CA - Plural Investing Q3 2023 Quarterly Letter

2023-11-01 12:00:00 ET

Summary

• Plural Investing is a long/short hedge fund based in New York. We invest in businesses that we believe are worth substantially more than the price they are trading at.
• Plural Partners Fund L.P. delivered a gross return of -11.4% and net return of -11.6% in Q3.
• The fund focuses on value investing and only invests in businesses trading at a substantial discount to intrinsic value.
• The fund remains confident in the undervalued nature of its holdings and sees opportunities for growth in its portfolio.

To our Partners:

Plural Partners Fund L.P.delivered a gross return of -11.4% and net return of -11.6%% in Q3. Our goal is to deliver returns over a five-year period significantly above that of global markets. While our portfolio is experiencing a significant drawdown that is undoubtedly frustrating, we are confident that the value of our businesses will be recognized over our investment horizon.

We are value investors. We invest in businesses that we believe are worth substantially more than the price they are trading at. We think of risk primarily as the chance of a loss over a five-year horizon and not the temporary drawdowns in stock prices that occur from time to time. We manage this risk by only investing in businesses trading at a substantial discount to a conservatively calculated intrinsic value and that we would be happy to own if the market shut for five years. We welcome stock price volatility as it often presents opportunities to invest further at even better prices. When such opportunities cannot be found we hold cash instead.

The majority of our capital is typically allocated to our six to eight best investments. We look for qualities such as attractive business economics and management teams who possess and foster a culture of high integrity, customer focus, and prudent capital allocation. Our businesses may be ‘hidden gems’ because they are small, receive little coverage, listed on under-researched exchanges, operating in unpopular industries, or offer terrific opportunities beyond short term concerns. We develop a research edge over other investors by doing extensive primary research and utilizing quantitative tools. This edge can be significant when we are competing mostly against retail investors or the small positions of larger institutions, which is why we deliberately fish in those waters.

A one-page appendix entitled “Principles of Our Partnership” is attached to this letter. This should give you an idea of what you can and cannot expect from our partnership.

We estimate that our businesses trade for 5.9x their net profits in three years’ time and will still be growing at double digit rates then. These businesses have strong balance sheets with little or no debt, earn an average post-tax return on tangible capital of 23%, and are run by well-aligned management teams with an average ownership of 20%.

While we have made some mistakes assessing the short-term pressures on some of our businesses, much of the portfolio’s drawdown has been driven by declining valuation multiples. We remain confident that our holdings are significantly undervalued relative to conservatively estimated intrinsic values, and that valuations will normalize higher to reflect the strong outlook of these underappreciated businesses.

This year has been a difficult one for small cap value stocks and we are finding an increasing number of opportunities as a result. We made new investments in the quarter and our research pipeline remains full.

Below, we discuss Currency Exchange International and Jet2. Both stocks were large detractors to the portfolio this quarter. We describe some mistakes we made in each case but continue to believe that these are temporary setbacks. Both stocks remain greatly undervalued in our view and our valuation has not changed for either company.

Currency Exchange International ( CXI:CA , CURN )

CXI is one of only three major suppliers of foreign banknotes in the United States and of US dollar banknotes internationally. Banknotes are typically used for travel and the Covid induced downturn masked major market share gains made by the company after its key competitor Travelex exited. CXI is run by Founder Randolph Pinna, who owns 21% of the company and has high integrity, delights customers, and a 35-year track record of building two banknotes businesses that have delivered strong shareholder returns. The company trades on 8x P/E today and we expect earnings to nearly double over the next three years. That puts the stock on just 4x our estimate of profits in three years’ time, net of cash generated in the interim. We started buying shares at US$14/shr in mid-2022, it trades at US$15/shr today, and we believe intrinsic value will be US$55/shr in three years. The stock ended Q3 down 24% from its peak earlier in the quarter.

As outlined in our last letter, we see two key opportunities for the company. Both of those disappointed investors in the quarter, but we expect that disappointment will be temporary.

