Artko Capital LP
July 17, 2017
Investing in small/micro cap companies and special situations within a concentrated portfolio

Artko Capital LP 2Q 2017 Partner Letter

For the 4th fiscal and 2nd calendar quarter of 2017, a partnership interest in Artko Capital LP returned 8.3% net of fees. At the same time, an investment in the most comparable market indexes—Russell 2000, Russell Microcap, and the S&P 500—gained 2.5%, 3.8%, and 3.1%, respectively. For the 12 months of our fiscal 2017, an interest in Artko Capital LP returned 28.5% net of fees, while investments in the most comparable aforementioned market indexes were up 24.6%, 27.6%, and 17.9%, respectively. Our monthly results and related footnotes are available in the table at the end of this letter. We are excited to finish our second year as a partnership while maintaining a 20.4% internal rate of return (IRR) for our partners. As always, we are thankful for your long-term commitment to the partnership’s success.

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Peter Rabover, CFA
Portfolio Manager
Artko Capital LP
July 16
, 2017
Dear Partner,
For the 4
th
fiscal and 2
nd
calendar quarter of 2017, a partnership inter
est in Artko Capital LP
returned
8.3
%
net of fees. At the same time, an investment in the most comparable market indexes
Russell 2000,
Russell Microcap, and the S&P 500
gained
2.5%, 3.8%, and 3
.1
%, respective
ly. For the
12
months of our
fiscal 2017, an interest in Artk
o Capital LP returned
28.5
% net of fees
,
while investments in the most
comparable aforementioned market indexes were up
24.6%, 27.6%, and
17.9
%, respectively. Our monthly
results
and related footnotes
are available in the table at the end of this letter.
We are excited to finish
our second year as a partnership while maintaining a 2
0.4
%
internal rate of return (
IRR
)
for our partners
.
A
s always
, we
are thankful for
your long
-
term commitment to the
partnership’s
success.
3Q16
4Q16
1Q17
2Q17
CY 2017
YTD
1 year
Inception
7/1/2015
Inception
Annualized
Artko LP Net
10.6%
11.2%
-3.5%
8.3%
4.6%
28.4%
45.0%
20.4%
Russell 2000 Index
9.1%
8.8%
2.5%
2.5%
5.0%
24.6%
16.2%
7.8%
Russell MicroCap Index
11.3%
10.1%
0.4%
3.8%
4.2%
27.6%
12.2%
5.9%
S&P 500 Index
3.9%
3.8%
6.1%
3.1%
9.3%
17.9%
22.6%
10.7%
Return On Invested Capital (ROIC) and how it fits into our process
If we were to pick an investment process topic that we suspect we
will return to many times in
the coming
years, Return On Invested Capit
al (ROIC) or Cash Flow Return On Assets (CFROA), is probably one that will
come up more frequently than others.
During a recent
Fourth
of July small
-
town parade in
90
-
degree
weather
,
we came upon a simple business with the greatest ROIC in the world: a lemonade stand powered
by a little girl
on a busy corner
.
A girl with a (likely borrowed) folding table that can be boug
ht for $10 on
any
website and
a
$10, 136
-
serving
Country Time
Lemonade mix
was selling those cups like gangbusters
for
50 cents a cup (a price we suspect could have been doubled without much trouble).
In a few hours
she ran out of lemonade mix and
went
home with
at least a
$60 bounty or
a
whopping 200% ROIC in one
afternoon!
While
this example is shown in jest
and no
little girl
’s
lemonade stand will
likely
survive the
onslaught
of
the inevitable
Amazon
lemonade drone delivery business,
analyzing
a potential business
in the public
markets isn’t dissimilar.
We tend to look for simple to explain
business models
that can generate
substantial
and sustainable
returns using little capital
. Easier said than done
,
since most of these
b
usinesses tend to already trade at justifiably high valuations.
W
hile
the small
-
and micro
-
cap space
offers
more opportunities to find these, they
tend to be
few and far between
.
