity in perspective, OPRX has less than .25% share of their projected addressable market at current run-rate levels.

Beyond these, resolution of the Vicis Capital buyout, revenue growth from consulting services, and OPRX’s potential as an acquisition target could all serve as catalysts to drive the business in 2014. The company’s acquisition potential should not be underestimated as Merck recently bought a controlling stake in OPRX’s lone competitor, Physicians Interactive, in a deal that valued PI at a rumored $100M (per ex-CEO Shad Shastney on the 2Q13 conference call).

Conclusion

OptimizeRx is in the sweet-spot of their industry with an offering that enables drug companies to market their products while helping patients and doctors realize better outcomes. The market’s concern over near-term fixable issues have created an opportunity for investors willing to looks past these uncertainties and focus on OPRX’s accelerating business. Conservative assumptions around platform adoption point to a valuation over twice the current price and potentially far higher given the market opportunity the company has before it.

Disclosure: Long OPRX

7

JEMTEC: A Canadian Hidden Champion Trading at a 40% Discount to Net Cash

JEMTEC (JTC.V, $.72) is a provider of offender monitoring equipment and services to provincial and federal corrections agencies in Canada. Since pioneering this emerging field two decades ago, JEMTEC has risen to hidden champion status by having started all electronic monitoring programs operational today in Canada. Unfortunately, being a hidden champion does not guarantee profitability, and the loss of a key contract in 2007 has sent the company to a loss-making state that management has struggled to find a way out of. Despite its lackluster operational performance, the company remains woefully undervalued, trading at a 40% discount to the net cash on the balance sheet.

Business

JEMTEC offers a suite of solutions to monitor offenders and individuals under court-ordered restrictions in the local community. These products typically consist of global positioning, electronic monitoring, and alcohol/drug detection equipment that are rented to clients under long-term contracts.

Courts and law enforcement agencies use JEMTEC’s solution to monitor pre and post-trial clients and ensure adherence to mandated restrictions. JEMTEC completes its solution by leveraging its 24/7 monitoring center, which allows the company to quickly respond to alarms generated by offenders and alert the appropriate law enforcement agency.

JEMTEC first began developing remote monitoring systems in 1984 and landed Canada’s first ever home incarceration contract with the BC Ministry of the Attorney General in 1987. Operating under a public-private partnership model, the company grew to become the dominant supplier of offender monitoring technology, winning subsequent contracts with many of Canada’s provincial agencies, including BC Corrections, Saskatchewan, New Foundland, and the Ontario Ministry of Community Safety and Correctional Services (OMCSCS). JEMTEC’s dominance in this narrow market niche, gave it the status of “hidden champion,” a term popularized in Hermann Simon’s classic 1996 book, “Hidden Champions.”

Financials

The last ten years have been rocky for JEMTEC, going from 5 years of rapid growth and niche domination to 5 years of complete stagnation and operating losses:

Capture

From 2004 to 2008, JEMTEC’s revenues soared on the heels of multiple contract wins with Canada’s largest public agencies and domination of their niche market. Examining this period allows us to see the potential of JEMTEC’s business – their asset-light model and minimal operating structure enabled the business to achieve impressive financial results over this time, consistently producing EBIT margins of 30-40% and a ROIC in the 100-200% range.

The last five years have been a different story, however, as the loss of their largest customer(the OMCSCS) sent revenues down nearly 70% from their peak and caused a string of operating losses the company has yet to find a way out of. Since 2007, the company has managed to win only one new contract with Nova Scotia’s Department of Justice, and the recent news of two more non-renewals all but ensure the company will be operating at a modest loss for at least the near future.

Valuation

While JEMTEC’s operating business is hardly creating value, the company’s true value lies in its balance sheet:

Capture

The boom years in the mid-2000′s piled cash up on JEMTEC’s balance sheet and management has been very conservative with the companies resources, spending only nominal amounts on CAPEX and shying away from acquisitions of any form. JEMTEC has a very clean balance sheet with nearly all  of their assets in cash and no debt, and at a 41% discount to their net cash, qualifies the business as a true Ben Graham “net-net.”

To understand if such a valuation is warranted, we need to consider the rate the operating business is destroying value, for which the burn rate will serve as a good proxy. Diligent cost containment efforts helped bring the business to near break-even levels on an EBITDA basis in 2013 and using the most recent burn rate of ~$30K/yr, we can see it would take a little over 45 years for the business to burn through enough cash to equal the current market valuation. Should the business suffer more contract non-renewals and the burn rate worsen to say, 2011 levels, then it would take about 5.5 years to burn through the discount to net cash. Given JEMTEC’s minimal CAPEX requirements and modest burn rate, I would argue the business should be worth at least the cash in the bank, which would imply about 70% upside in JEMTEC’s shares.

Insiders/ Risks

JEMTEC is a closely held company with CEO Eric Caton owning over 16% of the shares outstanding and the board combining to own another 8%. CEO Eric Caton is a JEMTEC veteran, having served on the board since 1991, while the other directors have been in their positions for an average of two decades. While the board has not exactly destroyed value and jeopardized JEMTEC’s cash pile, they haven’t done much to revitalize the business. They engage in little product development, have won only one contract in the last 8 years, and though discussed yearly in the CEO letter, have yet to expand into ancillary markets through a strategic acquisition.

