March 02, 2024
Investing in small/micro cap companies and special situations within a concentrated portfolio
Artko Capital LP 2023 Annual Partner Letter
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Peter Rabover
, CFA
Portfolio Manager
Artko Capital LP
February
29
, 202
4
Dear Partner,
For the
fourth
calendar quarter of 202
3
, an average partnership interest in Artko Capital LP
was
up
6.9
%
net of fees. At the same time, investments in the most comparable market indexes
—
Russell 2000, Russell
Microcap, and the S&P 500
—
were
up
1
4.0
%
,
16
.
1
%, and
11
.
7
% respectively.
For the calendar year of
202
3
, an average partnership interest in Artko Capital LP was
up
1
.
6
% net of fees. At the same time,
investments in the most comparable market indexes
—
Russell 2000, Russell Microcap, and the S&P 500
—
were
up
16
.
9
%,
9
.
3
%, and
26
.
3
% respectively.
Our detailed results and related footnotes are available in
the table at the end of this letter. Our
positive
results this
year
came from
Potbelly
, Currency Exchange
International and
Rese
arch Solutions
, while
a pullback in
Shyft
G
roup
and Polished.com warran
ts
detracted from the overall performance. We share our outlook and full portfolio review for 202
3
in the
sections below.
1Q23
2Q23
3Q23
4Q23
1 year
3 year
5 year
Inception
7/1/2015
Inception
Annualized
Artko LP Net
16.0%
-1.7%
-16.7%
6.9%
1.6%
-7.1%
0.5%
28.6%
3.0%
Russell 2000 Index
2.3%
5.2%
-5.1%
14.0%
16.9%
2.2%
10.0%
81.7%
7.3%
Russell MicroCap Index
-3.6%
5.3%
-7.9%
16.1%
9.3%
0.6%
8.6%
59.7%
5.7%
S&P 500 Index
7.5%
8.7%
-3.3%
11.7%
26.3%
10.0%
15.7%
169.3%
12.4%
The River Flows
“
Don
’
t go chasing waterfalls. Please stick to the rivers and t
he lakes that you
’
r
e use
d
to.
”
–
TLC
One of our favorite mental exercises is to distill the complexities of the market, with millions of
participants and thousands of external environmental factors, into more relatable, real
-
life examples
where the visual can create a more understandable repr
esentation of the factors that influence the
market’s direction. This isn’t an original thought, and one of our favorite examples of the creativity of
humanity to help with the visualization problem was the 1949 invention of the Phillips Machine, also
know
n as the MONIAC (Monetary National Income Analogue Computer), Phillips Hydraulic Computer, and
the Financephalograph. It is an analogue computer that uses fluidic logic to model the workings of an
economy. Observing the machine in operation makes it much e
asier for investors to understand the
interrelated processes of an economic system
.
The machine is approximately 6 ft 7 in high, 3 ft 11 in wide, and almost 3 ft 3
in deep. It consists of a series of transparent plastic tanks and pipes fastened
to a wooden board. Each tank represents some aspect of the UK national
economy, and the flow of
money around the economy is illustrated by colored
water. The flow of water is automatically controlled through a series of floats,
counterweights, electrodes, and cords. The flow of water between the tanks
is determined by economic principles and the set
tings for various parameters.
Different economic parameters, such as tax rates and investment rates, can
be entered by setting the valves that control the flow of water about the
computer. For the curious mind, a few machines are still in working order and
are on display in places such as the University of Leeds Business School,
London School of Economics, and Istanbul University.
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The fascinating concept of the Phillips Machine, which your portfolio manager learned decades ago, has
resulted in a never
-
ending career quest to create more visual representations of our thought processes
when it comes to the equity markets. The best exam
ple we can think of when it comes to visualizing
markets is that of rivers, which are incredibly important to wider ecosystems and whose stocks and flows
have natural and manmade exogenous factors that can create substantial changes in the river’s
environm
ent. While, of course, the creation of manmade dams over the last century is the obvious parallel
with direct consequences for global river systems, one of our favorite examples of the river’s
environmental complexities is how the introduction of wolves in
to Yellowstone Park in 1995, after a 70
-
year absence, substantially and unintentionally changed the park’s river system through a trophic
cascade
—
an ecological process that starts at the top of the food chain and tumbles to the bottom. The
reintroduction o
f wolves to the ecosystem changed the grazing behavior of its top prey, the elk, which
began to avoid certain geographical areas where they could be trapped more easily, particularly the
valleys and the gorges. This, in turn, spurred incredible growth in v
egetation and regrowth of forests,
which reintroduced more species such as beavers and otters, all of which contributed to substantial
geographical changes in rivers. The rivers meandered less, there was less soil erosion, channels narrowed,
more pools for
med, regenerating forests stabilized the banks, and the physical geography changed
substantially.
The savvy reader of our letters can probably see where we are going with this. If the rivers are the market,
then the Federal Reserve and the regulatory agencies are the dam
-
building and wolf population
-
controlling agencies that can, and do, create substan
tial changes in the market rivers and their
ecosystems. With the Federal Reserve being the “unnatural” dam maker in controlling the flows of the
market rivers, the stopping of its flows and the subsequent re
-
flooding of the economic river as a result
of th
e Covid
-
19 pandemic with monetary stimulus has substantially changed its downstream flows. As it
directly relates to our visualization of the small and micro
-
cap segments of the market, it seems that the
same forces that unleashed the wave that propelled l
arge capitalization and tech companies to ride the
powerful liquidity stream ended up creating stagnant pools of water on the banks of the rivers,
increasingly untouched by the subsequent regular monetary flows into the system. Looking back even
further, i
n the wake of the Great Financial Crisis, Wall Street, fearing a drought, introduced a heretofore
rarely seen Silicon Valley “species” to its public equities ecosystem, seemingly uncontrolled by the
regulatory agencies, which also substantially changed the
“river banks”, though, in your portfolio
manager’s humble opinion, not necessarily in the positive way that the introduction of wolves changed
Yellowstone.
