GrizzlyRock Value Partners, LP

2012 Year End Investor Letter

January 11
th
, 2013
Fellow Partners,
During 2012, GrizzlyRock Value Partners, LP (the Fund) returned 13.56% net of fees while averaging
55.8% net long exposure (measured at month end). The Funds positive performance each quarter and
Sharpe ratio of 1.54 represents solid progress toward GrizzlyRocks goal of excellent long-term risk
adjusted returns. GrizzlyRock outperformed many market indices and hedge funds by maintaining a
defensive posture while selecting attractive corporate investments. As an investor with 100% of my net
worth in the Fund, I view the Funds return in 2012 as acceptable given the risk-constrained approach.
Financial markets during 2012 were decidedly uncertain with investors facing various issues including
slowing corporate growth, macroeconomic fears in Europe and China, and a US trifecta of questions
concerning quantitative easing, the election, and the fiscal cliff. Market sentiment swung from ebullient
during the first quarter to despondent during the early summer before moderating during the third and
fourth quarters. Overall, corporate risk markets rallied substantially with a particular focus on yield bearing
securities.
A siren song of macroeconomic uncertainty adversely
affected many investors in 2012. As Odysseus
generations ago, GrizzlyRocks commitment to the
task at hand regardless of extraneous factors led to
sound results. At GrizzlyRock, long-form analysis
guides portfolio investments regardless of market
sentiment or the fad du jour. GrizzlyRocks long /
short strategy focusing on dramatically mispriced
assets is designed to navigate stormy and placid seas. Above: Odysseus is tempted by the Sirens
on his journey back to Ithaca
2
Investment Management is Risk Management
During 2012, the primacy of risk control was paramount due to macro uncertainty and robust valuations of
risk assets entering the year. Early in the year, the Fund gained from specific value and credit investments
while maintaining a defensive portfolio. During the second half of the year, compelling event driven
situations and single name shorts justified a more aggressive approach.
GrizzlyRock avoids arbitrary performance goals in order to focus on capturing opportunity as situations
arise. Throughout 2012, I indicated the Funds conservative investment profile may provide 10% to 15%
annual gains (net of fees) over the next three to five years. The current portfolio positioning likely supports
returns in this range with additional upside possible from a handful of deep value investments. My belief is
based on the following reasons:
(1) GrizzlyRock estimates the Funds value equity investments as a whole are trading at 35% discount to
business value. Assuming a two year holding period, a mid-teens yearly growth rate is reasonable.
As GrizzlyRock does not invest thematically, equity investments are uncorrelated by risk factors and
have unique catalysts.
(2) Event driven opportunities remain plentiful with many spin-offs offering ex-ante return prospects of
20%+ with minimal risk. Currently, many current present an attainable path to value realization.
(3) GrizzlyRock has identified a handful of overvalued businesses with low competitive advantages. Single
name short positions were slightly unprofitable last year while risk markets rallied. In 2013
GrizzlyRocks short positions are likely to return a profit based on specific company risks and extreme
valuations.
Given the aforementioned portfolio characteristics, now would be an excellent time to increase your
investment in the Fund.
Performance Attribution (see chart on page 3)
GrizzlyRocks 2012 gain of 13.56% was based on select long credit and equity positions while being
slightly offset by single name short positions and market hedges. Performance for the fourth quarter was
+0.80% compared to a -0.27% quarterly return for the S&P 500. Although GrizzlyRock focuses on medium
and long-term asset growth, the Fund
gained value during each quarter of
2012 while the S&P 500 Index
declined two out of four quarters.
Q1 Q2 Q3 Q4 Yearly
GRVP 5.74% 2.15% 4.30% 0.80%
13.56%
S&P 500 12.68% -2.67% 6.19% -0.27%
16.15%
2012
2012 Quarterly Return of GrizzlyRock and S&P 500
3
2012 GrizzlyRock Value Partners LP Performance Allocation by Investment Type
13.56% -0.52%
-2.14%
-0.28%
+6.56%
+9.94%
0%
2%
4%
6%
8%
10%
12%
14%
16%
Credit Equity Short Positions Market Hedging Fees Total
Comparative Performance
While GrizzlyRock does not attempt to outperform certain indices or benchmarks, an analysis of
comparative results sheds light on Fund performance. During 2012, the Fund provided superior absolute
returns to the Dow Jones Industrial Average with less volatility. Compared to the S&P 500, GrizzlyRock
outperformed on a risk-adjusted basis (as measured by the Sharpe Ratio) while not quite reaching the
Indexs total advance. GrizzlyRocks performance was bolstered via high yield credit exposure and
individual security selection slightly offset by low average net exposure to risk assets and relatively less
investment in well performing sectors such as autos, finance, and technology.