The biggest risks to the valuation and investment thesis are management’s allocation of resources and the future of the business with regard to customer concentration and contract renewals. Management has stated they continue to evaluate acquisitions and given that they have little history in this regard for investors to judge, this could serve as a major risk. In many ways, management’s lack of urgency to invest their cash in the core business is a risk itself, in that it increases the likelihood of JEMTEC losing their competitive edge to competitors and suffering further contract non-renewals as a result. Restoring the business to profitability will likely require significant effort to innovate and market their core offering, yet management seems content to operate at break-even levels while taking home comfortable salaries.

Conclusion

In summary, JEMTEC offers the rare opportunity to purchase a business at a significant discount to the cash on the balance sheet. The business has been shown capable of producing very high margins and returns on capital, along with the ability to generate nearly half the company’s current valuation in annual operating income. Should management prove capable of investing the company’s resources and reinvigorating JEMTEC’s core business, then the company should at least be worth net cash and potentially multiples of the current price if the market turns to a valuation based on earnings potential. Personally, management’s inaction over the last 5 years gives me little confidence the initiatives necessary to bring the business out of its value-destroying state will be undertaken anytime soon – I am taking a pass on this one for now.

Disclosure: No position

6

XPEL Technologies: An Undervalued Growth Machine with Multi-Bagger Potential

XPEL Technologies (XPLT, $1.47, DAP.U.V, $1.48) is a marketer and distributor of after-market automotive paint protection products. Far from the average automotive parts supplier, XPEL has built a marketing model around an extensive customer base that has given the business many desirable qualities: recurring revenues, high returns on capital, low customer concentration, and high barriers to entry. On top off all that, XPEL has experienced torrid 50+% revenue growth over the last few years on the heels the company’s breakthrough product, the ULTIMATE Film that has revived a long-stagnant industry and left XPEL’s competitors struggling to keep up. With a market penetration rate of just 2-4%, XPEL’s future could see revenues into the hundreds of millions of dollars and a share price multiples of today’s price if paint protection film can achieve the 20+% penetration rate of many common automotive products.

XpelUltimate_01

Industry Overview

Paint protection film (PPF) is a thin material, typically made out of urethane, which is applied to select parts of a car to protect the paint against rock chips, gravel, and other abrasions. Installing paint protection film is an involved process and typically requires a trained installer to cut the film on-site to specification and meticulously apply it to the vehicle.

XPEL Porsche

The film is most effective when installed at the time of initial purchase and provides a powerful value proposition to the consumer, preserving the appearance of their new car while also maintaining the resale/trade-in value. The value proposition is equally enticing for car dealers, providing them with a high-margin up-sell while also lowering their risk of receiving rock chip complaints, which happens to be the number one complaint found on customer satisfaction index surveys.

The paint protection film industry has relatively low penetration in the domestic market, which the company estimates to be in the range of 2-4%. The low penetration can be primarily attributed to low-quality early generation products (3M’s Scotchguard film) that became notorious for causing an “orange peel” discoloration that led dealers to abandon the product altogether after a barrage of customer complaints. As product quality, led by XPEL’s ULTIMATE Film, has improved dramatically, the PPF industry has gained traction from a number of “early adopters”, specifically car enthusiasts, customers living in harsh weather environments (Denver, Salt Lake City), and serial vehicle leasers looking to avoid damage charges at trade-in. As the company notes, the desire to product one’s car is a universal concept, and a focus on consumer awareness campaigns to drive PPF penetration will be key for the industry moving forward.

XPEL has risen to become the leader of its industry through marketing a superior product and offering a customer solution that is unmatched in the marketplace. XPEL leverages multiple features to gain an edge over competing film, including material design to prevent orange peel discoloration, self-healing properties that allow the film to reconstruct itself after incurring minor scratches (see a video demonstration here), and an industry-leading 10-year warranty. XPEL perfected these features in its latest generation product, the ULTIMATE Film, which was released in late 2011 and has driven the rapid growth that will be seen later in the company’s financials.

To offer a complete customer solution, XPEL markets their film along with licenses to their Design Access Program (DAP), which gives the installer access to over 70,000 vehicle applications updated in real-time. XPEL spent most of its history building the DAP software and recreating the database, along with the car manufacturer relationships necessary to match this offering, would be formidable challenge for a competitor.

Business Model

XPEL’s business model is also unique in that it sells its product directly to installers instead of going through distributors, as is commonplace in the industry. This is a huge advantage which gives XPEL very low customer concentration and allows them to bypass the middlemen who extract a sizable portion of the profit pool and don’t have much of an incentive to sell one product over another. Acquiring this advantage requires a large trade-off, however, as XPEL must have a support staff and sales force in-place to educate each customer about the advantages of their product, ensure each installer is properly trained, and service the account over the lifetime of the relationship. Given the infrastructure necessary to support this model, the company can only operate this way domestically and still must rely on distributors for all of their international sales.

After understanding this aspect of the business, it becomes clear XPEL operates more like a franchisor than an automotive supplier. The company treats each installer like a franchisee: they provide them hands-on training, accompany them during sales pitches to large dealerships, and capture leads for them in their local markets. In return, XPEL receives a loyal customer who will do the work for them as they grow their own local business. Since each film type requires a slightly different method to install, XPEL also benefits from customer switching costs once the installer gets comfortable with their film and learns to use their software for cutting patterns.

Financials

Below is a summary of XPEL’s financials over the last nine years:

XPEL Summary

Current management’s refocus on sales and marketing had a dramatic effect on the business, bringing XPEL to profitability for the first time in 2009. Management’s decision to shift from software licensing to film sales caused a decline in gross margin percentage but a sharp rise in overall revenue and gross profit. The power of the company’s asset-light business model also shows in the financials, with ROIC rising over the 50% mark in the last two years.