As such, a big part of our
investment process focuses on those companies
that
have significant opportunities to expand their ROICs
from depressed levels
, in addition to having a
valuation
-
or asset
-
based margin of safety
.
There are many
formulas
t
hat show how to calculate various definitions of ROICs or Economic Value Added (EVA) and even
more
showing
a
theoretical
value of a company based on
its
growth and
ROICs
.
Nevertheless,
a simple
truth holds:
A
company that is expanding its ROICs is going to expand its valuation multiples and value.
In
other words, the little girl’s business would be worth more if she could make more th
an $60 using
t
he
same table and
lemonade mix the following week.
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Of course
,
low capital requirements and high returns on capital present a different challenge: the
attraction of competitors.
Seeing the success of our adorable
lemonade
-
peddling
friend is sure to attract
her classmates setting up tables on nearby corners within a few days.
Therefore,
the second half of any
ROICs analysis should always include an analysis of sustainability of these returns and the length of
the
competitive advan
tage
period (CAP) where a company can reinvest its profits at similar rates of return.
It’s
no surprise that software
has
the highest returns
and
tends to have the shortest competitive
advantage periods due to its low
capital requir
ements and “winner take all” characteristics
. In comparison,
staples like food, drugs
,
and transportation tend to have longer CAPs due to higher capital intensity and
higher barriers to entry via regulat
ion
.
If our friend had cheape
st source of lemonade
,
was the only one
with $20 among her friends
,
or had the exclusive permission from all of her neighbors to set up shop on
the block
,
she is likely to continue to earn her $60 dollars for many town holidays to come.
We believe
our newest addition in Spartan Motors, discussed below, as well as most positions in the Core Portfolio,
fit
s
the narrative of simple, high incremental ROIC opportunity companies and a majority of our
investment
theses
will continue to focus on inv
esting in companies with high sustainable ROICs.
Core Portfolio Additions
Spartan Motors (SPAR
)
We added an initial 6% position this quarter, which we la
ter increased to 8
%,
in
a
fantastic manufacturer of
last mile
delivery vans, emergency vehicles
(think firetrucks
!
)
and
chassis
for large scale Recreational Vehicles (RVs). Spartan, a $300 million market capitalization
company with no debt, has a leading position in
a duopoly
delivery van
market, which
should
continue
to
grow above historical trends with
ecommerce and package delivery set to grow in double digits in
the near future.
While the
high ROIC
van business
segment
is arguably the jewel of the empire, with expanding 10%
EBITDA margins, and at current
relative
val
uation levels accounts for the entire value of the company,
we believe
the rea
l opportunity
lies in the turnaround of
bigger
emergency vehicles s
egment by the
reputable CEO Dar
yl Adams.
When
Adams joined the company two years ago, he found a historica
lly
mismanaged and culturally inefficient enterprise. Since then
,
Adams, who recently bought $3
million
worth of SPAR stock on the open market
to add to his $2 million holding
, has made great strides i
n
improving operations in
every segment. In our exp
erience of investing in
turnarounds of
small
industrial manufact
urers
,
we believe
the company’s problems are easily f
ixable
under Adams’
leadership
and should drive company
-
wide EBITDA margins from 4% today to above industry
averages
of 10% in the next two to three years.
Included a
mong some
of the
easy fixes
are
consolidating
facilities and purchasing depar
tments, investing in hereto non
-
existent Enterprise Resource Planning
software, implementing a culture of
l
ean
m
anufac
turing
,
and compensating
the
new slate of
impressive managers on
ROIC enhancing metrics
,
such as operating income growth and working
capital improvement
s
.
We expect SPA
R’s EBITDA to grow from $30 million in 2016 to over $90 million by 2019 and with low
additional
capital investment requirements a
nd a
substantial portion of those profits to convert to
Free Cash Flow.
