Investing in companies on the cusp of change

By Ironwood Investment Management

investing-change

How often do you hear this from a public company: "We're happy to share with you that our strategic plan just isn't working.”

Of course, the answer is rarely, if ever. Companies are programmed to pursue their original plan. The board of directors and senior management set their priorities, allocate capital, make acquisitions, pay bonuses - all based on their strategic plan.

Investors are equally programmed to buy stocks of companies with successful strategies. Earnings are easy to model, valuations fit into historically normal ranges, and the stories are upbeat and comfortable to talk about.

Yet Plan A's do not always work. Execution sometimes isn't up to par, customers move away from the company's products and services, the corporate strategy itself becomes dated or flawed. In some cases, a division no longer fits, and in an extreme case, the company has to file for bankruptcy. Most investors have little if any patience for failing Plan As. The weaker Plan A looks, the faster investors abandon the stock.

This is exactly when we start looking - when Plan A isn't working.

We want to see a company make a major transition to a better future, driven by an event that will result in big changes in how these companies utilize their assets. That can include new senior management, a spin-off transaction, emerging from Chapter 11 bankruptcy, a major restructuring or turnaround, or some other significant strategic-level change.

If the transition looks particularly promising, we'll take our position (long-only) and look to stay for several years, as long as the transition remains on track our turnover is about 25% to 30%. Not all events are worth the risk (we currently hold only 34 positions) and we only look at small/mid-sized situations or companies with market caps ranging from $500 million to $10 billion.

Eighteen months into the history of our Smidcap Value portfolio, the returns have been encouraging. The strategy has returned 19.7% since its inception date of September 5, 2013, vs 18.2% for the benchmark S&P 500 Index (SPX).

The return in the quarter was driven by gains across the portfolio, most notably from Carrizo Oil & Gas (CRZO), Dynegy (DYN), Halcόn Resources (HK), Micron Technology (MU), Office Depot (ODP) and Platform Specialty Products (PAH).

We purchased three new names in the quarter: Triumph Group (TGI), Civeo (CVEO), and KBR. Triumph Group has an activist investor helping improve its operations. Civeo is a spin-off looking to convert to a REIT, and KBR has a new CEO and new CFO who are doing a complete review of the company's operations.

We also sold three positions: Timken (TKR), Hillshire Brands (HSH), and Comverse ( CNSI). While Comverse continues to struggle, Timken and Hillshire Brands successfully completed their transitions and reached our price targets.

Our holdings overall continue to deliver the fundamental improvements we expected. One example from the second quarter is Dynegy.

Dynegy emerged from Chapter 11 bankruptcy in October 2012 with a few strikes against it. They included an under-managed roster of ten gas-fired power plants and four undesirable coal-fired power plants, a poor reputation following a contentious bankruptcy battle, and what appeared to be mediocre prospects for meaningful improvement in prices for its electricity.

However, we saw several positives, including a new and highly-experienced management team led by industry veteran Bob Flexon. In addition, there was a healthy balance sheet with little debt, considerable potential to improve costs, and little downside valuation risk given the positioning of its generation plants.

Given this, we purchased the stock and have owned it since our inception. In our opinion, management has improved the underlying value of the assets, made a successful acquisition, and appears poised to make another. Importantly, the company is benefiting from better prices for the electric power it sells.

While Triumph Group's Aerospace Systems and Aftermarket Services divisions (a combined 33% of revenues) are operating well, the Aerospace Structures unit (67% of revenues) has suffered in recent quarters.

Revenue is weaker due to military program roll-offs and Boeing's (BA) commercial aircraft production cuts, and margins have suffered as overall costs are too high. Two events have captured our attention.

First, management has announced it is taking sharper, shareholder-friendly steps to reduce costs and improve manufacturing efficiency in the structures division, to make acquisitions to reduce the importance of the Structures division, and to repurchase shares.

And, second, activist investor Atlantic Investment has filed as a shareholder. This group has a history of helping mid- sized industrial companies improve their operations. With these two events, the sizeable potential for better earnings, and the stock's low valuation, we initiated a position on May 29th.

Civeo was spun-off from Oil States International (OIS) on June 2nd. The company provides temporary and long-term accommodations to more than 20,000 workers in the energy industry in Canada, Australia, and the United States. Now that the company is independent, we believe that management, led by Oil States veteran and former CFO Bradley Dodson, will focus on two primary drivers to boost the share price.

The first is to improve its operating results to return its EBITDA to the $400 million level it achieved in 2012 and 2013. In our opinion, the company may accomplish this by 2016.

The second is to convert to a REIT structure, which we expect will increase its multiple to approximately 11.0x EBITDA from its 9.0x spin-off valuation. With this combination of events, we purchased the stock on the spin-off date.

KBR is an engineering and construction company with expertise in the energy markets. The business is cyclical and cost management is crucial, yet KBR has struggled with new orders and cost over-runs over the past few years.

Investors have abandoned the stock. We believe the company is beginning a multi-year transition, led by new CEO Stuart Bradie (June 2014) and new CFO Brian Ferraioli (October 2013). They are currently conducting a top-to-bottom strategic review of the company's entire operation.

We expect the review will result in cost cutting and margin improvement as well as a new focus on businesses where KBR has a competitive advantage, particularly in gas monetization and hydrocarbons. The company has no debt, holds $1 billion in cash, and is actively buying back stock.

While its backlog is in decline temporarily, we expect large opportunities in gas monetization will materialize starting next year. The company has $3.00+ EPS potential at the mid-point of the cycle, implying an attractive 7.8x P/E in our opinion. We purchased the stock on June 27th.

As long-term investors, we patiently look through temporary set-backs in a company's transition as long as the overall outlook remains intact. However, if the company's transition becomes permanently impaired, we will exit that position. This sell discipline drove our sale of Comverse.

This software company was spun-off from Comverse Technologies in late 2012, and was a since-inception holding in our strategy. The spin-off, combined with new management that could focus on pursuing new revenue opportunities and reducing costs, appeared to be a fresh start that would leave the problems of its former parent company behind.

However, Comverse has continued to struggle with producing new orders, particularly in the important Asia Pacific region, and its other efforts to improve operating results also remain off-track. Our analysis of the company's competitive positioning led us to conclude that the transition had become permanently impaired, and we sold our shares on April 17th.

Our more preferred reason we sell a company is when it successfully completes its transition and its share valuation reaches our price target. We sold Timken and Hillshire Brands for this reason.

The company was being pressured by activist investor Relational Group to spin-off the steel business, allowing the higher-multiple bearing business to be re-valued on a standalone basis.

After a lengthy process, including a non-binding vote by shareholders and management's hiring of an investment bank, Timken management agreed to pursue a spin-off with a target date of the end of June. As the company successfully completed its transition the stock eventually reached our fair value on both a P/E basis and sum-of-the-parts basis for the two stand-alone businesses, and we sold the stock on June 3rd.

Hillshire Brands Company (HSH), also a since-inception holding in our portfolio, was spun off from food conglomerate Sara Lee Corporation in June, 2012. Hillshire had an under-managed collection of outstanding brands, including Jimmy Dean Sausages, Ball Park Franks, and Hillshire Farms lunch meats.

The new management team began to pursue a three-pronged strategy of rationalizing costs to improve margins, investing in innovation and brand-building, and pursuing acquisitions to drive top-line growth. Hillshire was executing on all three of these strategies.

On May 12th they announced the acquisition of Pinnacle Foods, which would have doubled the size of Hillshire and greatly expanded their product offering. We had a moderately favorable view of this acquisition. However, on May 27th, Pilgrim's Pride announced an unsolicited offer to buy Hillshire and we sold our shares that day.

DISCLAIMER: The investments discussed are held in client accounts as of July 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.
Ironwood Investment Management

Ironwood Investment Management

Ironwood Investment Management is an employee-owned investment management firm based in Boston that formed in 1997. It invests in undervalued

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