A closer look at XPEL’s quarterly financials allows us to appreciate just how rapidly this business has grown following the release of the ULTIMATE Film:

XPEL Quarterly Summary

The last three quarters have seen revenue grow 50-100% y/y and earnings grow 65-170% as the business has scaled. Also encouraging is that gross margin percentage ticked up in the latest quarter and appears to have stabilized around the 33% level. These results have brought XPEL’s 3-yr revenue CAGR to over 60%, a figure few businesses in the world can claim. As would be expected, the market responded positively to these developments, sending shares up nearly 600% in 2013 alone. As it stands, here is XPEL’s current valuation:

XPEL Current Valuation

At 2.3X sales and an EV/EBIT multiple of nearly 20, the company’s valuation clearly has an element of future growth priced in. For us to determine if the stock is wildly overpriced or deeply undervalued, we need a firm handle on the company’s growth potential. Fortunately for XPEL, a plethora of growth opportunities lie ahead that could all combine to keep the company on its rapid growth trajectory.

Growth Opportunities

Increased Market Penetration

For the reason stated above, PPF penetration remains quite low, especially when compared to window tint’s 50+% penetration rate. Taking the high end of XPEL’s estimated range (2-4%), we can estimate the current market size:

Screen Shot 2014-01-28 at 9.23.00 AM

Also, given that 70% of XPEL’s revenues are domestic, we can estimate XPEL’s U.S. market share:

Screen Shot 2014-01-28 at 9.23.10 AM

It would not be unreasonable to see penetration reach 10% in the near future, especially given that a few Western markets, namely Denver and Seattle, have already surpassed the 20% penetration level. Provided XPEL maintains their market share, they stand benefit substantially from increased penetration:

Screen Shot 2014-01-28 at 9.23.24 AM

Market Share Gains

Though the PPF market has been growing overall, there is no question XPEL has been taking share from competitors with their superior product and direct-to-installer business model. Slowing XPEL’s progress would require a competitor to not only design a superior product, but also match their business model and support infrastructure. Since PPF is such a small part of their main competitor, 3M’s overall business, I think it is reasonable to anticipate future market share gains. If XPEL can take their current share from 16% up to 25%, this alone would add significantly to their revenue base:

Screen Shot 2014-01-28 at 9.23.35 AM

International Growth

Perhaps the biggest growth opportunity for XPEL lies in international expansion. Not only is the propensity to protect one’s car just as strong overseas as it is domestically, but XPEL makes far more per car in some countries. For example, customers in China typically opt to cover their entire vehicle to protect it from acid rain. Protecting an entire vehicle costs around $5,000 for the labor and materials, which yields 5X the revenue for the company as compared to the typical $1,000 domestic install. A similar dynamic also exists in the Middle East, where drivers need to protect their vehicles from sand damage.

The combination of low penetration rates and higher revenue per install creates huge opportunities for the company abroad. In fact, management believes it is possible that their current 70/30-domestic/international revenue split could invert over time. Assuming the company can bring the revenue split to 50/50 in the mid-term, this scenario would serve as a further revenue driver for the company:

Screen Shot 2014-01-28 at 9.23.47 AM

Company-Owned Install Shops

XPEL recently began experimenting with opening company-owned install shops with the intent not to take share from their customers, but to learn more about the end-users and installation process. Outside of San Antonio, the first shop opened was in Houston last year and all signs are it has been a big success. In fact, opening a company-branded shop has brought XPEL accounts that local mom-and-pop shops would likely not have been able to win, such as Lamborghini and Porsche dealerships.

This dynamic clears the way for XPEL to open more of these without risking upsetting their customer base – it wouldn’t be a stretch for them to open a few of these in each major market and get to 50 nation-wide over the next few years. Based on my estimated shop performance metrics, here is the revenue impact such a roll-out could have on the company’s financials:

Screen Shot 2014-01-28 at 9.23.57 AM

One thing to remember is that this model would earn the company installation labor revenues as well, which even after considering the additional overhead, would be a significant driver of XPEL’s bottom-line. For simplicity, I have only considered the incremental film sales from this avenue.

Franchising Program

As explained previously, XPEL already operates like a franchising business and has the entire infrastructure in place to begin selling XPEL-branded franchise licenses. Further, the success of the company-owned shops proves the concept and would serve as a platform for selling the first few licenses. Assuming they extract a standard franchise fee of 7% of sales and manage to convert 25% of their installer base to franchisees, such a program would bring the company a valuable high-margin revenue stream in addition to existing film sales:

Screen Shot 2014-01-28 at 9.24.08 AM

Beyond these growth avenues, there are further opportunities that are difficult to quantify but should not be discounted when considering the company’s growth potential. These include growth into ancillary markets, like motorcycles and heavy machinery, development of new products such as window film, and the sale of customer leads to their install shop base.

Growth Scenarios / Valuation

So which growth route will the company choose to pursue? Management has made it clear each of these avenues will be integral to the company’s growth strategy, though no plans for a franchising program have been laid out. Viewed independently, we see the potential for nearly $35M in incremental revenue from these sources. Viewed in combination, however, the impact on the company could potentially be much higher.

The company likely won’t have the resources to fully execute on each of these opportunities, so we will call the above analysis the bull case. After assigning a bear case where only modest revenue growth is realized, we can take the mid-point to generate a base case growth scenario:

XPEL Growth Parameters

Assuming it takes the company 3 years to capture this incremental revenue, we can project how the company will perform under this growth scenario:

XPEL Base Projections

The base case allows the company to continue with solid 30% revenue growth, which would be far below the company’s current 60+% rate. We will assume gross margins stabilize and trend up slightly as the company scales and reaps purchasing efficiencies. XPEL will have to build their infrastructure to support this growth, which we will assume drives OPEX up 20% per annum. The company’s operating expenses have risen roughly 35% during the period of 50-100% revenue growth so this would appear to be a reasonable assumption moving forward.