This is the environment that we’ve mentally been wrestling with for the last few years. The foundation of
this partnership has always been grounded in the belief that we’re all floating on the same river, and a
variation on “a rising tide lifts all boats”
—
a Fed dam release lifts all boats
—
would carry our “microcap
boats” alongside their larger
-
cap brethren. In that sense, trying to pick the best boats is a more useful
exercise than timing the flows and the turns of the river itself. The proverbial market ri
ver was always
seen as just a place for our boats to get in, out, and to travel on. However, with the introduction of the
“Silicon Valley” species into the market river ecosystem and the “park rangers” seemingly asleep at the
gate, the focus of the margina
l market participant increasingly turned from finding the best boat to
navigate the rapids to catching the next momentum wave on flimsier and flimsier rafts, with dangerous
captains, that ordinarily would quickly sink but due to the increasingly passive an
d focused flows that
bypassed the aforementioned pools, look like Donzi speedboats.
Which brings us all the way back to our partnership holdings and our portfolio review and outlook. 2023
started out as a year where “our boats” seem to be lifted out of their swamp
-
like stagnant pools only to
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stay seemingly in place, up only 1.6%, while the sinking flimsy rafts of tech companies were rescued by
another burst of tech momentum waves. While we’ve certainly had substantial fundamentals growth and
some stock price appreciation, such as a doubling in
Potbelly stock, as a concentrated portfolio, even one
mistake can cost you a whole year, and our “adventure” in the Polished.com warrants cost us almost 400
basis points of performance this year. We’ll discuss our frustrations with this investment in more
detail
below, and while the losses here certainly stung a bit, our “activist” efforts this year in Acorn Energy
(ACFN), Research Solutions (RSSS), and Currency Exchange International (CURN), which together
represent close to 60
.0
% of our portfolio holdings, are beginning to bear some real fruits which we hope
to harvest in the near future.
We’ve written to you in the past years about what we considered naivete by the Federal Reserve in
assuming that the substantial bouts of inflation in 2021 and 2022 are “transitory” and that inflation is an
animal, that once is out of its cage, is incredibl
y hard to put back in and unfortunately our predictions are
showing themselves to be correct. While the 500 basis point increase in rates in the last 2 years has
certainly lowered inflation from high single digits to close to 3
.0
% with a pleasant bonus of continuing
strong economic growth, the “last mile” effort of getting inflation down to the 2
.0
% target without denting
the economy will be uncomfortable for those hoping for lower rates in the near future, a prospect we see
as unlikely until at least mid to late 2025. As such, the prospect of a stable economic and interest rate
environment is likel
y to remain elusive for at least another year, and the boats may continue to swirl in
stagnant waters.
These are frustrating times. As you will see in our statistics and portfolio discussions below, 2023 was a
solid year for the fundamentals of our companies on a consolidated basis. Our portfolio remains
statistically cheap on many metrics. Yet a lot of our
boats seem to be moored. We see a number of paths.
One is to stay the course. Eventually the excess liquidity will dry out via an extended period of elevated
rates and the rivers will return to regular flows. The question we continue to ask ourselves, as
do most of
our peers: are these rivers fundamentally altered and there’s no going back? Path two is to recognize that
the answer to the question is yes and to alter the strategy from boat picking to focusing more on river
flows and only on crafts that navi
gate these flows. We’ll refer to this path as “chasing waterfalls”. Finally,
there’s a third path. If the river won’t come to you, you focus on fewer boats and get them to the river
yourself. This is not unlike what we’ve been trying to accomplish with CUR
N, ACFN, and RSSS. These are
great boats that needed a few extra pushes to get them unmoored. So far we’ve taken the combination
of paths one and three. We are staying the course hoping the rivers aren’t forever altered, where our
performance in Potbelly l
ast year gives us said hope that things haven’t changed permanently, while on
the margin, trying different approaches of getting some of our boats to them. In 2023 we dropped some
dead weight and added a new investment in Maui Land and Pineapple Company (M
LP). We are in the
process of patiently investing in a very illiquid but substantially profitable net net, i.e. a company whose
market capitalization is less than the net cash on its balance sheet. By mid
-
2025, our partnership would
be ten years old, and w
e believe this would be a great time to assess whether paths two or three are the
more prudent course. In the meantime, as our quote above from TLC implies, we won’t be chasing
waterfalls and will be sticking to the rivers and the lakes that we’re used to.
To share some portfolio statistics
for
7
companies
which
represent approximately 9
8
% of our portfolio
:
•
Our median
/average
market cap is
$1
82
mm/
$2
21
mm.
These numbers compare to
$21
9
mm/$
864
mm for the Russell Microcap Index, our closest comparable index, and represent
our continued commitment to offer you an investment product in securities that for the most
part are unable to be in
cluded in an index due to their size or liquidity constraints.
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•
Our median
/average
portfolio’s net cash balance is
2
.0
%
/1
3
.0
%
of the market cap
representing
our commitment to strong balance sheets.