As the company improves its Cash Flow Return on Assets (CFRA) and
ROIC
from l
ow
single digits to potentia
l
l
y
20%
or higher
,
we expect the valuation
multipl
es to expand from 8x to over
10x
and for the potential return
on this investment
to exceed 200% from our initial $8.55 per share
purchase levels. In the
meantime
,
the Sum Of The Parts valuat
ion
of at least 100% higher than today’s
stock price
and a CEO willing to monetize the company as
sets for the right price,
provide
the right
margin
of safety for this investment.
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Core Po
rtfolio Sales
CSW Industrials (CSWI) and Graham Corporation (GHM)
We sold our combined
~
7
.0
% position in
the two small industrials this past quarter to make room for
our investment in Spartan Motors. In the
end, there was nothing wrong with CSWI or GHM.
They were good investmen
ts each earning over
20% during
our
two
-
year
holding period. However, with our expectation
s
going forward of l
ow
double
-
digit returns from the
se investments
,
they just did not meet our hurdle for staying
in
the
portfolio
,
as we generally look for at least a 100%
potential upside from our invest
ments
. We have
not been adding to the positions for some time now with new partnership asset inflows and their size
in the portfolio has shrunk from 12% to below 8%. Finally, we felt that while GHM’s cash
-
laden balance
sheet provided a strong margin safet
y
,
the current struggling energy environment would prevent
the
business from thriving in the foreseeable future. In the end, we will keep our eye on these high ROIC
businesses and would look to potentially enter again at lower prices.
Other Port
folio Updates
Hudson
Technologies (
HDSN
)
In a reversal of last quarter’s
20% stock price drop where we added
an additional 2% on the dip, Hudson came roaring back 30% higher in 2Q as unfounded fears of
the
Environmental Protection Agency (
EPA
)
repealing the R
-
22
phase
-
out
began to dissipate.
The
company also reported solid results during the quarter with refrigerant pricing ticking up in double
digits as supply problems ahead of a hot summer continue to manifest and very strong gross
margins,
above 32% from 27% a year ago, showing how pricing power can quickly translate to significant
profitability.
Finally, the stock was added to the Russell indexes
this past quarter, which increased
liquidity and visibility for the company.
While
at current $9.30 stock price, the stock is up 180% from
our initial purchases a year ago, we still believe there is significant value left in this investment
and
continue to hold it as a 9.0
% portfolio position.
Destination XL
(
DXLG
)
Destination XL has been our biggest under
performer this quarter
,
swinging
wildly
fro
m $2.85 to $1.95 back up t
o
$2.75
and closing the quarter at $2.35.
The stock performance
of this low liquidity stock
driven by broad market fear factors on the overall retail sector does not
match the fundamental reality of the company’s performance. While the 1
st
quarter results came in
line with our
and the company
expectations
of flat revenues, by April 2017 the comp
any had ramped
up its
announced
advertising campaign resulting in a 6.4% comparable same store sales increase
for
the first month.
The company is on track to deliver 2
-
4% same store sales growth for the year and
over $30 million in pre
-
growth capital expen
ditures Free Cash Flow. While we are mindful of the
competitive environment
,
we believe that 3x Free Cash Flow multiple is just too low for a quality
company with its own significant online business boasting an incredible 8% return rate.
We’ve been
addin
g to our position on the dips
,
lowering our overall cost basis to below $2.50 per share, though
these adds should be viewed as temporary
as this is likely to remain
,
a smaller
, 6
%
to 7%,
core portfolio
position
. (Further discussion of
the impac
t of
macro
-
economic
uncertainty factors
is
discuss
ed
in our
Market Outlook section.
)
State National Companies
(SNC)
We could
n’t
be more pleased with the performance of this
investment over the last year. It is up over 80% since our September 2016 purchase
and 30% for the
quarter
. The company has continued to hit on all cylinders in its Fronting Services segment
and
Collateral Protection and continu
es
to raise its guidance
quarter after quarter
.
One of our bigger
worries for this
company
was its
concentration of
big contracts on the Fronting Services side of the
business. During the quarter
,
State National a
nnounced two
big contract wins
totaling
$200 million in
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a
nnualized premiums
,
which
significantly boost
ed
the company’s Free Cash
Flow generation and
diversified
its book of business
to lower the aforementioned concentration worries
.