We think CXI’s first opportunity is to grow outside the United States.

The company is one of only three licensed to supply dollar banknotes from the Federal Reserve to banks across the world, which is a market that we think is worth around $380mm in revenues. We expect CXI will take substantial share in this market, which is material versus the company’s total revenues of $77mm today.

Building out the international business has proved frustrating. While the company has signed on several major banks as potential customers, the US banking crisis earlier this year made these customers reluctant to rely directly on supply from a small company like CXI, even though CXI does not take deposits and does not carry traditional banking risk.

The company has only $130mm in assets, which means that if a customer like the Bank of Singapore makes a payment for $100mm of banknotes CXI’s assets would temporarily almost double until it shipped those banknotes.

CXI and its customers have found a solution, which is to use a major bank with hundreds of billions of assets to act as a middleman and guarantee transactions for a small fee.

We see this as a frustrating delay for a couple quarters and so while we were wrong in our timing, we have not changed our value of the company.

We think CXI’s second large opportunity is to use its cash.

The company holds $98mm in cash and $6mm in debt, a huge amount of net cash compared to its $95mm market cap. We estimate that $80mm of this cash needs to be held as physical banknotes so should be thought of as inventories, meaning excess cash that could be deployed is closer to $20mm. Still, investors are increasingly skeptical that this cash will ever be deployed as it appears to grow every quarter and management’s capital allocation plans could be clearer.

We have a different view. On the recent earnings call management stated that their most likely use of cash is to make acquisitions and that some incumbents in the banknotes market may want to exit.

We see this as a potentially excellent use of cash if the company remains disciplined in the price it pays. Virtually any merger of banknotes businesses would result in large synergies as much of the cost base - such as vaults, IT, and staff - does not have to be duplicated.

While management provided no further details on potential acquisition targets, there are only three other major companies in the industry: Bank of America, Wells Fargo, and Moneycorp. We view a deal with Moneycorp as unlikely as much of its business is in regions that CXI views as high risk. On the other hand, both Bank of America and Wells Fargo have downsized their business over time, which suggests they are willing sellers of some or all of those operations.

We believe that CXI’s roughly $80mm in banknote inventories could be financed with credit facilities at a conservative 0.5x loan-to-value. That financing would free up an additional $34mm beyond the $6mm in credit facilities that are already used. Combined with the company’s nearly $20mm in excess cash brings deployable cash for an acquisition above $50mm while still leaving a strong balance sheet with no debt beyond modest inventory financing.

A $50mm acquisition at CXI’s valuation of 8x P/E would (i) increase earnings by roughly 50% before synergies, (ii) demonstrate that the company’s cash is not 'trapped', and (iii) likely lead to a much higher multiple as investors start pricing in future cashflow being deployed in further high return acquisitions.

The company has yet to make acquisitions of this size and so some investors have concluded that it will never meaningfully use its cash. On the other hand, we believe that while having to wait is frustrating management fully intends to use its cash but that deals like this take time and they are keen to not overpay – an attitude that we support. Founder & CEO Randolph Pinna has been involved in several large M&A transactions in his career.

We expect that investors will greatly reappraise CXI’s intrinsic value over time as the business grows outside the US and management deploys cash. We also believe that the potential downside over a 3-5 year horizon is low if we are wrong given the company’s fortress balance sheet, 8x P/E valuation, and double-digit growth rate.

Jet2 ( DRTGF , Jet2.L)

Jet2 is a UK based package holiday business that operates its own airline. The company is run by CEO Steve Heapy and CFO Gary Brown, both of whom have high integrity, exceptional customer focus, and concentrate on long term value creation when allocating capital. They have done an outstanding job, with Jet2’s excellent customer service and retention driving profitable market share growth from 2% to 21% over the last decade. We initially invested in the business at around £5/shr, the stock trades at £11/shr today, and we think is worth £25/shr. The stock ended Q3 down 22% from its high earlier this year. We added significantly to our position in the quarter.

