PRM - Tourlite Capital Management Second Quarter 2023 Investor Letter

2023-09-13 09:30:00 ET

Summary

• Tourlite Capital Management, LP is an asset management firm focused on long/short equity investing in public companies.
• Tourlite Fund, LP Founder Class returned -1.2% for Q2 2023 and -0.2% year to date.
• The fund's portfolio is concentrated in industrials, consumer, and technology sectors.
• The fund's long portfolio outperformed the S&P 500 and Russell 2000, but the short portfolio was a drag on performance.

To My Partners:

Tourlite Fund, LP Founder Class returned -1.2% for the Second Quarter of 2023 and -0.2% year to date. The fund has returned 4.9% since inception in April 2022, compared to 0.3% for the S&P 500 ( SP500 , SPX ) and -7.1% for the Russell 2000 ( RTY ). ^1,2

Gross Contribution & Portfolio Exposures

Portfolio Update

At the end of the quarter, our portfolio's sector concentration represented: industrials (~45%), consumer (~35%), technology (~15%), other (~5%).[1],[2] During the second quarter, the Fund's net exposure continued to remain low. Our gross exposure was in the range of 175% - 200%, which falls within our expected range of 180% - 250%.

Portfolio Exposures ^{[3] [4]}

Performance Commentary

For the first half of 2023, our long portfolio increased 19.1%, outperforming both the S&P 500 and the more diversified Russell 2000. Our short portfolio has been a drag, driven by the outperformance of select short positions and rally of low-quality businesses.

Our objective is not to draw a primary benefit from market tailwinds, but from the strong stock selection of longs and shorts. While we have had many "wins", we have given back a majority of these gains with other investments. Looking forward, we continue to focus on minimizing these detractors which have been a drag on performance.

While there are a few areas we are focusing on to "seal the leaky bucket" and reduce our unforced errors, the most significant and easiest to convey is more quickly identifying changes in our investment thesis and "cutting losses" sooner. While we know that it's impossible to eliminate all future unsuccessful investments, the earlier we can identify and exit the position, the better for our long-term preservation of capital. Later in the letter we discuss our recently exited investment in Perimeter Solutions.

The first half's market rally has been fueled by the strength of large cap technology stocks. In 2022 we had considerable exposure to large cap technology companies ( GOOG , GOOGL & AMZN ) but sold these positions near the end of the year to deploy the capital into what we believed were more attractive opportunities. While our long portfolio has tech exposure, this mostly consists of small and mid-cap companies. These companies have not benefited from overall flows into large cap indexes and the hype surrounding artificial intelligence ((AI)). On the short side, we have had exposure to large market cap equities including those in the tech sector, which negatively impacted performance. So far in 2023, we have seen a reversal of the Russell's outperformance of the Nasdaq.[5]

The recent market landscape has been dominated by technical swings, quants, thematic investors, and retail participants, making short selling challenging, especially in June and the early part of the third quarter. We observe a significant disparity between companies' valuations and their underlying business fundamentals. We believe our fundamental long/short investment approach will be well-suited to capitalize on this opportunity, as we continue to search for opportunities with foreseeable catalysts or points of inflection in companies' fundamentals.

Despite our bearish stance on the overall economy and market, we believe we are well positioned to take advantage of a potential reversal in the first-half rally and the overvaluation of lower quality businesses.

Second Quarter Gainers & Detractors

Top Gainers

1. Latch ( LTCH )

During the first quarter, we acquired the majority of our position in Latch, recognizing the value of Latch's technology that far exceeded its share price. Despite outstanding financials, our acquisition took place when shares were trading well below the $1.50 per share indicated on Latch's balance sheet. Our research unveiled a significant reduction in expenses and cash burn over the past year, supported by LinkedIn data demonstrating a decrease of over 50% in the number of employees.

In an exciting development on May 16th, Latch made a notable move by announcing its acquisition of Honest Day's Work for $22 million in stock. This acquisition is particularly significant as it brings onboard the founder of Honest Day's Work, Jamie Siminoff, renowned for his successful property technology venture, Ring (acquired by Amazon). Jamie Siminoff will assume the position of CEO at Latch, and we see this as a strategic step to bring in an experienced leader who is strongly incentivized to drive an increase in the company's share price. On June 21st, we published an overview of our thesis on our website.

As of August 10th, Latch was delisted from the Nasdaq due to the Company's inability to file restated financials by August 4th. As a result, Latch's shares fell over 50% and gave back a significant amount of our prior gains. While not impactful to the underlying business, this is expected to significantly reduce liquidity. Based on our conversations with management, we believe the company remains committed to restating its financial statements and eventually uplisting back to a major exchange.