While we do not
act on market rumors, the stock’s performance this quarter was
also
helped by reports that the
company was in the process of shopping itself to potential buyers.
Despite the significant run
up
in
the stock, we believe that at current valuation levels th
is excellent operator
,
with high in
cremental
and sustainable ROICs,
is still trading 40% below its current fair value and it remains one of our bigger
positions at 10% of the portfolio.
US Geothermal
(HTM)
US Geothermal, another 10% position, continu
ed its progress to
ward
developing its
pipeline of geothermal projects in
the
Western United States. While the company
currently has approximately 40 m
egawatts (MW) of ge
othermal power in three plants
under
management
in Nevada, Oregon
,
and
Idaho
, the real
value in the investment is the development of
its
pipeline of additional projects that we expect to come on line in the near future. One
is a 30MW
project in Geisers,
CA.
and another one is an expansion of its
Sam Emidio plant in Nevada. The goo
d
news
that came out during the quarter and
pushed the
stock up 15%
, is that the Nevada project, Sam
Emidio II, has increased its prove
n reserve estimate from 10MWs a
year ago to 47MW today.
At this
point, the company is in the
process of bidding for Pow
er Purchase Agreements (PPAs) with interested
parties in California and Nevada, a drawn out and uncertain process. We believe that at current $4.50
per share price
,
the company’s value is backed by its
long
-
life assets and significant
F
ree
C
ash
F
low
generation
.
S
hould these projects sign PPAs and begin construction, the upside is well over a 100%.
The characteristics of the risk
-
reward of this investment
(
heads we win and tails we don’t lose much
)
and its relatively small expo
sure to changes in
the economy, is why it contin
u
e
s to be a significant
holding in our portfolio.
We’ve invested under 1% of our portfolio this quarter in put options of two companies
where we
determined near term events would lead to a fall in their st
ock prices
.
So far
,
they have both work
ed
out well contributing approximately
0
.5% to portfolio performance this quarter.
Market Outlook and Commentary
The most popular T
V show in the United States
throughout this bull market cycle
has be
en
the HBO
-
bas
ed
fantasy drama “Game
o
f Thrones.” Over the last six seasons
,
set in the world
of seemingly
endless
summer
,
the recurring phrase that continued to permeate the show has been “Winter is coming.” The
characters pa
y
homage to the potential of winter but
because
it has
been warm
and sunny
for such an
unprecedented period
,
instead of truly preparing for winter it sort of devolved into a repeatable idiom
whose original meaning has been lost.
In a way, today’s markets are not dissimilar
. It
has
been almost a
decade
since
we saw real econom
ic
-
or market
-
based discomfort. The Great Recession and the stock
market crash of 2008 have
been replaced by an unstoppable bull market and an
ever
-
expanding
economy.
The bogeyman
of a bear market is something portfolio m
anagers tell
their young analysts
to make them
work harder, but he hasn’t been seen or heard from in years
,
breeding incredible complacency as
measured by the historical
ly
low volatility in the markets today.
Since we wrote
our first letter
to you
two years ago, the broad market index, S&P 50
0 has returned 22.6%.
In mid
-
2015
,
the expected
2016 S&P earnings were $130 and 2017 earnings
expectations
were around
$146. Looking
at
the same earnings
expectations today, 2017 earnings are expected to
be
$131.5
0
and
2018 earnings
expectations
are
at
$147.
In other words, while the market
and market
multiples are
climbing, from 15.6x Forward Twelve Months (FTM) in 2015 to 17.6x toda
y, the hope for earnings growth
keeps being pushed out further and further.
It’s
been one off thing or another as to why this is happening
,
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such as the energy sector getting hit or the dollar getting stronger resulting in negative earnings revisions
.
T
he
economy continued to grow at a d
ecent clip of over 2% during
that time, interest rates were low and
investment choices for real returns relative to the U
.