•
Our median/average insider holding
is 2
6
.
0
%/26.5% at over $
3
0mm of what we call insider
-
value
-
at
-
risk, which we believe is an important metric where we feel we are co
-
invested
alongside
our
management teams and have shared incentives and risk tolerances.
•
Our median growth expectations for our
companies’
EBITDA/Cash flows for the next
5
years are
at
40
.0
%/
40
.0
% and our median valuations for
next
twelve months
EV/EBITDA and Price to Cash
Flows are at
6
.
0
x/
8
.5x for 202
4.
P
ortfolio Review
•
Currency Exchange International
(
CURN
)
–
19
.0
% of
Portfolio; $8.0
8
cost basis/$1
8
.
00
current price
CURN was a good performer for us in 2023, up almost 11
.0
%, though down about 12
.0
% from its winter
2023 highs. Operationally, the year was a mixed but mostly positive bag. The company continued to grow
its revenues, up 21
.0
%, on the back of strong 23
.0
% Banknote segment revenue growth, as the company
continued to substantially expand its physical footprint, seen in the table below. Additionally, the
strategically important Banknote Wholesale subsegment grew 31
.0
% in the United States, representing
over 35
.0
% of overall revenues, reaching almost $30mm.
The Payments segment revenue grew a slightly disappointing 15
.0
%, but the bigger thing to note on the
year was the 30
.0
% growth in operating expenses, leading to a flat $19mm Earnings Before Interest and
Taxes (EBIT) year. Segmenting out the $14mm+ operating expense growth, the increases accounting for
most of the growth came from salaries, shipping, and supposedly one
-
tim
e losses and shortages of almost
$3mm. The latter expense is a small red flag. However, for 2024 and beyond, shipping costs have been
mitigated with pricing increases, and salaries are an investment in future growth from which we expect
substantial operati
ng leverage on future revenue increases. It is almost impossible to expect linear growth
in profitability in small
-
cap companies. The Value Line earnings quality scores of 90+ are reserved for
predictable large
-
cap companies like Johnson & Johnson. As such
, we are confident that with 2023
expense investments in salaries; a new Enterprise Resource Planning (ERP) software; as well as continued
growth in revenues, the company should reach $95
-
100mm in revenues and $25mm
-
$30mm in EBIT in
the next 12
-
18 months.
These results should be bolstered by the continued tailwinds in American tourism
that is expected to keep growing in low single digits, as seen in the chart on the next page; continued
market share gains in retail and wholesale; as well as the company begi
nning to increase pricing given its
market share and current, what we believe, product underpricing.
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Which brings us to our efforts in helping to bring this $115mm market capitalization company, with
$82mm in total net cash (of which approximately $50mm is working capital cash needed for operations),
that generates over $20mm in high
-
growth EBIT, to bette
r allocate its capital. As you’ve seen in our memo
to the company, which we shared with you during 2023, we believed that continuing to build up cash on
the balance sheet while the company is trading at 1.5X EBIT and generating high teens returns on capita
l
was highly inefficient. After a lengthy back and forth exchange with management, in November 2023, the
company announced a stock buyback of 5
.0
% of its shares. While the size of the buyback is tempered by
Canadian stock exchange rules, we believe this action to be a great first step. While, of course, spending
$6
-
7mm a year at current stock prices to reduce the share count by 5
.0
% a year is a big step in the right
direction on its own, we believe the optics of a management team that is both beginning to understand
the importance of capital allocation and listening to its shareholders are the more important signals to
the market. W
hile we have no illusions about current small
-
cap valuations, in this particular case, bringing
“our CURN boat to the river,” where we believe that these capital allocation steps alongside continued
growth in revenues and returns on capital, should begin t
o make the market appreciate the tremendous
value of this company and, at what we consider a low, 8x EBIT, target multiple and $30mm+ in excess
cash, should result in a near term $40 price target, or over 100
.0
% from today’s price.
•
Research Solutions (RSSS)
–
2
4.0
% of Portfolio; $1.80 cost basis/$
3
.
20
current price
Our investment in Research Solutions, originally at sub $1.00 in 2017, though with substantial additions
over the years our cost basis has drifted higher, was down 22
.0
% in 2022, up 41
.0
% in 2023 and up over
25
.0
% so far this year. This was an interesting and a bit tumultuous year for the company and the stock
but the end outcome, fundamental growth and the future outlook all look excellent from this point. The
provider of information services for the scientific i
ndustry, not unlike Bloomberg is for finance and Lexus
Nexus is for law, grew its 2023 revenues 15
.0
%, up from 8
.0
% last year, and what we believe to be the
more important metric, its gross profit, over 21
.0
%.
As a reminder, Research Solutions has a legacy Transactions business, the sale of scientific articles to over
1,360 customers, up 13
.0
% from last year, including 70
.0
% of the top 25 pharma companies. Up until
2022, this business has been a steady $26mm to $27mm revenue run rate segment for as long as we’ve
been shareholders, and with its 23%
-
24% gross margins has been a consistent generator of $6.0 to
$6.5mm in gross p
rofit. However, with a minor acquisition of a European customer list in 2022, as well as
expansion of transaction demand creating Platforms segment, the 2023 segment revenues were over
$30mm with close to $7.7mm in Gross Profit, 13
.0
% and 19
.0
% 2023 growth, respectively. With the client
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list acquisition anniversary in 2024, we expect the revenue growth to temper to low
-
single digits again, as
the Platforms segment begins to cannibalize demand instead of helping it, and for gross profit to stay
slightly over $8mm. This is still a substanti
al and unexpected “surprise” from just a few years ago when
the segment had multiple negative revenue growth quarters. While all of the focus continues to be on the
Platforms segment discussed below, this steady cash cow segment has shown itself to be a va
luable part
of the company. We believe the segment’s value is approximately $1.00 per share as we begin to think
about eventual exit multiples for the company in an event of a transaction.
Platforms, a SaaS solution to the scientific research community, which has an average price point of
$12,330, again grew its revenues at 32.0% to $10.3mm and Annual Recurring Revenues (ARR) to $15.7mm
(or 77
.0
% growth) as the company absorbs two significant acquisitions in 2023. In a flip of the margin
contribution picture, Platforms’ gross margins are 86
.0
%, and its gross profit, at $8.8mm, is bigger than
the Transactions segment’s 25
.0
% margin gross profit and now represents 54
.0
% of Total Gross Profit of
over $16.4mm. This was due to 19% growth in subscriptions to 942 and a 13% increase in the average
sales price. The company has had a busy year in 2023, acquiring two Artificial Intelligence (AI) companies,
scite and Resolute. Th
ese are two very exciting acquisitions that as stand
-
alone companies were
interesting but combined in a Platforms segment with the flagship product, Article Galaxy, will create a
comprehensive AI based product suite that expands the value chain offerings t
o the
research
community
and the company’s Total Addressable Market (TAM) many times over. Additionally, while the scite
acquisition’s financial metrics are impressive and are already outperforming, what is more notable about
this acquisition is that this creates a here
to
-
hard
-
to
-
penetrate backdoor to most publisher databases,
creating a substantial moat
for the combined scite/Resolute/Article Galaxy product suite.
This was what we consider a substantial and transformative year for the company, but it wasn’t without
some tumult. Over two years ago, the company founder Peter Derycz, someone we respected and
admired since our original investment in 2017, stepped down a
nd took over the Chairman position while
allowing new CEO, Roy Oliver, to take over the operational reins. Roy had put out substantial goals for the
company, including almost tripling the Platforms ARR to $20mm by late 2024. This goal included an
acquisiti
on piece as well. The 2021 and 2022 years could be considered somewhat below plan as the
company expanded its expense base to support the upcoming growth, while at the same time facing a
slowing research customer market and overpriced acquisition targets.
In the summer of 2023, a frustrated
Peter Derycz, as Chairman, launched a surprising, and frankly incredibly unprofessional, proxy fight, with
Roy and the rest of the board, as he was continuously being sidelined at board meetings and was
frustrated with t
he expense base growing ahead of revenues. This was amateur to say the least and more
annoyingly, distracting from the closing of the scite and Resolute acquisitions, which Peter knew about.
The shareholder base response was angry and swift. This is where,
while not on the board, our
representation of close to 5
.0
% of outstanding shares helped behind the scenes. Peter was removed from
the board,
his
value destroying
brother
-
in
-
law forced to sell down
hi
s
investment stake
to below 5% to
prevent
him
from being
a
further negative detractor
from the stock and the story, and the board added
one new independent member. With the majority of substantial shareholders and management team in
agreement over the near
-
term future plans for the company there was no need to fight for an additional
board
position and we were happy with the outcome that was achieved with some behind the scenes
communication.
So what does the future look like in the near term? It appears that Roy will be able to achieve, or come
very close, to getting to the $20mm ARR number by 9/30/2024, the three
-
year anniversary of the goal.
Additionally, the company put out more ambitious g
oals of growing Platforms organically at a 30%+ rate
to a $30mm ARR target by late 2026. It’s a high hurdle, but with the cross
-
selling opportunities and other
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strategic synergies of the two acquisitions, we believe to be very achievable. However, we do not expect
the company to remain public for long. With the $20mm/3
-
year Platforms ARR goal “in scite” (sorry,
sometimes we can’t help but make a bad pun) we antic
ipate the company to begin a sales process in the
2nd half of 2024 and the 2026/$30mm ARR number was more of a helpful guidepost, for likely acquirers,
of the company’s potential than actual guidance. We believe with the company sporting close to 1,000
sub
scribers paying over $12,000 a year on average; as well as its access to publisher’s databases
,
as well
as significant AI capabilities, its strategic and financial acquisition value and multiples should be on par
with other information service providers such as FactSet, Verisk, and CoStar group at over 10x forward
revenue multiples and 20
-
30x EBITDA
multiples. While a sale may not happen in 2024, we anticipate one
in the next 12
-
18 months at $7.00 to $10.00 price targets or over 200
.0
% from today’s stock price.
•
Acorn Energy (ACFN)
–
12
.0
% of Portfolio; $
4
.
80
cost basis/$
6
.
00
current price
Acorn’s price performance, down 45% in 2022 and up 13% in 2023, has been frustrating, but not out of
the realm of normality of the nanocap world, given the company’s average daily volume is less than
$9,000. It is closer to a private equity investment than
a public one. 2023 was a decent year fundamentally
for the $15mm market capitalization company, whose main business is providing monitoring services for
backup electrical generators in the United States. This is a nice, very high
-
margin, recurring revenue
business with a typically low churn $4.5mm monitoring revenue base at close to 90% gross margins. The
other half of the $8mm+ cash revenues is the sale of hardware, where any revenues above a few hundred
thousand result in an increase in the valuable moni
toring revenue base.