2. APi Group ( APG )

APi Group continues to trade at a compelling free cash flow yield. The acquisition of Chubb, previously mismanaged by Carrier Global, offers numerous opportunities for value enhancement. The current share price appears to underestimate: 1) the growing resilience of APi's US safety segment, driven by recurring service revenue with higher margins; and 2) management's capabilities in turning around Chubb's operations. While there are execution risks associated with Chubb, there are several manageable initiatives such as addressing loss-making branches, real estate consolidation, and optimizing the salesforce, primarily focusing on the technicians to nontechnical staff ratio. These efforts should lead to near-term margin improvements.

3. Undisclosed Long

We identified this opportunity as a near-term catalyst and exited this position early in the third quarter.

4. FTAI Infrastructure ( FIP )

Recent developments indicate that FIP's portfolio of assets is experiencing an inflection point. The new 10-year Exxon contract has transformed Jefferson Terminal into a highly cash flow generative asset. By 2025, we anticipate Transtar and Jefferson together could generate over $120 million in cash flow. Value realization lies in management's ability to restructure the capital structure though debt refinancing and preferred equity redemption. While investors may be primarily focused on FTAI Aviation, we see an overlooked opportunity for investors in FIP.

5. FTAI Aviation (FTAI)

The rising CFM56 engine lease rates are driven by increased interest rates, delivery shortages, and reliability issues with next-gen aircraft. Airlines are delaying maintenance events and using up green-time, which we expect to lead to significant growth in shop visits over the coming years. Given the escalating costs of OEM parts and servicing duration, FTAI is well-positioned to offer more cost and time-effective solutions though its modular factory and soon-to-be approved PMA parts. In recent quarters, FTAI's modular factory has demonstrated remarkable success, boasting numerous repeat customers and a steadily expanding customer base.

Top Detractors

1. Undisclosed Long

We acquired a position in a promising small-cap technology business that operates within a highly regulated industry. We believe the business could eventually be worth multiples of its current valuation. The business holds a dominant market position and is poised to benefit from strong secular trends. Notably, the current management team and insiders are deeply invested. Since acquiring our position in the first quarter, the share price has traded lower. However, we remain confident in the underlying fundamentals of the business and its growth potential.

The business currently trades at approximately 1.5x sales (less than 2x at the time of our purchase) and approximately 7x gross profit. These metrics represent a significant discount compared to larger public company peers, despite exhibiting stronger growth prospects. We anticipate robust revenue growth of over 30% for the next two years, along with sustained margin expansion.

From a technical standpoint, we identify several potential catalysts on the horizon. One such catalyst is the possibility of an uplisting, which would enhance liquidity for the company. This is particularly significant as the company currently faces challenges due to low liquidity and a high cost of capital.

2. Perimeter Solutions ( PRM )

We have previously discussed our investment in Perimeter in several of our previous letters. While we maintain belief in the company's competitive advantages and its ability to withstand competition from Fortress, we have observed that the market is currently unwilling to look beyond this immediate concern. Consequently, we have made the decision to sell our remaining stake in Perimeter, considering that investors are unlikely to give the company due credit until it proves its ability to maintain its market share.

From the outset of our investment, we anticipated the entry of a competitor into the market, albeit not as soon as it appears it will actually occur. Despite Perimeter's decent earnings report on May 10th, the market reacted negatively to the news of Compass Minerals acquiring the remaining interest in Fortress. This development led market participants to speculate that Compass Minerals might allocate resources towards disrupting Perimeter's market share.

In retrospect, the optimal opportunity to exit our position would have been in December when news of Fortress's approval became widely known. This would have mitigated the impact of the subsequent developments.

While we acknowledge the competitive landscape and the market's response, it's important to note that our decision to sell our stake in Perimeter reflects our uncertainty regarding the timing of the market's perception aligning with our own. We will continue to closely monitor the situation. At the current time, we believe there are better opportunities to allocate the fund's capital.

3. Undisclosed Short

We have a short position in a business that will likely need to raise capital in the near term, around the same time as insiders' shares become uplocked. During the quarter, the company achieved a few milestones, which the market reacted positively to. That combined with slightly higher short interest has had a positive impact on the company share price.

4. Undisclosed Short

We have a short position in a technology business that has benefitted from the "AI hype" trend. However, we anticipate that weaker demand will present growth challenges for the company. Additionally, we believe that the company misleads investors regarding the profitability of its core business. Despite these concerns, multiple "AI" headlines have generated excitement in the stock, leading to hype overshadowing the underlying business fundamentals.

5. Kyndryl ( KD )

Kyndryl spun out of IBM in 2021. Spin-offs by nature reflect management's intention to unlock shareholder value which may present an asymmetric set-up. Kyndryl's value lies in management's ability to work through their focused contracts - infrastructure services that, on average, generate 0% gross margin as a result of reckless bundling under IBM. More importantly, management has demonstrated their confidence in doing so by purchasing shares in the open market. Kyndryl's latest quarter reflects solid progress; gross margins have expanded by over 200 bps sequentially and more than 300 bps year-over-year. Pre-tax margins on recent signings are in the high single digits. We expect both gross and pre-tax margins to expand as post-signings get recognized from Kyndryl's backlog. Kyndryl continues to present compelling upside.