S
.
s
tock markets were non
-
existent allowing investors
to shrug off
the continuous push out of
earnings growth
.
If you’ve been reading the
market
commentary
section of our investor letters
,
you know we’ve been a fan
of comparing the
real 10
-
year Treasury rate to the inverse of the S&P 500 Price to Earnings ratio, the
earnings yield.
Over the last t
wo
years,
that spread, the equity risk premium, has gone from
approximately
6%
to closer to 4%
on higher market valuations, and moving in
line with historical averages.
This analysis
also required
us
to believe that earnings expectations will be cor
rect
;
however, as we see today, those
earnings expectations remain the same as they were two years ago
so the true earnings yield may
be even
lower
.
However, the bigger signal coming through the
macro data
noise
is the flattening o
f the yield
curve.
While the 10
-
year T
reasury has remained consistently in place at around 2.35%
,
the short
er
-
term rates
have gone from .05
% to over 1.00% on Federal Reserve tightening actions.
In the past, yield curve
flattening
or inverse movement
signals have impli
ed higher potential for economic
and market trouble
ahead
. At the same time
,
we believe political uncertainty coming from the Trump administration on its
tax and healthcare policies and the possibility that the Federal
R
eserve overshoots on macro policy c
reate
an environment of high uncertainty,
for not only
us,
but also
companies and consumers alike.
As a
partnership, we are likely to become more cautious in the near future and may look to hold 20
%
to 30%
of our assets in cash in anticipa
tion of better investment opportunities at lower prices
or
engage in
hedging out market risk
.
Winter is coming.
Don’t expect us to be complacent in the face of increasing
uncertainty
.
Partnership Updates
We’ve welcomed 6
new partners to the partnership th
is quarter
bringing our total to 21
by the end of
July
.
With 90% of our assets having a lock up of over 3.5 years
,
we feel comfortable taking much
longer
term oriented investment decisions going forward.
We are
excited about the continued partnership
growth and look forward to seeing you at our annual
partner
event on July 17
in San Francisco.
We are
likely to have our next event in
early
2018,
as we will move to converge our fiscal
and calendar years in
line with your tax reporting periods.
Next Fund Opening
Ou
r next fund openings will be August
1
, 2017, and
S
e
p
t
e
m
b
e
r
1
, 2017
. Please reach out for updated
offering documents and presentations at
info@artkocapital.com
or 415.531.2699
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Appendix: Performance Statistics Table
Artko LP Gross
Artko LP Net
Russell 2000 Index
Russell MicroCap
Index
S&P 500 Index
Jul-15
2.1%
1.7%
-1.2%
-3.2%
2.1%
Aug-15
-3.7%
-3.7%
-6.3%
-5.4%
-6.0%
Sep-15
1.6%
1.4%
-4.9%
-5.8%
-2.5%
Oct-15
1.7%
1.5%
5.6%
5.4%
8.4%
Nov-15
4.1%
3.3%
3.3%
3.8%
0.3%
Dec-15
0.2%
0.0%
-5.0%
-5.2%
-1.6%
Jan-16
-5.2%
-5.4%
-8.8%
-10.4%
-5.0%
Feb-16
0.9%
0.8%
0.0%
-1.5%
-0.1%
Mar-16
8.9%
7.5%
8.0%
7.1%
6.8%
Apr-16
1.4%
1.1%
1.6%
3.2%
0.4%
May-16
3.5%
2.7%
2.3%
1.3%
1.8%
Jun-16
2.3%
1.8%
-0.1%
-0.6%
0.3%
Jul-16
12.4%
10.0%
6.0%
5.2%
3.7%
Aug-16
0.5%
0.4%
1.6%
2.6%
0.1%
Sep-16
0.1%
0.1%
1.1%
2.9%
0.0%
Oct-16
-1.5%
-1.3%
-4.8%
-5.7%
-1.8%
Nov-16
13.5%
11.0%
11.2%
11.6%
3.7%
Dec-16
1.8%
1.4%
2.8%
4.6%
2.0%
Jan-17
-2.2%
-2.3%
1.5%
0.4%
1.9%
Feb-17
2.3%
2.2%
1.9%
1.0%
4.0%
Mar-17
-3.4%
-3.5%
0.1%
0.9%
0.1%
Apr-17
2.7%
2.7%
1.1%
1.0%
1.0%
May-17
0.1%
0.1%
2.1%
2.4%
1.4%
Jun-17
6.7%
5.4%
3.5%
5.2%
0.6%
YTD
5.9%
4.6%
5.0%
4.2%
9.3%
1 Year
36.4%
28.4%
24.6%
27.6%
17.9%
Inception 7/1/2015
61.1%
45.0%
16.2%
12.2%
22.7%
Inception Annualized
26.9%
20.4%
7.8%
5.9%
10.7%
Monthly Average
2.1%
1.6%
0.9%
0.9%
0.9%
Monthly St Deviation
4.4%
3.8%
4.5%
4.8%
3.1%
Correlation w Net
-
1.00
0.80
0.75
0.62
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Legal Disclosure
