RRGB - Courage & Conviction Investing On Farmer Bros Red Robin And Yield10 Bioscience

2023-10-24 08:00:00 ET

Summary

• Focusing on small cap stocks and emphasizing the importance of admitting you're wrong.
• Farmer Brothers, Red Robin Gourmet Burgers, and Yield10 Bioscience examples of small cap stocks with potential.
• Risks associated with Red Robin and Yield10 Bioscience, highlighting their volatile nature and potential for significant losses.

Listen below or on the go via Apple Podcasts or Spotify .

Courage & Conviction Investing details how you know you're in a small cap stock for the right reasons using Farmer Brothers as an example (0:45). Why he likes Red Robin Gourmet Burgers and binary bet, Yield10 Bioscience (6:30). This is an abridged version of our recent conversation ' Stay Hungry, Stay Foolish' Small Cap Strategies '.

• Subscribe to Second Wind Capital by Courage & Conviction Investing

Transcript

Rena Sherbill: How do you know that you're in a small cap stock for the right reasons and the headwinds that are coming at you are just headwinds that may kind of dispel or dissipate as the weeks and months move on?

Courage & Conviction Investing: You have to know when you're wrong in this game. I think that's what really separates the people that are very successful and can do this for a long period of time that have longevity.

And the way I run the Courage & Conviction Investing on Farmer Brothers, Red Robin and Yield10 Bioscience is fairly concentrated. So, my top five positions are usually 50% to 70% which is pretty aggressive, 15% usually my max. But you just – you have to know the names and you can't be -- if the thesis does change, you have to take a loss and you have to get out and that's just part of the process. But the other thing is kind of scaling into the names.

So, I'll give you an example. So, this is a company that we own, Farmer Brothers (NASDAQ: FARM ). And it's a wholesale coffee roasting company. It's been around 100 years. Ticker is 'FARM'. And they had two businesses. They had a routes business where they would deliver the product to restaurants, hotels, convenience stores. And then they had a direct ship business and they built the state of the art factory in Northlake, Texas. And they took on a lot of debt and they ran the business kind of poorly.

And so some activists came in, they acquired a 15% stake in the company and like I want to stay in the high 5s or 6 and then they became directors and they had a standstill agreement. So a couple of months ago, they reached an agreement with TreeHouse Foods to sell Northlake, Texas as well as the money losing direct ship business. So, the purchase price was $100 million. There was $8 million in legal fees and costs. So, they netted $92 million.

Now, some of that price was also some of the inventory. So it's a little hard to get it like a precise dollar figure. But just to frame to see how like irrational and inefficient the markets are, prior to this company doing this deal, the company was like $2. And so there's 20 million shares, I assume.

So it's a $40 million market cap. They had $105 million in net debt. They announced the deal. The stock shoots up from like $2 to $3.60, 10 times the volume trades. And then the meme and the hot money kind of dissipate. The deal does close. But then like two weeks - last week the stock drifts all the way back to $1.82.

So, pre-deal you got a company $40 million market cap, $105 million in debt. Yeah, they did own the factory, but they literally had a gun to their head that if they didn't get the same refi, they're going to go bankrupt. Got the deal done and closed the deal. And remarkably, the equity was valued at the same price when a company had like 15 million in net debt.

Yeah, they don't have the factory, but the thing it had round tripped from $2 to $3.60, to under $2. And so I aggressively was buying between $1.82 and $2.05. They came out, the management got let go, or they agreed to get let go. Probably because the board pushed them out because they were making a lot of money.

They did make a lot of good changes finally, but the conference call was really good. The forward outlook is really good. And there are some really good tailwinds going on here. So the stock comes -- it was like $2.80 yesterday. So, I didn't get involved till after this because I wasn't comfortable with the balance sheet.

But when I saw this deal, and it was going to go through, I started buying it at $3, bought more at $2.50 and then got really aggressive between -- in the low 2’s. So from the initial purchase price of $3 to $1.80 that's a 40% drawdown.

But I had done enough work on the business and the valuation and we had the comfort of the activists on the 15%. They want to protect their investment, that the business was actually shaping up. And you also have a tailwind because coffee bean prices are actually now kind of oversupplied. So, that's a huge tailwind going forward.

But there are a number of other tailwinds to the business, they brought in this AI algorithm that's going to -- it's already improved margins like a couple 100 basis points. The conference call was fantastic.

I don't want to spend too much more time on it, but it's a perfect example of, okay, I bought a 5% position at $3 and it goes down 40% in your face. But if you've done enough work in the business and the valuation and are following closely you have enough conviction to continue to add because you're buying at a much better - the market gives you an opportunity to acquire more shares at a better price. And lo and behold, the sky is not falling and the thing bounces from $1.80 to $2.80.

Now, they're going to have to string together a couple of good quarters here to make the Street really believe it. But one of the directors of the activist actually bought some shares on the 15th, which is a good sign because he hadn't been in the market for a long time.

But that's like a good example that you have to be able to have something go down 40% in your face and not be afraid that if you've done your work that you think you're buying it at a good valuation to aggressively add more. So, I went from 5%. I took it up to my max 15%, 16%.

And so that's kind of one example, but clearly there are times that you're wrong. If the thesis changes, you have to take your medicine and get out oftentimes, the sooner the better.

RS: You want to share with investors any other stocks that you're thinking about or points of interest or points of light or ways to be thinking about small caps these days?

CCI : Yeah, I mean, I want to talk two more names. So Red Robin (NASDAQ: RRGB ), which I've written on , and that's a top five position for me. I'm in it like, well, I've been adding recently, but it was lying in like the 13s, and it's gone from like 12 to almost 16 and now it's in the 8s. I did speak with G.J. Hart the CEO, couple weeks ago. And I spoke with Todd Wilson the CFO, had a really good talk with those guys. They really know the business. They’re really trying to turnaround the brand. They're playing in a long game.

