Tippapatt

Tourlite Fund, LP Founder Class returned 3.4% for the Fourth Quarter of 2022. The fund has returned 5.0% since inception in April 2022, compared to a -14.2% decline for the S&P 500.1,2 Below, we show greater detail on performance contribution.

Our fundamental long/short equity portfolio performed extremely well in 2022. Our long portfolio declined -12.7%, outperforming a decline of -14.2% for the S&P 500 and -14.0% for the Russell 2000. Our short portfolio returned 32.2%. This represents a significant outperformance of 18% above the inverse S&P 500 and 18.2% for the inverse Russell 2000. During the second and third quarter of the year, we allocated a greater portion of our exposure to hedges, resulting in a negative drag on performance.

Given our limited net exposure during the year, we show the performance of the HFRI Market Neutral Index.[9] While a fair benchmark for 2022, it may not be the best comparison in a typical year if our net exposure is increased to our targeted 15-20% net exposure range. The HFRI Equity Hedge Index[10][11] is a broader long/short universe with a higher beta relative to the equities market.

Special situation investments had a negative impact of -7.3% on our gross performance. These investments included event driven, arbitrage, activism, and other special situations. In situations where we believed to have identified a hard catalyst, the fund purchased equity options. In some of these scenarios we believed the risk reward to be up to 4:1. At the time of entering these positions, we had the belief that the market was not correctly pricing in the potential range of possible outcomes. In hindsight, there are some of these positions we would not make again but we would for many, as we believe we correctly analyzed the available information.

When analyzing performance, we consider our batting average and slugging percentage. Batting average is the percentage of positions where we generated alpha. Slugging percentage, a function of position sizing, reflects the amount of alpha generated when correct vs. alpha lost when incorrect. Ideally, if winners are sized larger than losers, your slugging percentage is higher than batting average. For 2022, we had a higher batting average than slugging percentage due to a handful of large special situation investments.

Much of these losses were due to timing rather than having an incorrect thesis. Being early, especially when using derivatives, often results in being wrong. As we look to improve our slugging percentage, we aim to tighten our risk management by reducing the size of individual special situation positions. This will allow us to withstand greater price variability while our theses play out.

A large detractor in our special situation portfolio was an arbitrage position during the third quarter. While there was no timeline for the value of the securities converge, we believed it to be highly likely over time. The apparent risk was the chance the spread would widen before converging. After accumulating a position, the spread between these securities widened, negatively impacting the fund’s performance for the month of August. Though discussions with management, it became unclear when there would be a catalyst to reduce the spread, and therefore we exited the position at a loss. In the following months, a plan was announced that would converge the gap between the securities and the spread meaningfully converged. Our mistake was having a position too large to withstand the actual downside risk, even as our original thesis played out.

Our investment philosophy is derived from the belief that a business’ long-term ability to generate cash flow is the primary driver of value. We are focused on purchasing high quality businesses at attractive valuations and aim to take short positions in companies with poor fundamentals trading above fair value.

We look to capture diversified sources of alpha from both long and short positions. Our long/short portfolio, built upon the foundation of our fundamental research process, allows us to achieve our stated objectives to drive alpha and hedge risk. We focus on acquiring high quality businesses trading at a significant discount to fair value. These businesses include compounders, orphans, positive expectation gap and special situations. Our short portfolio uses a barbell approach to combine traditional fundamental shorts (over earners, structural declines, forensic accounting, fallen angels) with more aggressive shorts (frauds, fades).

Our objective is to achieve above market, risk-adjusted returns over the course of a cycle by capturing the spread between our long and short portfolios. With a lower correlation to the market and economic cycles, we believe this offers us flexibility with the portfolio’s exposures and the ability to use leverage.

Generally, the portfolio’s exposures will fall within the following parameters. Net exposure between 0% - 50%, with a typical exposure closer to 15% - 20%, and gross exposures between 180% - 250%. We view net exposure on a beta adjusted basis. We consider a blend of the company specific opportunity set and macroeconomic factors in determining our exposures. For example, a robust opportunity set, with an abundance of attractive short positions, allows us to reduce the portfolio’s net exposure and increase our gross exposure (leverage) to capture the expected spread in future share price performances.

Many believe the “health” of the American consumer may limit the impact of an economic contraction. We hesitate to believe these arguments as the effect of inflation has impacted those across all income levels. 1 in 4 workers making over $200k per year say they live paycheck to paycheck. The number is significantly higher for the average American. According to a study by Lending Club, the figure is over 60%.[12] Savings rates are down, prices have soared, and now asset prices have retraced.

In our third quarter letter, we discussed the likelihood of a fourth quarter market rally given bearish positioning and a potential shift back to dovish tone driven by slowing inflation. The October CPI report on November 10th of 7.7% YoY / 0.4% MoM, each 20bps below expectations, resulted in the S&P 500 spiking 5.5% and the Nasdaq gaining 7.4%. This was an approximately 4.5 standard deviation move for both indexes.[13] According to Bloomberg, $225 billion of short positions were covered over the two-day rally.