Through operating leverage, EBIT would grow at a rapid 50% clip and the lofty EV/EBIT multiple would quickly compress. I would argue that at a minimum, a 15X EV/EBIT multiple would be a fair multiple for this business, should it achieve the projected financial performance. Discounting our results back to today would yield a share price of $3.21, offering nearly 120% upside from current levels. To put things in perspective, here are the bear and bull cases:

XPEL Sensitivity Cases

Note: Though significant, the effect of cash build has been ignored for simplicity in the above analysis

Even in the bear case, the company would grow revenues 7% per year, which I estimate the company could support with only a modest 5% annual lift in OPEX. This disaster case would still give the company solid EBIT growth and imply only ~5% downside, assuming multiple compression to 12X. Should the company execute flawlessly and realize the bull case growth, investors could be looking at business doing 4X the revenues, which at a 25% EBIT margin and conservative 15X EBIT multiple, would have shares worth nearly $8.00 – over a 5-bagger from current levels. The bull case may seem like a long shot, but keep in mind all it requires is for the company to sustain it’s past 3-yr growth rate for the next 3 years.

Risks

In my opinion, the biggest risk with the XPEL thesis is competition. As with any expanding market, competition is virtually guaranteed to enter the market and attempt to get a piece of the growing pie. Given that XPEL’s product is not particularly advanced from an R&D standpoint, it wouldn’t be a stretch to see a few competitors bring comparable film to the market and attempt to undercut on price. One dynamic to mitigate this is the difficulty a competitor would have in replicating XPEL’s direct-to-installer business model and convincing their loyal customers to switch from an already established premium product. Lastly, given the issues the PPF industry in the past, competition could actually be a positive for XPEL in that it could legitimize the industry and catalyze market penetration.

For a company with so many growth avenues available to it, there is high degree of execution risk, especially since management will be pursuing multiple opportunities at once. The company only has 40 employees and if the base case growth is realized, their organization could rapidly become strained. International growth, especially, will stretch the company’s resources and could leave a window open for competitors to take share from XPEL in the domestic market.

Insiders

XPEL has very high inside ownership, with management, directors, and employees collectively owning over 50% of the shares outstanding. CEO Ryan Pape owns 6% of the shares and has done an excellent job of turning around the company since coming on board in late 2009. His vision to rebuild XPEL as a marketing/branding company from a technology company has been the primary driver of XPEL’s financial performance and has resulted in a 2000% share price performance during his tenure.

Ryan has also been an excellent steward of shareholder’s capital. Ryan has exhibited a conservative management style, operating the company debt-free, shying away from acquisitions, and issuing very few press releases. Under his leadership, XPEL has adopted a policy practically unheard of in the investment world: the company has no stock option or warrant program and hasn’t issued a single share since he took the helm nearly 5 years ago.

Conclusion

XPEL Technologies finds itself in the early innings of rapidly growing industry, where it has taken a leadership position with its superior product and its unique pseudo-franchising model. Major growth avenues in increased domestic penetration, market share gains, international expansion, and company-branded install shops are all poised to give the company a runway for revenue growth that few companies possess. Competition and consumer awareness remain as large obstacles for XPEL’s growth, but if management can execute and maintain the company’s market-leading position, the company’s value could realistically increase multi-fold as the PPF market develops and more investors become aware of this compelling growth story.

Disclosure: Long XPLT

26

Kopparbergs Bryggeri: The World’s Cheapest Craft Brewer?

Kopparbergs Bryggeri AB (KOBR-MTFB.ST, 67.00 SEK) is a Swedish brewing company famous for pioneering a sweeter version of alcoholic pear cider that has catapulted it to status of number one in the world for this niche product. Its flagship cider, along with Sweden’s best selling domestic beer brand, have given Kopparbergs all of the characteristics of established brewing companies: local brand loyalty, pricing power, high returns on capital, and stable, recession-resistant cash flows. Further, its focus on the specialty segment of the beverage market has given the company something rare among brewing companies in mature markets: double-digit organic growth rates. Despite all these positives, the company remains shrouded in obscurity and trades at just over 9.5X EBITDA and 11X FCF, giving it one of the lowest valuations of any company like it in the world.

Business History

Kopparbergs’ history dates back to 1888, when a brewery was founded in Kopparbergs, SE to take advantage of the town’s famous water quality. After hitting a rough spot in the early 90’s that left it seized by a bank, Kopparbergs was purchased by two brothers, Peter and Dan-Anders Bronsman, who saw great potential left in the business. They hired a talented brew master and in 1996 had the breakthrough idea to create a Swedish strong cider that was sweeter than the more bitter English style that had dominated the domestic Swedish market up to that point. Thus was born the Kopparberg Cider that has become the best selling pear cider in the world and is sold in over 30 countries world-wide.

Kopparbergs Brands

Through select acquisitions and organic product development, Kopparbergs has built an extensive product portfolio around its flagship cider:

Kopparberg Cider – In addition to the best-selling pear cider, Kopparbergs produces apple, strawberry & lime, and mixed fruit ciders. Kopparberg’s mixed fruit cider was recently voted as the UK’s hottest alcohol brand by Publican’s Morning Advertiser, edging out Heineken’s dominant incumbent brand, Bulmers.