As shown below, GrizzlyRock also posted superior returns when compared to many other hedge funds. Per
Hedge Fund Research, the HFRI Fund Weighted Composite Index returned 6.16%. The HFRX Equity
Hedge: Fundamental Value Index, comprised of funds with similar strategies to GrizzlyRock, generated a
+5.88% return during 2012. While a risk-adjusted comparison is not possible as index component net
exposure levels are unknown, GrizzlyRocks 2012 returns were successful.
2012 GrizzlyRock Returns Compared to Equity and Hedge Fund Indices
Fund / Index
2012
Return
Standard
Deviation
Sharpe
Ratio
Net Long
Exposure
(1)
GrizzlyRock
Alpha
(2)
GrizzlyRock Value Partners, LP 13.56% 8.7% 1.54 55.8 N/A
Dow Jones Industrial Average 10.20% 9.6% 1.06 100% 7.87%
S&P 500 Index 16.15% 10.5% 1.52 100% 4.55%
HFRX Fundamental Value Index 5.88% 2.9% 2.02 Unknown N/A
(1) Average gross long investments minus short positions as a percentage of NAV as assessed at month end.
(2) GrizzlyRock Alpha = GrizzlyRock Return (Index Return x GrizzlyRock Net Long Exposure)
4
Yearly Portfolio Review
GRVP Allocation
at Month End
March
2012
June
2012
September
2012
December
2012
Long Exposure 72% 52% 63% 78%
Short Exposure 15% 10% 12% 15%
Gross Exposure 87% 62% 74% 92%
Net Exposure 58% 43% 51% 63%
Beginning the year, the portfolio was composed primarily of high yield credit as well as venerable (yet
inexpensively-priced) businesses such as Berkshire Hathaway, Lowes (the home improvement retailer),
Visa, and Fairfax Financial. Market turmoil during fall of 2011 presented an opportunity to purchase
excellent companies with strong balance sheets and competitive advantages for discount prices.
Following Buffetts mantra be fearful when others are greedy and greedy when other as fearful I reduced
net long portfolio exposure during the spring as market prices increased. As a result, the Fund gained
during the second quarter driven by several short positions and market hedges while risk markets declined.
During the summer and fall, my focus was on intriguing event driven and short positions. In December, I
added two deep value investments which have highly asymmetric risk-return prospects and significant
positive skew. These businesses are in quality industries with incentivized management teams and have
clear catalysts for value realization. (Next section highlights one)
At the individual security level results were broadly strong with a few misses. The Funds largest position
during the year rallied 65% yet remains undervalued. My biggest mistake during the year was clear: selling
Visa Inc. (NYSE:V) in June for $120 as prevailing market prices neared my initial valuation estimation.
While the Fund netted a 62.7% profit taxable at long-term rates on the sale, Visa was selling for about
~$150 per share at year end 2012. After accurate analysis and prescient investment (see GrizzlyRocks Q2
letter for more detail), I sold Visa as the Fund captured the low hanging fruit yet the market continued to
increase Visas price. Great businesses compound valuation as they grow and I neglected to adequately
account for this phenomenon when I sold Visa. I have incorporated this lesson into my sell methodology
and plan not to repeat the error.
Performance for the rest of the portfolio was as follows: Most long positions gained in value. A few short
positions made money, a few broke even, and one short impacted performance. Event driven positions were
broadly positive although certain catalysts expected during the year are now likely 2013 events.
5
2012 Lessons Learned
Reviewing annual portfolio gains and losses is an excellent time to reflect on decisions and strategy.