2023 was a year in which the company continued to shoulder some losses of customers as the 2022
-
2023
period saw the sunsetting of 3G technology, which resulted in a one
-
time loss of usually very high
recurring revenue customers who chose not to go through
the hassle of installing and paying for new
technology. The company’s natural organic revenue growth rate is 20%, but it is not linear. In 2022, the
company’s revenues grew 3%, and 11% in 2023, continuing to absorb the technological sunsetting.
However, th
e company managed to grow its gross profit by 15%
for the first nine months of
2023, and by
the 3rd quarter of 2023, the revenues and gross profits grew back to the expected run rate at 22% and
28%, respectively. More importantly, the end of 2023 saw some significant developments that are setting
up for a strong 2024 and beyond.
While it has taken a little longer than anticipated due to operational hurdles, 2024 should begin to see
revenues from the company’s Demand Response program, where the generator monitoring customers
will be part of the electric grid, providing backup power
not only to their homes but to the grid in case of
overload. The customers, brokers, and technology providers, in this case, OmniMetrix, will all participate
in the revenue share from the utilities for providing this service, which should significantly bo
ost the
Average Revenue Per User (ARPU) for Omni’s monitoring service subscribers. We don’t anticipate more
than a few hundred thousand dollars or a few hundred basis points of revenue growth off this project in
2024, but we believe by the second half of 2
024, we will begin to see substantial revenue pick up as the
company begins to leverage its 2023 operational and technological investments in the program. Just as
significantly, in the fall of 2023, the company announced a reseller agreement with one of th
e country’s
largest commercial generator dealers that could result in as much as an additional $2mm in 2024
revenues, and more importantly, substantially contribute to the 90% gross margin monitoring revenue
base. We believe that in 2024, the OmniMetrix su
bsidiary can grow its revenues at more than 25%, above
a symbolically important $10mm number, achieve close to 30% operating margins, and generate
substantial cash flow at the Acorn Energy holding company level.
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The fundamental story is great, but Acorn remains an example of a company that has not caught the
powerful Federal Reserve liquidity release streams and continues to tread water in the microcap swamp
pools. To that end, in 2023 your portfolio manager joine
d the board of directors of this company to help
with unlocking the substantial value, including over $70mm in Net Operating Losses (NOLs), for the
shareholders. There are two paths that can happen with this company: one is the continued strong growth
and
profitability and uplisting to Nasdaq, i.e., bringing the proverbial boat to the river, which should result
in a stock price many multiples higher than today’s price implying only a $15mm market capitalization.
Accordingly, the company has taken its first
steps toward the uplisting by doing a reverse 1
-
16 split, getting
its stock price above $5.00. This move should create slightly more liquidity and attract investors that have
in the past not been able to participate due to the company’s former penny stock
status. There are other
opportunities to enhance this path that are in process. Of course, the second option is an outright sale of
the company, with the valuation closer to mid
-
single
-
digit revenue multiples for similar Internet
-
of
-
Things
companies, and w
here the company’s valuable NOLs are taken into account. 2024 should have some
updates on which one of these paths is the most likely to maximize shareholder value.
As a final note, please be aware that our discussions here are from publicly available information as of
9/30/2023, and there are things we are not able to update you on due to our responsibilities as a member
of the board of a public company.
Together, these three companies represent close to 60% of the portfolio today, which also reflects our
confidence as well as time commitments where we are working on helping to unlock significant value.
•
Potbelly (PBPB)
–
1
7
.0
% of Portfolio; $
3
.
70
cost basis/$
1
4
.
00
current price
After remaining flat in 2022, Potbelly was our big winner in 2023, up almost 100%, and another 30% so
far this year. As a reminder, our investment in PBPB was originally a post
-
Covid recovery special situation
with a substantial opportunity to change its b
usiness model from managing 400 specialty sandwich shop
locations to managing 2000+ franchises as the company hired former Wendy’s COO, Robert Wright, to
execute on the strategy.
Our thesis continues to play out and then some. For 2023, the company’s same
-
store sales are expected
to come in at 12.0%, while below last year’s 18.0%, strongly above average in the Quick Service Restaurant
(QSR) industry in 2023. Additionally, shop
-
leve
l margins are expected to be 14.0%, almost a full 4.0%
improvement from 2022. While the average unit volumes (AUVs) are in the industry’s upper echelons at
$1.3mm/year, we believe shop
-
level margins have a bit to go, to higher teens, from here. The overall
2023
revenues should come in above $490mm or 9
.0
% higher than year
-
end 2022 while EBITDA should be close
to $30mm, though still only 6
.0
% margins, with a lot more room for expansion, especially as franchised
locations continue to be a bigger part of the mix.
The company currently has 430 locations, which is flat unit growth for 2023; however, that mix now
includes 69 franchises, or 16.0% of the mix, up from 45/10.0%, from last officially reported 9 months ago.
This resulted in year
-
on
-
year growth for the first
9 months of 92
.0
% in Franchise Royalty fees, whose
marginal contribution to future profitability and cash flow generation is expected to be substantial. The
near
-
term goal remains for the current base to be at a 25
.0
% franchised mix, meaning there are
approximately 40 currently owned locations which can be sold to franchisees at what we believe can be
$500k to $1.5mm per location resulting $20mm to $60mm in cash inflow to this $400mm market cap
company. Additionally,
the company has a goal to grow to 2,000 shops, growing franchised locations at
about 10
.0
% per year. To that end, the company has signed Shop Development Area Agreements for 150
future locations (which may take up to 7 years to open) in 2022 and 2023, which is a fantastic 100
-
unit
pipeline growth from last year. We believe this pillar of the c
ompany’s strategy to be the most important
9
|
P a g e
one, and the key to our thesis as we still believe it may add $5.00 to $40.00 more per share to the value
of the company in addition to its ongoing business valuation. So far, this investment is approaching a
300
.0
% return for us, and we’ve taken a little bit off the table, though still holding close to 80
.0
% of our
original shares, as we think there should be at least one more doubling from here in the intermediate
term as the company still has substantial aforementioned value creating levers to pull.