Sofiero – a well-hopped pilsner that has become the staple of the Swedish beer market. This brand recently hit a milestone, logging its tenth consecutive year as the best selling beer in Sweden.

Zeunerts Craft Beer – located in Northern Sweden in a region famous for its water quality, the Zeunerts brewery produces a full suite of craft beer styles including lagers, pilsners, and hopped ales.

Kopparbergs’ hit cider has enabled it to expand entirely organically into 30 countries, achieving success in nearly every country it has targeted. Review after review I read demonstrated the superior flavor and uniqueness this product has that resonates with consumers despite its premium pricing:

Kopparbergs Review 1

 

Kopparbergs Review 2

The attractive economics of branded beverage companies are well understood. Brewing has been called a local business, referring to customer loyalty that makes it difficult for foreign companies to make in-roads on dominant local brands. This brand power along with the low relative cost of beverages, creates strong a dynamic for pricing power that has allowed brewing companies to combat raw material inflation and maintain high returns on capital. Finally, alcohol’s habit-forming nature keeps consumer demand robust across all parts of the economic cycle, enabling brewing companies to maintain steady cash flows and comfortably boost returns on equity through use of leverage.

Financials

Turnings to the financials, they are just what we would expect for a successful brewing company:

Kopparbergs Financial Summary

Sales have grown every year since 2005 and earnings have increased right along with them. The company went through a large capital upgrade cycle over 2011-2012, but FCF has surged over the trailing twelve months as investment has tapered off. The strong FCF generation has improved Kopparbergs’ financial position, sending the debt position to its lowest level in nearly 10 years.

A closer look at Kopparbergs’ profitability metrics reveals the dramatic improvement that has taken place as the business has scaled and their brands have gained a foothold in international markets:

Kopparbergs Peformance Metrics

Gross margin has steadily increased as the business has scaled and benefited from purchasing efficiencies, surpassing the 50% mark in 2010. More dramatic has been Kopparbergs’ operating margins, which nearly doubled in 2010 following the companies decision to divest a number of marginal products and focus solely on its best-selling cider and beer. These margin improvements have pushed ROIC over the 20% level – even better, the company is deploying capital more efficiently as it grows as evidenced by 3-yr and 5-yr returns on incremental investment of over 40%.

Across the other key value driver, growth, Kopparbergs has also produced impressive results. Since its inception in 1994, sales have increased in all but two years:

Kopparbergs Turnover

A closer look at Kopparbergs’ sales breakdown reveals the explosive growth that their products have been experiencing abroad:

Kopparbergs Sales Growth

Note: TTM sales breakdown estimated based on projected sales growth rates. These figures are disclosed only in the annual reports.

Kopparberg’s largest market, Sweden, has yielded steady growth of 6%. Growth in neighboring Europe, however, has far exceeded this figure at a rate of nearly 20% per annum and growth in the rest of the world has been continuing at a breakneck pace, albeit from a low base. Important to note is that nearly all of this growth has been organic, an impressive feat in an industry dominated by consolidation. As CEO Peter Bronsman explains in the 2009 Annual Report (taken from Google Translate):

“All of our export markets have been built up from scratch. We have gone in with a small agent or by our own staff…”

This organic approach allows Kopparbergs to strategically enter each market and avoid the issues often associated with large acquisitions. All signs are Kopparbergs has still a long runway for organic growth as they have no share in the rapidly growing U.S. cider market and just recently entered the Australian market though a strategic alliance with SAB Miller.

Valuation

Before looking at Kopparberg’s valuation, we must first adjust for significant minority interest claims that result from numerous non-wholly owned subsidiaries. After adjusting for this claim, which averages ~20% of earnings, we can look at the key valuation metrics:

Kopparbergs Valuation Metrics

Correction 1/30/14: Including the A-shares outstanding, the correct share count should be 20.6M and not 17.8M. The corrected valuation metrics are 11.1X EV/EBITDA and 12.9X P/FCF.

At first glance, this valuation may not seem exceedingly cheap but it is important to consider that branded beverage companies command premium valuations due to their stable cash flows, pricing power, and solid returns on capital. Here is a comparison of a handful of the world’s most familiar brewing giants:

Kopparbergs Peer Comparison

Despite having anemic growth rates and mediocre returns on equity, this group commands a healthy EBITDA multiple of over 11. What’s more is that these companies have had to rely on expensive acquisitions to fuel this growth, as alcohol consumption is barely growing and in some cases even declining in developed economies. Brewing companies that are growing at double-digit rates, however, command far higher valuations and typically fall into one of two main categories:

1) Brewing companies in emerging markets that are growing at rates far higher than the developed world. Well known examples include India, China, and many countries in Africa.

2) Brewers of craft beverages that are taking share from traditional beer and wine companies. Examples include brewers of craft beers, ciders, and malt beverages.

To get a handle on the valuations these companies command, we can turn to a peer analysis with both categories of high-growth brewing companies:

Kopparbergs High Growth Peer Comparison

Compared with Kopparbergs’ craft brewing peer group, the company appears to be woefully undervalued trading at less than half the peer multiple. A direct comparison with a company possessing similar economic characteristics, Boston Beer, provides a telling example of the valuation this business could command in the more-established U.S. market.

For valuation purposes, I’d argue that at a minimum, Kopparbergs should trade at a multiple comparable to the slow-growth brewing giants. On the high end, I don’t think it would be unreasonable for Kopparbergs to command the peer group multiple of 20X EBITDA given the superior growth and returns on capital it has achieved. Put together, the valuation looks like this:

Kopparbergs Valuation

Taking the mid-point of these two valuations, Kopparbergs shares appear significantly undervalued, offering nearly 70% upside potential from current levels.