Investment markets often dole out humbling lessons as well as rewards for prescient analysis. Here are a
few lessons learned in 2012:
(1) Not All Balance Sheets Are Equal
In early 2012, GrizzlyRock purchased a consortium of early stage precious metal mining businesses
well below book value. The summer swoon of gold prices lead to poor market economics and book
value plummeted while the discount from share price to book value of equity remained. Discounts to
book value can lead to attractive returns yet book values themselves must remain robust.
(2) Dont Fight the Market Wait For The Right Time To Express A Position
This lesson was predicated by the Funds on-again, off-again short of Salesforce.com (NYSE:CRM).
Without a lengthy expose, Salesforce.com has been increasing revenue growth by signing less
economic contracts with customers in exchange for long contract terms while attempting to convince
Wall Street that sales compensation is not a cost! All Wall Street recognized was revenue growth
regardless of Salesforces inability to generate earnings or fair free cash flow. After much
consternation, GrizzlyRock returns from Salesforce.com were flat in 2012.
(3) Markets Overpay For Growth and Certainty (Reminder of Fundamental GrizzlyRock Belief)
Pricing inefficiencies are often created by investors who abandon positions as growth wanes or outlook
clouds. GrizzlyRock purchased Ituran Location and Control (NASDAQ:ITRN) for well below intrinsic
value last summer as ancillary noise regarding growth rates depressed share prices. GrizzlyRock paid
just 10.7x earnings and 3.9x EV to EBITDA for a monopoly business in Israel (50% of revenue)
generating immense free cash flow and a growing Brazilian unit (40% of revenue) with a new,
exclusive contract with Chevrolet and positive forthcoming regulation. Ituran gains to date are ~26%.
In early October, the stock price of Alliant Techsystems (NYSE:ATK) languished as market
participants focused on macroeconomic fears of impending sequestration of military spending and a
potential decline in defense spending by a second term Obama administration. GrizzlyRock purchased
Alliant at 7.4x earnings and 4.5x EV to EBITDA for a technologically advanced business which just
received a 10 year renewal of its largest military contract. Alliant Techsystems gains to date are 23%.
By the time business economics are clearly visible the price will be clearly reflected. As such
GrizzlyRock desires to be a net seller of businesses with clearly priced-in economics.
6
Current Fund Investment: Liberator Medical (PINK:LBMH)
Late in December, I invested Fund capital in a small direct-to-consumer medical supply distribution
business with a straightforward business model, experienced management with large equity ownership,
excellent industry dynamics, and rock-bottom valuation. Liberator Medical is the market leader in selling
urological (i.e. catheters) and ostonomy products to Medicare eligible seniors through direct response
advertising. Liberators high ROI model works as follows: Liberator purchases direct response
advertisements (primarily on TV and online) which generate incoming leads. After customers are qualified
through insurance and medical documentation, Liberator has added a customer for highly necessary
recurring products at 60% gross margin. GrizzlyRock estimates Liberator retains customers at a ~85%
yearly rate while management indicates customers are retained for up to 10 years.
CEO Mark Libratore founded the company in 2007 after noting the urological product (78% of 2011 sales)
market as highly attractive given the sensitive nature of the product, low cost per unit, industry
demographic trends, and underpenetrated market. Management is recreating their previous success at
Liberty Medical (the largest direct-to-consumer distributor of diabetes supplies) in an adjacent market.
Industry growth rates should average 6% annually based primarily on US demographic trends. Medicare
pays about three quarters of product cost with the remaining amount paid by secondary insurance and
consumer self-pay. Although some investors view Medicare reimbursement risk as plausible, this risk is
mitigated by the following reasons:
(1) In 2008, Medicare increased total catheters available for Medicare seniors from 4 per month to 200.
Moving from self-sterilization to providing disposable catheters decreased total spending per patient
due to a lower incidence of infection and costly hospitalization.
(2) In 2012, Medicare raised reimbursement rate prices of Liberators urological products by 2.4%.
Further, urological products were not included in the last round of competitive bidding.
(3) Catheters are a low cost, commoditized product necessary for many seniors with proven overall cost
effectiveness. While Medicare budgets are under pressure on all sides, catheters most likely will not
be the place for Medicare to reduce expenditures.