The Partnership’s performance is based on operations during a period of general market growth and
extraordinary market volatility during part of the period, and is not necessarily indicative of results the
Partnership may achieve in the f
uture. In addition, the results are based on the periods as a whole, but
results for individual months or quarters within each period have been more favorable or less favorable
than the average, as the case may be. The foregoing data have been prepared by
the General Partner and
have not been compiled, reviewed or audited by an independent accountant and non
-
year end results
are subject to adjustment.
The results portrayed are for an investor since inception in the Partnership and the results reflect the
reinvestment of dividends and other earnings and the deduction of costs, the management fees charged
to the Partnership and a pro forma reduction of the General Partner’s special profit allocation, if
applicable. The General Partner believes that the compa
rison of Partnership performance to any single
market index is inappropriate. The Partnership’s portfolio may contain options and other derivative
securities, fixed income investments, may include short sales of securities and margin trading and is not
as
diversified as the indices, shown. The Standard & Poor's 500 Index contains 500 industrial,
transportation, utility and financial companies and is generally representative of the large capitalization
US stock market. The Russell 2000 Index is comprised of
the smallest 2000 companies in the Russell 3000
Index and is generally representative of the small capitalization U.S. stock market. The Russell Microcap
Index is comprised of the smallest 1,000 securities in the Russell 2000 Index plus the next 1,000 secu
rities
(traded on national exchanges). The Russell Microcap is generally representative of the microcap segment
of the U.S. stock market. All of the indices are unmanaged, market weighted and reflect the reinvestment
of dividends. Due to the differences am
ong the Partnership’s portfolio and the performance of the equity
market indices shown above, however, the General Partner cautions potential investors that no such
index is directly comparable to the investment strategy of the Partnership.
While the Gene
ral Partner believes that to date the Partnership has been managed with an investment
philosophy and methodology similar to that described in the Partnership’s Offering Circular and to that
which will be used to manage the Partnership in the future, future
investments will be made under
different economic conditions and in different securities. Further, the performance discussed herein does
not reflect the General Partner’s performance in all different economic cycles. It should not be assumed
that investor
s will experience returns in the future, if any, comparable to those discussed above. The
information given above is historic and should not be taken as any indication of future performance. It
should not be assumed that recommendations made in the future
will be profitable, or will equal, the
performance of the securities discussed in this material. Upon request, the General Partner will provide
to you a list of all the recommendations made by it within the past year.
This document is not intended as and
does not constitute an offer to sell any securities to any person or
a solicitation of any person of any offer to purchase any securities. Such an offer or solicitation can only
be made by the confidential Offering Circular of the Partnership. This informa
tion omits most of the
information material to a decision whether to invest in the Partnership. No person should rely on any
information in this document, but should rely exclusively on the Offering Circular in considering whether
to invest in the Partners
hip.
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