For further support, we can look to recent private market transactions to confirm that these lofty publicly traded peer multiples reflect what an informed buyer would pay for a company like Kopparbergs. The most notable example is C&C Group, an Irish cider brewer that paid 20X EBITDA in October 2012 to acquire U.S.-based Vermont Hard Cider (brewer of the popular Woodchuck cider brand) and gain access to the rapidly growing U.S. cider market. And just this past Monday, bourbon maker Beam agreed to be acquired by Japan’s Suntory in a blockbuster deal that valued the company at over 22X EBITDA.

So how did Kopparbergs become one of the cheapest companies of its type in the world? For one, Kopparbergs trades on an obscure exchange, the Nordic Growth Market, which is a collection of highly speculative, unprofitable companies primarily in mining and bio-tech industries. An investor searching on this exchange for investments would hardly be excited by a beverage company. Kopparbergs is also a thinly traded micro-cap and buying its stock is exceedingly difficult for foreigners – I can honestly say I am the first person in the history of Fidelity to buy this stock and doing so required an hour on the phone with a rep and paying outrageous fees.

Insiders

Founding brothers Peter and Dan-Anders Bronsman have a large stake in the business and exercise control over the company through their Class B voting shares. The brothers also hold a significant amount of Class A shares, which bring their economic interest in the company to just over 25%, aligning their interests well with shareholders. These owner-operators have pursued a disciplined organic growth strategy has paid off very well for shareholders with sales increasing in 18 of the past 20 years and a 5-year share price performance of nearly 1500%. Also of note, Peter Bronsman was recently recognized for his business acumen as the winner of the prestigious Ernst & Young Entrepreneur of the Year award in 2013 (Swedish speakers can view the video here).

Risks

No investment is risk-free, but I feel an investment in Kopparbergs carries limited risk at these levels. Kopparbergs’ dominant incumbent brands, stable cash flows, and modest valuation all provide strong downside protection. That said, one major risk for investors is Kopparbergs’ international expansion campaign. Given that beer is an inherently local business, displacing local brands will be no easy task for the company – this is evidenced by their failure to crack the crowded U.S. market. Lastly, because the founding brothers essentially control the company through their voting shares, investors will have little recourse should management begin making poor business decisions in the future.

Conclusion

Kopparbergs Bryggeri presents the rare opportunity to purchase a rapidly-growing, craft brewer for a fraction of what comparable companies are valued at. Shareholders are in good hands with skilled owner-operators pursuing an organic growth strategy that has put the company’s financial performance at the top of their industry. Continued penetration of international markets with their flagship cider along with interest from growth-starved established brewers could both serve as catalysts to drive Kopparbergs’ valuation in 2014 and beyond.

Disclosure: Long KOBR-MTFB.ST

2

2013 Portfolio Performance Review

I hope everyone had a great holiday and happy new year. With 2013 now in the books, I feel now is a good time to review how my investments played out, consider lessons learned, and set out a few goals for the New Year. As I have mentioned before, I don’t calculate performance more than annually as I feel one year is the absolute shortest period that performance can be gauged. So without further ado, here is how I fared in 2013:

Portfolio Returns

Overall, performance was satisfactory and certainly exceeded my expectations for the portfolio. If you had asked me last month, I would have had no idea and in fact told someone I estimated my return was around 40% for the year. In an extraordinary year that lifted almost all major markets, it was pleasing to be able to outperform the market by a healthy clip, though I am by no means expecting to repeat this sort of performance anytime soon. These results, together with my 2012 return of 17%, have brought my cumulative return to just over 100% since I began seriously investing and tracking my performance.

My focus has always been on absolute return with no attempt to reduce volatility and it shows in my results. Brace yourself, as this next graph shows just what a wild ride 2013 was:

Portfolio Return Chart

Interestingly enough, I was about 5% underwater at midyear and underperforming the S&P 500 by about 20%. Over 100% of my returns were realized in the back half of the year, including a 40+% return in the last quarter. These results again confirm why I don’t analyze performance more than once per year. Had I done an in-depth look-back at midyear, it is entirely possible I would have made premature adjustments to my portfolio that would have prevented me from realizing the strong performance I had in the second half.

To see how these returns were generated, let’s first have a look at my how portfolio looked on January 1st of last year:

Portfolio Starting

Looking at my starting portfolio foreshadows my evolution as an investor and reveals the full spectrum of strategies I have employed: a core position in Apple (one of the first stocks I ever bought), some deep value plays, and a few micro-caps that more reflect my current strategy. Had I practiced Charlie Munger’s sit-on-your-ass (SOYA) investing, my starting portfolio would have produced a decent result with a few-hundred basis point outperformance of the S&P. Fortunately, I made quite a few adjustments to my portfolio and strategy over the course of the year, which resulted in this portfolio at year end:

Portfolio Ending

The majority of my current holdings were initiated in the back half of the year and reflect two fundamental shifts that occurred in my strategy over 2013:

1)     A complete focus on micro-cap stocks (<$300MM market cap and preferably <$50MM)