•
HireQuest (HQI)
–
11
.0
% of Portfolio; $5.50 cost basis/$
1
3
.
40
current price
HireQuest, the company, had a bit of a mixed bag fundamental year with mostly positive results.
HireQuest, the stock, had a flat 2023. However, with an up/down 80
.0
% round trip, it remains substantially
above our original purchase prices. A combination of cyclical labor market fears and challenges in
absorbing a large acquisition resulted in a disappointing year for this investment.
The company, which had a great 2022 with revenues up 67
.0
% for the nine months ended on September
30th, 2022, grew its 2023 first nine
-
month revenues by 23
.0
%. More importantly, its Franchise Royalties,
which account for most of the profit, increased almost 27
.0
% for those nine months, though that number
is mostly due to the MRI acquisition, with labor market softness offsetting the impressive growth. With
the MRI acquisition came a 54
.0
% increase in SG&A expense, a number that does not include volatile
workman’s compensation expense that in the 3rd quarter of 2023 came in at almost $3mm or almost
30
.0
% of revenues. Overall, 2023 was a kitchen sink year where a combination of a slowing labor market,
surprising workman’s compensation expenses, and a slower
-
than
-
expected culling of expenses from the
MRI acquisition made for some jittery stock performance.
As a reminder, HireQuest, now a $180mm market cap company, is a consolidator in the staffing industry,
acquiring $32mm worth of businesses in 2021 and 2022, with over $20mm in 2023. Led by its impressive
CEO Rick Hermans, the company buys owned locations,
sells them via franchise agreements to the branch
managers, and collects an approximately 6
.0
% franchise fee off the subsequent revenues. This model has
been incredibly successful due to providing the right entrepreneurial incentives to salaried branch
managers who get to have an opportunity to earn six
-
figure entrepreneurial incomes. While there
are,
what we believe to be unfounded, fears of an economic slowdown, which have been given more room in
the market participants’ minds than we believe necessary, the unemployment rate is still only 3.7%, up
only slightly from 3.4% last year, despite a 5.0%
+ increase in interest rates. The company increased its
system
-
wide sales run rate from $500mm last year to close to $650mm in late 2023, with the acquisition
of TEC Staffing Services in late December, implying a $40mm+ franchise royalty fee revenue run ra
te.
While the aforementioned expense issues were not great from a one
-
year snapshot perspective, overall
we believe the company will come out of 2023 with an efficient, sub
-
$20mm expense base, which Rick
should be able to continue to leverage in stacking m
ore on top of a “high franchise royalty fees/low
marginal expenses” business model.
As we usually mention in our letters, while we are contrarians on the path of inflation and interest rates,
we have also been contrarians on the path of economic growth in the United States and believe that the
resilience of the domestic economy can contin
ue to produce low unemployment rates, relative to
historical averages, for at least a few more years. As such, we expect continued strong organic growth and
acquisition opportunities to grow the company’s EBITDA to over $30mm toward the end of 2024, where
an 8x to 10x multiple, which we believe is appropriate given the lucrative franchise economics of this
business model, should result in a near
-
term price target of $35.00, once cyclical and expense fears
10
|
P a g e
dissipate. Of course, we intend to continue holding this investment through the cycle, other than risk
management adjustments, until Rick Hermans eventually sells the company.
•
Shyft Group
(
SHYF
)
–
10
.0
% of Portfolio; $
9
.50 cost basis/$
11
.00 current price
Much like our investment in HireQuest, 2023 was the year our long
-
term holding, Shyft Group, faced
cyclical headwind fears and realities, declining over 50
.0
% in 2023 on top of a 50
.0
% drawdown in 2022.
What a continuous gut punch from a company whose business model we've admired since our initial
investment in 2017. During this time, the company, formerly known as Spartan Motors, divested its
money
-
losing Emergency Response segment an
d strengthened its Fleet Vehicle and Services (FVS)
segment with tuck
-
in acquisitions, narrowing its focus on supplying the growing e
-
commerce
-
led parcel
delivery business with its capital
-
light commercial truck and specialty vehicle assembly model. In 202
1,
the company, anticipating the shift to electric vehicles, launched BlueArc, an impressive commercial
-
class
electric walk
-
in van and beyond.
However, since 2022, several headwinds have materialized. While the secular tailwinds of e
-
commerce
taking share from retail continue, there is a cyclical slowdown in parcel delivery. Additionally, parcel
delivery companies like UPS and FedEx recently fina
lized expensive labor agreements and scaled back
some CapEx expenditures, such as fleet upgrades. Simultaneously, the company's production schedule for
BlueArc faced a major setback as its battery supplier declared bankruptcy, later acquired by Volvo,
post
poning BlueArc's revenue generation to 2025. Meanwhile, product development costs continue to
impact the income statement as R&D expenses, totaling $30mm annually.
The company, with revenues of $991mm and $1,027mm in the 2021/2022 periods, and a 2021 peak of
$95mm in EBITDA, experienced a 15
.0
% revenue decline in 2023 to $872mm, with flat revenue growth
expected in 2024. As mentioned earlier, the ~$30mm of product development costs recognized as
Research & Development expenses are distorting the historical and industry comparable profitability.