Why is the Opportunity in Liberator Shares Exist?
(1) 3.2% revenue growth during the nine months from October 2011 through June 2012
Prior to this time period, Liberator had been growing revenue over 20% per year. In fiscal 2011
(ending 9/30/11) Liberator advertised more than any previous year yet customer acquisition was less
effective than in years past. GrizzlyRock believes this spend was weighted disproportionately towards
secondary product categories including ostonomy and mastectomy as opposed to the core urological
7
market. Liberator reaccelerated their sales growth in the fiscal 4
th
quarter of 2012 with the highest ever
quarterly sales of $16.5 million (over 10% growth quarter over quarter).
(2) Liberator does not have a natural buyer of minority shares
With a market capitalization of $37.1 million, Liberator flies under the radar for funds investing large
amounts of capital. The natural buyer of this business is a strategic medical device manufacturer or a
private equity firm who would take control of the business and leverage the customer list and
distribution channels. Liberator is a predictable, growing business with discernible economies of scale
that could support financial leverage. This combination is highly attractive to control buyers.
GrizzlyRock views a buyout as a highly likely catalyst for Liberator.
(3) Current GAAP financials do not reflect Liberator Medicals economic reality
Liberator has been investing significant amounts in operating staff to aid business growth. These
SG&A expenses have obscured Liberators margin potential. Liberator management is not running the
business for Wall Street; they are focusing on developing a robust, scalable business.
(4) Liberator has not been a historical producer of free cash flow
Liberator is at an inflection point of free cash flow generation. The company has historically been a
net user of cash as they invested $45 million over the past five years to acquire recurring customer
relationships. After spending $15.2 million on advertising in fiscal 2011 and $13.1 million in fiscal
2012, management is projecting a decline in 2013. A decline in ad expenditures coupled with absolute
revenue growth will significantly bolster free cash flow in 2013 which may provide a catalyst for
share price appreciation.
Valuation & Conclusion
Liberator is currently trading at 10.5x 2013 earnings, 0.6x sales, and 5.6x EBITDA for a business
GrizzlyRock expects to grow high single digits while increasing operating margins in 2013. These metrics
are drastically undervalued for the largest business in a growing industry. Liberators undervaluation is
conferred by the September 2012 sales of 180 Medical, the second largest market participant, for 4.7x sales
and 13x pro forma EBITDA.
GrizzlyRock conservatively estimates Liberators base case valuation to be approximately $80 million
which implies 100%+ equity upside for the share price over a few years. The upside case implies equity
price appreciation of 200%+ from the current share price predicated on Liberators purchase by a middle-
market private equity business or strategic medical product distribution firm. A sale to a larger entity (such
as a private equity backed roll-up of similar distributors) would allow Liberator to remove significant costs
from their operating structure. Further, the inherent stability of cash flows could allow a purchaser to
8
include modest financial leverage in the transaction. The combination of operating and financial leverage
for a business growing in the mid-single digits per year would be highly valuable to an acquirer.
As return potential is inconsequential without considering potential investment downside, what is
Liberators value in a stress scenario? Assuming below industry growth rates and EBITDA margins less
than half of managements projection for a flat case GrizzlyRock values the business at ~$30 million which
implies a ~20% decline in share price. GrizzlyRock considers the base or upside case much more likely
than the stress case. Regardless, even if the base case has a 50% probability of 100% gain and the stress
case has a 50% probability of 20% loss Liberator is a highly attractive investment. Assuming three years
for value realization, GrizzlyRock projects a probabilistic ~25% yearly return on Liberator. (For further
information on Liberator contact me yet be prepared to receive a 20+ page analysis!)
Fourth Quarter Closed Positions Review (organized alphabetically)
The below briefly reviews investments exited during the fourth quarter.
EnCana Corporation (realized gain of 26.6% from position inception): A large-cap oil and natural
gas firm, I purchased EnCana in April of 2012 as fears regarding industry oversupply in the US
natural gas market adversely affected stock prices. As a robust company which will earn economic
profits under most plausible scenarios in the unfolding natural gas industry, EnCana was priced
considerably below its true worth in April 2012. EnCanas sale was predicated on a significant
increase of market price towards intrinsic business value.