We got really specific in terms of like the menu and the different quartiles and the stores, and how they brought - like all the enhancements they made to the menu and the philosophy of hire more people and the open grills. But it's completely like it because I'm sized up in this thing and it's, say I'm long at like 12 and now it's like in the 8s. But I don't understand why, notwithstanding the macro.

I am talking with Todd tomorrow, just to catch up because he spoke at a couple of conferences like it seemed like a comment he made was out of context, but I wanted to just hop on the phone with him, but I had a really good time.

RS : What was the comment? Just out of curiosity.

CCI : It's just, I guess September, the restaurant industry, the traffic is down in September, which you have hurricanes and you have gas prices and student loans resetting, the moratorium has been lifted. And it could have been any confluence of events, but like the stocks got cut in half from the July highs.

And I don't think anything's really changed with the business. And my thesis is these companies, they guide it to 1.3 billion in revenue that the mid-point of the EBITDA $77.5 million. So, the enterprise value is like sub-300 million. So, it trades cheap.

There isn't a lot of free cash flow generation because they're investing it back in the business and the interest rates are high, but they've done sales leasebacks where they've paid down that 12% debt and then they've actually bought back a little bit of stock.

So, I don't really know why it's gotten cut in half and notwithstanding just a negative sentiment towards small caps and maybe there's some big macro long short book and that happens to be in that basket. But I'm sticking with it. I've been adding here and I'm going to see this one through unless the thesis is dramatic. It's a dramatic departure on the thesis.

But if you take a step back and cover those $1.3 billion in revenue, an extra 200 bps in EBITDA margins, that's $26 million. And so, it's not -- what they're doing is they moved away from discounting and they've upped the product quality. They've upped the service because they're fully staffed, and it's really just a -- this is a margin story more than a sales story.

So, I don't really care what the comps are. I don't want to be like double digits negative, but if they're down 5% the margins are better and you’re doing the right thing for the brand and the business that's fine. And so, I'm happy to weather that drawdown again par for the course.

And then tying back to the stay hungry, stay foolish, I have one other stock, it's called Yield10 Bioscience . Ticker is (NASDAQ: YTEN ). And so this is absolutely fascinating. But let me be crystal clear. This is - this could go to zero. Okay. So, this is 100% binary. And I'll explain the thesis, but I want to be crystal clear, like if they run out of capital by December 1st, this is a zero. So anyway, just mention that.

But what they do is, these are MIT scientists and they’ve developed this seed, Camelina. And it's oily, it's a cover crop. So, you plant it after the harvest in the fall and in the winter. So it's a cover crop. So it prevents erosion and the fertilizer runoff. So it's good for farmers and then you harvest it in the spring.

And so, there's hockey stick growth for SAF, sustainable aviation fuel and renewable diesel. And so, a lot of the big refiners are converting some of their refineries because they know to meet the Paris Accord and the mandates, they need to get on board with this. But you physically can't divert the soybean and corn supply to just make biofuels. And so what these guys have done is, they've spent years developing this seed that's weed resistant, that can be double stack.

So, it can be planted, unlike these different herbicides you need on the soil and they've thought off the whole value chain. So, they have the relationships with the farmers a lot of times in Canada, Western Canada and they have a seed that they've developed that you can grow at scale.

But they have a -- they signed a nonbinding letter of intent with Marathon Petroleum ( MPC ), the $60 billion market cap refining company. And so, Marathon put up a million dollars in a convert and they had 120 days to negotiate a deal and that exclusivity ended on August 25th. And so, I don't know what happened nor could they.

I have spoken with all of our peoples twice. He obviously couldn't comment specifically about private negotiations, but because the deal hadn't got finalized, they were trying to negotiate an investment and an offtake agreement. So, they had to do a secondary and this would be fascinating to readers that are people really in the weeds.

So, on August 2nd, they filed the S-1 to raise capital, but it was a best efforts deal and in a best efforts deal there's some nuances here. So, I want to just keep it - I don't want to be super specific, but essentially there's like a provision that when they market the S-1 in a best efforts deal, people that do take up on the deal can be short the stock.

So in a bought deal, you announce a deal, you probably price under market. You fill up the book, it gets priced and it gets - it's done. This thing was out dangling for a couple of days. So they were out trying to market to fill up the book and you had a lot of structured guys that came in. And so the stock went from $2.20 to $1 by the time the thing was done. And then they priced the deal at $0.65. It came with five year warrants at $0.65.

And so talking about signaling the noise, the stock got decimated because of the dilution, but they had to raise the capital because the exclusivity ended and they are talking to other big oil companies. And there's an Omega-3 angle as well.

So, here we have a - I'm in like at $0.60 on this one. Because I had a small position like a foothold and I did like to buy more. But if they don't get a deal, this thing's vapor in a couple of months. But I'm looking at a company that's – arguably it developed this incredibly innovative seed to spawn a new industry in terms of Camelina. That arguably is empirically going to be one of the sources of biofuels because you can't just have soybean and corn oil.

There's an Omega-3 aspect. The market cap right now is like $5 million, notwithstanding the warrants. But at the end of the day, if Oliver doesn't get a deal and they also - they're talking to Mitsubishi, the big refiner in Japan, the big conglomerate giant.

And so, it's a binary bet and I just think the upside is so big, but make no mistake if they don't get a deal because they can't get to terms, it's going to be a donut. So, that's staying hungry and staying foolish.

For further details see: