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Raritan Capital Q2 Letter


jawn619
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Many thanks to board members for their support! Special shoutout to Palantir and Packer16

 

http://raritancapital.com/wp-content/uploads/2016/06/Q2-2016.pdf

 

Please subscribe at http://raritancapital.com/investors for updates of quarterly letters, case studies, and investment ideas. I look forward to sharing more with the board, especially those interested in the smaller cap space.

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Eh - I strongly dislike ideas like this where the perceived discount is based on a SOTP analysis that includes ownership of public equities. It makes the *huge* assumption that the market is correctly valuing those public companies.  I've seen many SOTP analyses like this where instead of the investment increasing in value to close the discount to the perceived SOTP value, the value of the underlying holdings decreased in value to close the discount.

 

I think if you want to put together a compelling idea you have to go through each of those underlying public companies and get really really comfortable that the market is valuing them correctly.

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Eh - I strongly dislike ideas like this where the perceived discount is based on a SOTP analysis that includes ownership of public equities. It makes the *huge* assumption that the market is correctly valuing those public companies.  I've seen many SOTP analyses like this where instead of the investment increasing in value to close the discount to the perceived SOTP value, the value of the underlying holdings decreased in value to close the discount.

 

I think if you want to put together a compelling idea you have to go through each of those underlying public companies and get really really comfortable that the market is valuing them correctly.

 

Thanks Glory! To address your concern, I did. I believe the valuations of the underlying businesses are reasonable, if not understates intrinsic value for all except maybe Matrix. For example, Take Magic, which trades at 1.2x EV/Revenue, has 40% gross margins and trades at 7.5 EV/EBITDA.

 

Check the 3 statement model where all the subsidiaries are listed in different tabs.

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I did look at the 3 statement model. Not my intention to sound overly critical, but your model doesn't really analyze anything. It just summarizes the financials.  For example, SPNS and MGIC have very similar margin profiles and while SPNS is growing slightly faster does that really warrant valuation premium of >100%?? I mean I obviously haven't done a ton of work on these names, but right off the bat that seems a little crazy. I just don't think your model is much of a model, if that makes sense.

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I did look at the 3 statement model. Not my intention to sound overly critical, but your model doesn't really analyze anything. It just summarizes the financials.  For example, SPNS and MGIC have very similar margin profiles and while SPNS is growing slightly faster does that really warrant valuation premium of >100%?? I mean I obviously haven't done a ton of work on these names, but right off the bat that seems a little crazy. I just don't think your model is much of a model, if that makes sense.

 

Thanks for the feedback. If you couldn't see the difference, it's my fault for not explaining more clearly, no offense taken.

 

Sapiens and Magic are very different businesses. Over 90% of Sapien's revenues are maintenance and support, which is highly recurring in nature and has extremely high gross margins. What does this mean? imagine a scenario where  Sapiens grows revenues at around 15% for the next two years. This mean they'll have about $250M of revenue. This last year 30% of the revenue increase fell to EBIT, and i'm guessing as they grow even more than 30% of the incremental increase will drop to EBIT. Let's just say 35% falls into EBIT and the company will be $250M of revenue and $45M of EBIT. Now all of a sudden a 12x EBIT multiple doesn't seems so crazy for a company growing 20%, has a long runway, sticky recurring revenue and possibility of price increases.

 

Looked at another way, since most of the revenue is recurring, an acquirer could come in and cut a lot of SG&A and still maintain a 30-40% EBIT Margin. Off currently $185M of revenue that's around $55-75M of EBIT. Acquirer could pay 10x that multiple and it would still be an attractive valuation.

 

TLDR: because of the recurring nature of maintenance and service revenues, Sapiens is worth more and current market valuation is modest.

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Eh - I strongly dislike ideas like this where the perceived discount is based on a SOTP analysis that includes ownership of public equities. It makes the *huge* assumption that the market is correctly valuing those public companies.  I've seen many SOTP analyses like this where instead of the investment increasing in value to close the discount to the perceived SOTP value, the value of the underlying holdings decreased in value to close the discount.

 

I think if you want to put together a compelling idea you have to go through each of those underlying public companies and get really really comfortable that the market is valuing them correctly.

 

Why? The best part of a SOTP with public equities is you can actively hedge away any market risk.  I didn't read this summary, but typically there's something where 4/5ths of the company is public and the 1/5th is basically undervalued or not valued.  If the 4/5ths are public you buy the company shares, then short the public portion equal to the ownership interest relative to your position size.  You'll have effectively created a stub of the portion you believe is undervalued.

 

I get that there are carrying costs to this, but if the stub is selling for an extremely low valuation then the carry costs could be worth it.  Being able to strip out the other parts and gain exposure to the most undervalued portion of the equity is extremely powerful.  I don't know how many investors do this in practice, but the fact that it isn't popular doesn't diminish the power of it.

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Why? The best part of a SOTP with public equities is you can actively hedge away any market risk.  I didn't read this summary, but typically there's something where 4/5ths of the company is public and the 1/5th is basically undervalued or not valued.  If the 4/5ths are public you buy the company shares, then short the public portion equal to the ownership interest relative to your position size.  You'll have effectively created a stub of the portion you believe is undervalued.

 

I get that there are carrying costs to this, but if the stub is selling for an extremely low valuation then the carry costs could be worth it.  Being able to strip out the other parts and gain exposure to the most undervalued portion of the equity is extremely powerful.  I don't know how many investors do this in practice, but the fact that it isn't popular doesn't diminish the power of it.

 

This is true, if you're highly confident in the value of the stub. But it still requires all of the other parts of the trade to go your way in order for the timing to work out. This isn't like arbing a bond by selling strips and buying the bond. You need the market to act rationally to realize value in these types of investments. I've tried structuring these types of trades before and there are just a lot of things that have to happen, and you have to assume the market is rational, in order for the trade to work out.  So personally, not a fan. If it's your thing, more power to you.

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