2)     The addition of international stocks to my portfolio

My current holdings also performed well over the course of the year, producing an average gain of over 20%. One of my largest holdings, Kopparbergs Bryggeri (KOBR-MTFB.ST), delivered a solid 63% return, while One Media iP (OMIP.L) and Pulse Seismic (PLSDF) were also sizeable contributors to the portfolio return. The only positions that were underwater at year end where Emeco Holdings (EHL.AX) and XPEL Technologies (XPLT, DAP.U.V), though both have appreciated considerably since 2014 began. My ending cash balance is well above what I typically hold and was due to the sale of a large position that had appreciated over the year. I am currently investing a good portion back into my existing positions and will likely target a cash balance in the 10-15% range going forward.Along the way there were a number of closed positions that contributed significantly to my portfolio performance:

Portfolio Closed Positions

There is no question that Pacific Health Care (PFHO) was my big winner for 2013, delivering a return of 310% over my holding period. I allocated 10% of my portfolio to it at the time so it had a major impact on my results as it took off in the last quarter of the year. I recently sold out of my entire PFHO position as I don’t feel I understand the business well enough to be confident it should be trading at 20X annualized earnings. Other notable winners included my position in Jewett Cameron Trading Co (JCTCF) and my Apple LEAPS position (discussed here).

Lessons Learned

Rather than discuss the winners, however, I feel there is far more value in focusing on the mistakes from the past year. Lucky for us, I made plenty of them, so here is what I would consider three of my top mistakes from 2013:

1)     The Dolan Company (DM) – Undoubtedly the biggest mistake of the year. I broke my own rules and set out to analyze a complicated business in flux that was also highly levered. When Dolan’s financial situation worsened, their largest customer scaled back orders, which further worsened the company’s financial condition – this death spiral has sent the stock down over 80% from my entry point. I was fortunate to see the trouble ahead and exit with a 25% loss, but the loss of principal I risked with this position was simply unacceptable.

Lesson: Highly leveraged companies with large customer concentration are dangerous situations and must be avoided in the future. Stick to situations that are easier to analyze to reduce the risk of making a material miscalculation in the thesis.

2)     Pizza Inn (PZZI) – I entered into my position in the Pizza Inn in late 2012 only to exit a few months later at a 4% loss. My original thesis was that I was paying full price for a marginal pizza franchising business but getting a promising roll-out of their new fast-casual concept for free. When the legacy business began to decline, I panicked and sold out of fear they would be stuck with company-owned restaurants draining cash flow. This proved somewhat correct but I missed out on a +150% return as the market has begun to value the company based on future earnings from their Pie Five franchises.

Lesson: Have conviction in your picks and stress test your thesis to get a good handle on the downside scenario for each position. This will allow more rational decision making should a decline in business performance occur.

3)     XPEL Technologies (XPLT, DAP.U.V) – this one may seem a bit odd given XPEL is now a core position of mine but this one falls into the category of mistakes by omission, which can be just as pernicious as mistakes by commission. I first analyzed this business back in June when shares were trading at $.40 and found a business that was growing revenues +50%, growing earnings +70%, and trading at less than 8X earnings. Knowing that XPEL was in the automotive supply business, I assumed these results were unsustainable and ended my research right then and there. As the saying goes, I sure made an ass out of you and me when the stock rocketed to nearly $2.00 after a stellar Q3 earnings report. Now after taking the time to study the business, I have established a position around $1.50, but missed out on large gains as more investors learned about the potential of this company.

Lesson: Stocks growing at extreme rates very seldom trade at single-digit earnings multiples – such rare cases are worthy of careful examination. Don’t make assumptions about a business based on preconceived notions about its industry or business model. Other investors may be making the same assumptions and this could be why the opportunity exists in the first place.

Beyond these three key lessons, I want to strive in 2014 to reduce my portfolio turnover and stay focused on my highest conviction ideas. I did a lot of buying and selling in 2013, mainly because my strategy was evolving, and being more patient will reduce my trading expenses and allow time for my theses to play out. Lastly, I want to work on being less of what Avner Mandelman refers to in his book, “The Sleuth Investor,” as a “stock scientist” – an investor that does all of his/her research locked away in a room reading 10-Ks and toying with 10-page spreadsheets. While these activities are important, I want go one step further with my due diligence by speaking to management teams, and when practical, customers and suppliers – all to further the edge I am constantly seeking in my investments.

Conclusion

Summing up, 2013 was a great year but I want to be careful not to read too much into it given it was a single extraordinary year for the markets and my performance was largely driven by one stock. Looking at my portfolio as it stands now, I feel comfortable knowing that my portfolio has global exposure and nearly all of my positions share the key characteristics that I seek: micro-cap, stable business, high returns on capital, recurring revenues, double-digit organic growth rates, high inside ownership, and most importantly, little to no debt. As I have said before, my strategy will be to continue searching the world for undervalued, high-quality micro-caps and keeping a concentrated portfolio full of the best ones I can find.

More so than any performance metrics from this past year, what I will take from it is how I grew as an investor and honed the strategy I plan to employ for the foreseeable future. Starting the blog was incredibly positive development for me and I have truly enjoyed connecting with so many talented investors from all over the world. So that’s it, the last you will hear from me about my performance for another 365 days. And if at the end of this year I am down 77%, you will find me right here discussing what went wrong to see if any lessons can be learned.

Thank you again for the readership and contributions that have made 2013 a great year for this blog. I hope you all had as much fun as I did investing in 2013 and that everyone has come back refreshed and ready to tackle what is sure to be another exciting year in the markets.

13

Top 10 for 2014

As a wild year in the markets comes to a close and we turn our focus to 2014, I’d like to take a moment to thank everyone who has read this blog and helped make it a big success since I launched it back in September. Starting this blog has exceeded all expectations I had for it and it is because of all you engaging readers who have contributed your comments and challenged my ideas. And so for my last post of the year, I thought it would be fun to share with you all a “Top 10″ list of companies that will be at the top of my research list heading into 2014.  Rather than using my portfolio picks that I have already presented, I will keep the list full of obscure micro-caps from all over that hopefully you have never heard of. Enjoy!