While we anticipate a small portion of the R&D expense becoming an ongoing recurring expense, we don't
believe that number exceeds single
-
digit millions on an ongoing basis. Consequently, the reported EBITDA
numbers of $62mm and $23mm for 2022 and 2023, a
s well as the guided $50mm for 2024, are actually
$95mm, $56mm, and $75mm, respectively. This is significant because, in some industries more than
others, the EBITDA number is considered a loose substitute for Free Cash Flow and is the currency of
valuatio
ns and transactions. With Shyft having a recurring $20mm maintenance annual CapEx spend, a
low 2% of revenues number, we believe that a
n
R&D expense
-
depressed EBITDA is one reason the market
is unduly punishing Shyft, showing that its profitability margins are mid
-
single digits versus the "real" high
single
-
digit ones.
A better, more economically reality
-
based way to examine the last two years and the next year is that the
$330mm market cap company will have generated $225mm in profitability. It has and will spend $60mm
in maintenance CapEx, $90mm in growth investments v
ia product development costs, and so far, $60mm
in returning capital to shareholders via $46mm in buybacks and $14mm in dividends. We expect a similar
$25
-
30mm return of capital to shareholders in 2024. By 2025, it should be back to above $1b in revenues,
a $90mm+ run rate EBITDA, and $70mm Free Cash Flow, with substantial and sustainable BlueArc and e
-
commerce tailwind
-
led revenue growth. This is fairly impressive, and taking out fear and cyclicality
-
based
emotions, the 80
.0
% price drop since 2021 seems aggressively illogical.
Our investments in Shyft and HireQuest, two economically cyclical companies in our portfolio, raise
philosophical investment strategy questions. Should a buy
-
and
-
hold strategy invest in cyclical companies
where, regardless of the quality of the business mo
del, management, and balance sheet, stock prices will
11
|
P a g e
follow sentiment, and 15
.0
% cyclical revenue declines, despite substantial secular tailwinds, will result in
near
-
term 80
.0
% price declines? Going back to our river analogy, does the quality of the boat matter if
the stream it is floating on is going backward? Is patience a virtue or a liability? We have to believe that
the core of our investment strategy is investing and hold
ing through cycles, even the most painful
bottoms, to get long
-
term outsized returns, and that from a historic perspective, playing the timing
-
the
-
market game is a losing one. We've seen Shyft go from $12.0
0
to $6.00 to $54.00 to $10.00, where we've
trimmed and added on the margin along the way. We added to our position at $12.00 and $11.00 in late
2023 to make it a full 10
.0
% position again as we believe that these are temporary headwinds, cycles
restart, and the company is in a good position to come out on top to ride the e
-
commerce and electric
vehicle transition tailwinds stronger and more profitably. We are mindful of a n
ew but reputable CEO and
will be watching closely. We don't have confident near
-
term return expectations as we do with our other
Core Portfolio holdings such as CURN or RSSS, but we continue to believe that, in the long term, Shyft
Group is a shiny diamond
that has multiples of upside from here, to above its previous highs.
•
Polished.com 6/2
6
$
2
.
25
Warrants
(
POL
-
WS
)
–
0
.
1
% of Portfolio; $
0.
29
cost basis/$
0
.
01
current price
As discussed in the 3rd quarter letter, our investment in Polished.com warrants has not been a great
adventure. It has cost us a little less than 400 basis points of performance
in 2023
, in addition to similar
losses
the
previo
us
year. From an update perspective, there isn’t much to report as the company's public
market value of approximately $5mm continues to be an option on its ability to refinance its
approximately $90mm in debt. If it can do that, it will still have going conc
ern value and two years left on
the warrants to bring revenues and profitability back to a level where the company's potential in a good
economy could result in substantial value. As it stands, while still possible, it does not look probable, given
reporte
d tensions between Polished.com and its Bank of America lenders. We suspect that this
investment's value lies in recognizing long
-
term taxable losses to offset eventual long
-
term gains in the
rest of our portfolio.
We've had mixed success with our adventures in warrant investments over the last nine years. We've had
decent returns on our Hostess, Del Taco, and US Ecology (NRC Group) warrants in the past. However,
we've also experienced 90%+ losses in Rosewood and, in
the most comparable situation, Kodak warrants,
where not only did an expected transaction fail to materialize, but the company's ability to remain a going
concern was also questioned by the market. Our lesson learned here is that we need to be better at
c
alibrating sizing despite our confidence in successful probabilities in these investments.
C
ore
Portfolio Sales
•
G
aia (GAIA)
–
4
.0
% of Portfolio; $6.50 cost basis/$
2
.
5
0
sale
price
As discussed in our 2Q23 Partner Letter, we sold the remainder of our original 8
-
year
-
old position in Gaia.
While we still made substantial returns in our initial investment, with multiple position reduction sales
above $10.00, in recent years, the positio
n has been a significant detractor from performance. The
expected fundamentals did not materialize, and key management departures led us to deploy the capital
into other positions.
12
|
P a g e
•
N
orthern Technologies
(
NTIC
)
–
6
.0
% of Portfolio; $8.80 cost basis/$1
1
.00
sale
price
We sold our position in Northern Technologies in the 4th quarter at an average price above $11.00, after
almost three years and a 30
.0
% total return, including dividends. Despite being fans of NTIC, its story, and
its management team, we decided to explore opportunities in the market to deploy microcap
-
focused
capital on companies with multiples of upside, such as our newest addition dis
cussed below, Maui Land
& Pineapple Company. We will continue to monitor NTIC closely and, if the cyclical and microcap doldrums
persist, we may get an opportunity to get back in at below $9.00 again.