Update on Select Positions

GasLog Partners ( GLOP )

We previously discussed our investment in GasLog Partners and expressed our belief that the $8.65 offer by GasLog's General Partner undervalued the business. As the General Partner controlled ~30% of the outstanding shares and rejected the conflicts committee's request for a majority of the minority provision, only a small percentage of independent shareholders' votes were required to approve the acquisition. On July 7th, shareholders voted in favor of the transaction, which has left us disappointed with the outcome as this is a clear illustration of poor corporate governance.

Short: Undisclosed Short

Our short position in this company was a major detractor during the first quarter of 2023 and fourth quarter of 2022. Despite the recent decline in the Company's share price, we had to reduce our exposure as it rose, which ultimately limited our potential gains when the share price retraced.

In our first quarter letter we wrote: "The largest detractor to our short book came from our largest position at the beginning of the year, which was up ~50% during the first quarter. This was a result of favorable guidance and an increase in M&A activity within the peer group. Despite this, we continue to question management's credibility and believe the guidance to be overly optimistic. Furthermore, we find it unlikely that the company will be acquired as there is a significant fundamental difference in their respective business models and asset ownership. However, we should have reduced our exposure after the updated guidance which had removed any near-term catalyst for price depreciation."

In the second quarter, the company's investor day revealed worse-than-expected guidance for 2024. Additionally, a secondary filing by a large insider will result in an increase of approximately 35% in the public float. These developments have added to our concerns and further reinforced our expectations of the downside for the company. We continue to see further downside as the company disappoints.

Short: Entertainment Short

We took a short position in this reopening beneficiary for several reasons. First, we anticipated a slowdown in revenue growth due to consumer spending contraction and a decrease in corporate events spending. Additionally, considering the substantial insider ownership, we believed that insiders might be inclined to reduce their position to get liquidity. While the business appears to have strong cash flow on the surface, a significant portion is allocated towards acquisitions and capital expenditure to sustain its growth narrative. We are concerned that these factors could be exacerbated if the economy deteriorates further. It is important to note that we do not perceive this business as fundamentally flawed, and we believe it could be an attractive investment at a lower valuation.

Short: Aggressive Short Basket

During the second quarter, we observed a surge in the strength of higher beta and lower quality stocks, extending beyond the "AI" trend. Capitalizing on the market's optimism, we took the opportunity to increase our exposure to "aggressive shorts." It was not uncommon to witness significant price surges, with some businesses doubling or even tripling within a short period. From our perspective, companies we place in this category are at risk of experiencing greater than 50% downside, and many may ultimately become worthless. We have attempted to utilize volatility to our advantage, strategically trading around positions to maximize gains and manage risk effectively.

Short Theme: "The Second Half Ramp"

We observe numerous companies, many in the consumer and retail sectors, with unrealistic guidance and estimates for the second half of 2023. One such example is Leslie Pool ( LESL ), which preannounced updated guidance on July 13th, before the start of earnings season. Initially indicating an acceleration in the second half of the year, LESL later revised their guidance to reflect a continuation of the trend from the prior quarter and a decline in the macroeconomic environment. While we currently do not hold a position in LESL, it serves as an illustration of the challenges companies may face in meeting their optimistic forecasts.

Market Outlook

It is widely acknowledged that the S&P 500's gains this year have been heavily driven by seven stocks. However, we maintain a cautious stance on the economy and companies' earnings, despite the market's optimism. While earnings expectations have seen a modest decline compared to past instances, we believe that a recession could result in a significant decrease in companies' earnings and lead to multiple contractions.

Past Peak to Trough Declines ¹³

Economic data appears robust, yet the market anticipates the Fed cutting interest rates in 2024. We find these scenarios contradictory, as the Fed is unlikely to cut rates unless a recession is likely. Over the past 45 years, there has been an average lag of two and a half months between the Fed's rate cuts and the start of an economic contraction, and this timeframe reduces to less than two months when excluding the Covid pandemic in 2020. These observations raise questions about the market's expectations and potential risks ahead.

Interest Rate Cuts as a Leading Recession Indicator ^[6]

Additional Updates

We are pleased to announce that Reagan Wong has joined Tourlite as our first investment analyst. Reagan was a Portfolio Manager at Nolan Capital, a Singapore-based special situations fund that he co-founded. Reagan holds a master's degree in management science and engineering from Columbia University. He graduated with "First Class Honours" from University College London (UCL). Prior to pursuing his education, Reagan served as a First Lieutenant in the Republic of Singapore Air Force. Please join us in welcoming Reagan to the team!

Thank you for your trust and support. Please feel free to reach out to me with any questions.

Sincerely,

Jeffrey G. Cherkin

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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