1. XPEL Technologies (XPLT, DAP.U.V) – after a monster 2013 that saw revenues growing nearly 100% y/y, this specialty after-market automotive company looks to make its next leg higher following a late-year sell-off. An uplist to a reputable exchange next year should bring more eyes to this company and if they can continue their breakneck pace of revenue growth, 2014 should make for a good year for this one.

2. OptimizeRx (OPRX) – the past year saw this company’s e-Couponing platform for prescription drugs gain solid traction in the marketplace and drive triple digit revenue growth across its highly scalable business model. Look for this company to address investor concerns about the abrupt departure of their former CEO and a highly dilutive financing overhang in the new year. If they can resolve these issues and continue forging partnerships with major pharmaceutical companies, 2014 could be a great year for OptimizeRx.

3. Cinedigm (CIDM) – a hidden champion that has the largest share of digital cinema projection software and equipment of any company on the planet, Cinedigm looks to enter the final phase of multi-year plan to create a high-growth media company in 2014. Reckless expansion and convulted financing had left this company forgotten by investors until this past year when a transformative acquisition turned the company into the largest distributor and aggregator of independent content in the US. Now with a simplified financing structure, an industry veteran at the helm, and a thriving content business, this company looks to make 2014 its first year of profitable growth in a long time.

4. ARI Network Services (ARIS) - 2013 proved to be a year of transformation for this e-Commerce solution provider. After the acquisition of a major competitor out of bankruptcy that took the entire year to integrate, ARIS now looks to spend 2014 realizing synergies and capitalizing on the organic growth opportunities brought on by the acquisition. With management committed to achieving double-digit organic revenue growth and driving ARIS’s recurring revenue base, look for this company to command a valuation more apt to niche SaaS companies if they can execute in 2014.

5. Viyranet (VRYAF) – one the few growing micro-caps still trading at less than 12X earnings, this company has made big moves lately after a key strategic partnership with GE and a new cloud offering helped Viyranet show top-line growth in the second half of 2013 after years of stagnation. Should demand for its workforce management software suite continue into 2014, this company would have a long way to run to reach a comparable peer valuation. And given that nearly all of Viyranet’s competitors have been acquired in recent years, a potential buyout could be a catalyst to watch in back half of next year if the company experiences a significant uplift in its valuation.

6. Issuer Direct (ISDR) – this niche provider of SEC reporting and shareholder communication services looks to build on momentum sparked by a phase-in of XBRL filing requirements that sent revenues and earnings soaring in 2013. With a transformative acquisition in the third quarter of this year that has doubled Issuer Direct’s client base and given them a full suite of disclosure management and shareholder communication products, look for this stock to make big moves in 2014 if they can capitalize on the big opportunities afforded by the acquisition.

7. Corum Group (COO.AX) – long the victim of poor corporate governance and incompetent management, the past two years saw this Australian hidden champion experience a swift turnaround with a restore to profitability, elimination of all company debt, and the initiation of a sizable dividend for the first time in many years. After an impressive run sparked by the turnaround, shares fell of a cliff as the market questioned the company’s growth opportunities in the latter part of 2013. If the Corum Group can maintain its market-leading position in pharmaceutical dispensing software and prove to the market that growth lies ahead, expect a recovery in 2014 for this company.

8. Intermap Technologies (IMP.TO) – after nearly going bankrupt attempting to create 3D digital models of the developed world with their IFSAR radar technology over the past decade, 2013 saw this company launch a suite of geospatial solutions that drove double-digit revenue growth and stabilized their liquidity position. With the expensive mapping endeavor complete, management looks to continue building a thriving location-based information business around their valuable 3D digital map assets. With management seeing big opportunities in Asia, 2014 could be a big year for Intermap if they can realize consistent growth from their licensing and services businesses.

9. Genesis IT AB (GENE.ST) – after a breakout 2013 that saw revenues double and earnings rise 7-fold, this unknown Swedish micro-cap enters 2014 with the wind at its back. With stock trading at less than 7X earnings, this one could have a long way to run if management can continue to build on the growth fueled by the company’s new mobile ERP product, iFenix.

10. DCD Media (DCD.L) – the past two years have been rocky for this company with a hostile takeover and subsequent recapitalization that spawned a turnaround focused on creating a profitable, vertically integrated media company. Management fell short of this goal in 2013 following  a big setback in the loss of their most profitable film series contract that kept profitability just out of reach. However with £15M in annual revenues and a £2.9M market cap, shares of this company could be in for a significant re-rating if DCD could merely manage to turn a profit in 2014.

So there you have it, my list of obscure micro-caps that will keep me busy as things get kicked off next year. As always, I have no opinion of where the general markets are heading in 2014 but remain committed to my strategy of searching the world for undervalued, high-quality micro-caps and keeping a concentrated portfolio full of the best ones I can find. If you are invested in any of these companies or are researching them currently, drop me a note – I’d love to hear your thoughts on them.

Thanks again to everyone who has read this blog, provided feedback, and helped make 2013 the most fun year I have had in my investing career. I hope Moatology will be at the top of your reading list in 2014 as I have many more ideas to share with you all. Stay tuned, as I will kick things off with my 2013 portfolio performance review and then get right back to presenting ideas and analysis on some of my top picks for next year. Happy holidays and I will see you all back in the new year.

Disclosure: Long XPLT