Core
Portfolio
Additions
•
Maui
Land & Pineapple Company
(
MLP
)
–
7
.0
% of Portfolio; $
14
.80 cost basis/$
20
.0
0
current
price
We added an initial 6
.0
% position at below $15.00 a share in the 4th quarter of 2023 as a replacement for
our
sales
of Northern Technologies and Gaia investments. This investment has seen a 35
.0
% return, mostly
in 2024. MLP is a Master Planned Community developer (MPC) that owns tens of thousands of some of
the most spectacular acres on the Hawaiian island of Maui, majority
-
owned by former AOL CEO Steve
Case. MLP is in the process of moving from
a business stabilization phase to a land development phase.
We believe that even a modest development of this incredibly valuable land could result in an
intermediate
-
term Net Asset Value (NAV) of $60.00 to $80.00 per share, and possibly multiples of those
targets in the long term.
For many years, since Steve Case purchased a controlling stake in the almost 200
-
year
-
old company in
1999, the company had been undergoing a restructuring phase. The company closed down the cash
-
draining pineapple operations, funded the pension plan liabil
ities, stabilized cash flow to break even, and
began to hire a new management team. We believe that the company is on the verge of beginning to
monetize its incredibly valuable land holdings in conjunction with the Maui government. Over the last
year or so
, the company changed its registration to Delaware; completely revamped its board of directors
with substantial real estate heavy hitters, including professionals with associations to MPC gold standard
13
|
P a g e
bearers of Howard Hughes Corp and St Joe, as well as with Hawaiian professional luminaries; added a new
CEO, who in the last few weeks had been awarded over 2% of shares outstanding in 10
-
year stock options.
We love incentive structures where the CEO has t
he opportunity to make tens of millions of dollars. It
even changed its 25
-
year
-
old website, which up until a few weeks ago looked like Steve Case designed it
himself as an AOL landing page. In short, all signs are pointing that the company is on the verge
of a
substantial positive directional change. Other positives, much like our investment in RSSS, MLP has an
existing leasing business whose Net Operating Income (NOI) covers the company administrative expenses,
while it begins to develop its real valuable
jewels.
With respect to a price target, we used conservative estimates, high discount rates, and assumed the vast
majority of the acreage and infrastructure, such as water, will be given to the government in partnership
arrangements. We’ve followed Howard Hughes a
nd St Joe companies for more than a decade and are
familiar with the MPC business model. There are a lot of factors that go into becoming a St Joe but at the
end of the day its all about location, location, location and MLP has some of the best acreage in
the United
States. If they do this right, MLP can be a multi
-
billion
-
dollar company, and we will carefully monitor the
management plans. We anticipate this investment eventually becoming a full, 10
.0
%
, Core Portfolio
position, and we are happy with the recent stock run up, and will be monitoring the developments as to
when to add more.
As a final note, we are also in the process of adding another position that we would rather not disclose
until we’ve finished buying, which may take up to a year. It’s a very illiquid net net, with a $23mm market
cap, and $24mm in cash, generating a depres
sed profitability $4
-
5mm a year. However, it barely trades,
as is the case with some of our positions, so we are being patient. We look forward to updating you once
we’ve finished buying our initial position.
S
ubsequent Events
With Potbelly
, Research Solutions and Maui Land & Pineapple Company all being
up
2
5
% to
3
5
% in the
first
two months of the year
our portfolio is up approximately
10%
year to date.
P
artnership Updates
After almost nine years since launching the partnership, we are switching some of our service providers.
While we are patiently waiting for our investment strategies to play out, we thought this would be a good
time for a refresh and upgrade of our operati
ons support. We are excited to welcome Richey May as our
new auditors and are thankful to Berkower for all the years of their audit services. We are also in the
process of migrating our fund administration services from HC Global to Formidium. For all stat
ements
and tax preparation services relating to 2023, HC Global will be the point administrator for all LPs.
Formidium has taken over fund administration services for 2024 and all future statements and operations
related investor relations will be serviced
by them.
We are not having an in
-
person partnership event in 202
4
and anticipate we will end up having a virtual
portfolio update presentation in summer 2024. Please be on the lookout for an invitation in your email
inboxes sometime in the next few months. Despite the current small
-
cap market challenges, we are
excited
about the growth in assets under management and, as always, are thankful for your business.
Next Fund Opening
Our next partnership openings will be
April 1
, 202
4
. Please reach out for updated offering documents and
presentations at
info@artkocapital.com
or 415.531.2699.
14
|
P a g e
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 future. 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 Partne
r 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 th
e General Partner’s special profit allocation, if
applicable. The General Partner believes that the comparison of Partnership performance to any single
market index is inappropriate. The Partnership’s portfolio may contain options and other derivative
secu
rities, 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 gene
rally 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 Microc
ap
Index is comprised of the smallest 1,000 securities in the Russell 2000 Index plus the next 1,000 securities
(traded on national exchanges). The Russell Microcap is generally representative of the microcap segment
of the U.S. stock market. All of the in
dices are unmanaged, market weighted and reflect the reinvestment
of dividends. Due to the differences among 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 General 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 investors 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 Circ
ular of the Partnership. This information 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 consider
ing whether
to invest in the Partnership.
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