Potash Corporation (realized loss of 4.2% from position inception): A large cap owner of valuation
potash, phosphate, and nitrogen reserves which sells into an oligopolistic market, Potash was
purchased during Q1 2012. Sale during the fourth quarter was predicated upon a less favorable
industry outlook.
Short Media General / Long Sinclair Broadcasting Pairs Trade (realized gain of 22.4% on net
exposure): During Q4 2012, I shorted Media General (NYSE:MEG) given drastic overvaluation
relative to broadcasting peers. Sinclair Broadcasting (NASDAQ:SBGI) was purchased to neutralize
industry exposure. Media General declined and the position was liquidated for a 7% gain while
Sinclair rose and generated an 8% return. Media General declined as expected yet the rise of
Sinclairs stock price was fortuitous. (Note: GrizzlyRock maintains a long-term investment in an
undervalued broadcaster with excellent prospects.)
9
Current Portfolio Update
At year end, the Fund had 17 long investments: three
credit positions, four event driven positions, and ten
value equity positions. The Fund also contained five
short positions that reduced net long exposure to 58.8%.
Geographically, Fund investments are primarily in the
US, Canada, and Western Europe with some exposure to
developed Asian countries, Israel, and Brazil.
GrizzlyRock Outlook
Moving forward into 2013, the environment for GrizzlyRock remains constructive. Yet, many risk classes
are fully valued and offer few compelling opportunities. Certain European and Japanese companies appear
inexpensive yet contain a macroeconomic sword of Damocles.
Current Fund value equity investments, when considered as a whole, are priced roughly 35% below true
business value and present sound ex-ante prospects. The most salient current opportunities exist in US
event driven and long / short equity positions focused on company specific factors.
High yield credit is near full valuation with little Fund investment focused on the asset class recently. High
yield bonds are currently priced to return as little as 6% per year for leveraged firms. Current market terms
are attractive for corporate issuers yet fail to adequately compensate investors such as GrizzlyRock for the
myriad of associated risks. When you speak with corporate CFOs give them some advice from the
esteemed Steve Miller Go on, take the money and run! Until market conditions improve, GrizzlyRock
will focus elsewhere for mispriced assets.
Two industries producing interesting short opportunities currently are enterprise software (primarily
software-as-a-service) and retail. Both industries offer high priced companies which are growing revenue
rapidly yet not materializing profits nor sustainable competitive advantages. I will comment on company
specifics as short positions are closed.
Credit
17.3%
Value
Equity
45.7%
Event
Driven
Equity
14.1%
Short
Positions
8.5%
Market
Hedges
6.5%
Cash
7.9%
GrizzlyRock Investment
Allocation at Year End 2012
10
Conclusion
GrizzlyRock is designed to earn attractive risk-adjusted returns in corporate securities over the medium and
long-term. By increasing Fund value each quarter during 2012 we achieved this goal on an interim basis.
The current portfolio is designed to profit regardless of market direction and I look forward to updating you
on investment progress throughout 2013.
As an emerging fund, GrizzlyRock Capital is actively seeking additional investors. I continue to share
GrizzlyRocks value proposition to investors who are interested in a risk-constrained, best ideas approach
to corporate investing. If you are satisfied with performance and process to date, consider sharing the
GrizzlyRock story with fellow investors.
As always, feel free to reach out to me to discuss any aspect of Fund operations. Best wishes in 2013!
Sincerely,
Kyle Mowery
Managing Partner
GrizzlyRock Capital, LLC
www.grizzlyrockcapital.com
(773) 278-9609 | kyle@grizzlyrockcapital.com
Legal Disclaimer: This is not an offering or the solicitation of an offer to purchase an interest in GrizzlyRock Value Partners, LP
(the Fund). Any such offer or solicitation will be made only to qualified investors by means of a Confidential Private Placement
Memorandum and only in those jurisdictions where permitted by law.
The Funds investment strategy does not track the S&P 500 nor any other index. Comparison shown for informational purposes
only.
No assurance can be given that the investment objective will be achieved or that an investor will receive a return of all or part of his
or her investment. Investment results may vary substantially over any given time period. Past performance not indicative of future
results.