Jet2 reported record profits for the summer which imply EPS of around £1.8/shr for this fiscal year, double the pre-Covid peak of £0.9/shr.

When we first started highlighting Jet2 in our quarterly letters during the Covid pandemic three years ago, we estimated that the company would generate £1.5-£2.5/shr in earnings in three years’ time and that the stock would be valued at £25/shr as a result.

That appeared to be an aggressive estimate during a period when travel had largely halted, yet while we turned out to be correct in our earnings estimate we were wrong on the multiple investors would pay. We had assumed what we thought was a conservative 12.5x P/E multiple – in line with pre-Covid levels – for a business with the industry leading balance sheet, competitive position, and management, all of which have been further demonstrated in recent years.

Instead, Jet2 trades on 6x P/E. That is by some distance its lowest multiple in the last decade, excluding the pandemic. As a result, the stock trades at £11/shr rather than £25/shr, which is disappointing and the only number that matters.

A record low valuation would typically suggest investors believes earnings are about to decline significantly. However, that appears not to be the case despite the difficult macro backdrop. Sell-side estimates are for earnings next year to hit another record. The company appears to be on course for double-digit growth for some time, with orders and pricing still tracking at new record levels, recent ATOL registrations showing another 1ppt in market share growth, and the general travel outlook continuing to be strong.

We have seen macro headwinds impact the stock many times over the last decade, including this time last year in similar circumstances. Over the longer term the company’s competitive advantages and earnings growth tend to punch through that noise. Jet2’s market share has increased from 2% to 21% in the last decade and the stock has largely followed from £0.7/shr to £11/shr despite its current valuation. We believe that this time will be no different.

A more important setback in the quarter was the retirement of Founder & Chairman Philip Meeson, although the stock still traded at £12.6/shr prior to the announcement – at a then record low 7x P/E.

Meeson has been a truly outstanding Founder. He launched the company in 1983 with two aircraft and through a rare combination of both customer focus and cost control grew the business to a roughly £100mm valuation by 2009.

Meeson – a former RAF fighter pilot – hired Steve Heapy in 2009 to build a package holiday business to compliment Jet2’s airline. That has been an enormous success, with Heapy growing Jet2Holiday’s market share from 2% to 21% and the package holiday business accounting for the vast majority of the company’s value today in our view.

Despite Meeson being an undoubted loss to the leadership team, we believe the transition will be close to seamless. Heapy has run the package holiday business since its inception and been group CEO since 2020. He is supported by an excellent CFO in Gary Brown, who has been with the company since 2013.

Meeson’s replacement as Non-Executive Chairman will also be internal, with board member Robin Terrell taking up the position. Terrell has been Chairman of several companies and worked in several senior customer centric roles, including as Chief Customer Officer of Tesco and MD at Amazon. He knows the company well having been a board member for 3.5 years and we were impressed when we met with him.

One potential overhang to the stock is that Meeson continues to own 20% of the company and some investors may be concerned that a large sale of shares is coming at some point. We view that as very unlikely anywhere near today’s prices. In fact, Meeson made a point of buying more shares – the first time he has ever done so – after his retirement was announced.

We have also found that management are receptive to buying back shares. Perhaps the only pushback against Meeson we could offer is that similar to many founders he did not like the company to buy back shares, instead preferring to use cash to accelerate the growth of the business even on occasions when the stock dipped to very cheap multiples.

However, we estimate that Jet2 generates enough cash that it can take advantage of the current 6x P/E multiple to buy back shares while continuing to invest in the business. We believe that a buy back would be an excellent use of cash and act as a catalyst for the stock.

Our thesis continues to be based on Jet’2 long-term intrinsic value as it expands upon its position as the UK’s leading package holiday provider. We estimate the company will continue to grow earnings at a double-digit rate over the next 3-5 years and trade for a double-digit multiple at some point.

Please do not hesitate to contact us at chris.waller@pluralinvesting.com .

Best Regards,

Chris Waller, Portfolio Manager

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