At the end of the year, we saw a continued sell-off in sectors exposed to tax loss selling (i.e. technology) and flows into cyclical names. The relative outperformance of cyclicals in the fourth quarter, going into a potential recession, provides a ripe hunting ground for opportunities. We see many cyclicals with peak earnings trading at mid-cycle multiples.

Entering 2023, we continue to see the same downside risk to earnings in the event of economic contraction. We believe the focus is shifting away from inflation to economic conditions and earnings. To update our analysis from our prior letters, the S&P 500 returned -18% and the NASDAQ Composite declined -33% in 2022. Since the beginning of the year, consensus estimates for the S&P 500 Ex-Energy have declined -10% for 2023 and -10% for 2024. Current consensus estimates imply a year-over-year increase of ~13% for 2023 and ~11% for 2024.

While the dominance of macroeconomic factors and factor exposures continued to result in high correlation between securities in the market during the fourth quarter, our analysis shows the level of this correlation has begun to come down in segments of the market. As the macro theme continues to shift from inflation to recession and earnings come into greater focus, we believe there should be greater dispersion among share prices. This gets us excited for fundamental stock picking in 2023.

At the end of the quarter, our portfolio’s sector concentration represented: consumer (~40%), industrials (~40%), technology (~10%), other (~10%).[17],[18] The Fund’s net exposure continued to remain low during the third quarter. Our gross exposure during the quarter at ~160%, continued to remain lower than our expected range (180% - 250%). We plan to continue increasing our gross exposure as the opportunity set improves and correlations within factors continue to decline.

Our long and short portfolios have different durations. The nature of holding long positions with a multi-year horizon is the potential for periodic periods of underperformance in the absence of a catalyst. This has been the case for Perimeter Solutions, a significant position in the fund which experienced an ~50% drawdown since we made our initial investment. A successful short book helps alleviate the detraction from overall fund performance.

APi Group is a fire safety business that inspects, maintains, and repairs fire safety systems. The installation and maintenance of these systems are non-discretionary and are regulated by law. APi’s acquisition of Chubb’s fire and safety business from Carrier Group provides additional scale with its large European footprint. There is a significant opportunity for margin expansion as management is focused on improving Chubb’s margins to APi’s levels.

We believe company guidance to be conservative. The market and sell-side analysts are underestimating the true normalized earnings power of APi’s business. We believe the market is too focused on the Company’s debt burden (3.5x EBITDA) which will be continued to be paid down over time to management’s target of under 2.5x.

With a double-digit 2023 free cash flow yield and single digit EBITDA multiple, we believe this business trades at a significant discount to fair value. On a relative basis, private market transactions have seen valuations around 20x EBITDA. We believe a middle ground is reasonable.

During the fourth quarter we began to purchase shares of a recent spin-off which we believe has significant upside. New management has laid out a detailed plan to turn around the business and achieve optimal levels of profitability. The business offers a relatively sticky product with low turnover and high switching costs. We believe normalized earnings power from a successful turnaround reflects a current P/E of 3x.

We accumulated a small position in Provention as a result of its upcoming FDA approval notification. We believed the share price was not factoring information available in the market. We published our findings in a note on our website, tourlitecapital.com, and Twitter.

As we expected, on November 17th, Provention announced the approval for its Teplizumab drug.

We maintain a position in Provention and believe the Company is a likely acquisition target.

This is one of our highest conviction short positions. The Company is a misunderstood, profitless, Covid beneficiary which claims to be revolutionizing its industry. Based on our research, we believe it to be a flawed business model, unlikely to achieve the level of profitability the market is currently assuming.

On a per customer basis, the Company’s valuation is 5-10x more expensive than peers. While Wall Street continues to value this business on a revenue multiple, we believe this to be inappropriate as the Company uses a different revenue recognition methodology than peers. Current guidance and Wall Street estimates are too high and assume unrealistic projections based on inflated levels of profitability. Most misleading to investors is the presentation of the Company’s key gross profit metric which we believe to be overstated by nearly 3x.

Perimeter is the sole qualified provider of aerial fire retardant for many applications. This mission critical product represents a small portion of its customers’ spend, and revenue is recurring in nature as long-term secular tailwinds (growth in number and size of fires) support growth. Perimeter is led by what we consider to be an experienced, best-in-class, capital allocation focused management team.

Perimeter checks our boxes for an investment. It is a market leader in a growing market, strong cash flow generation and return on capital, talented management team, trading at an attractive valuation.

On December 12th, Morgan Stanley published a note from management’s road show:

“PRM's major competitive moat in its core market remains its greatest value proposition — and the greatest investor debate… Near term, it seems likely that Fortress (the potential entrant) will reach full qualification for usage by the US Forest Service in 2023. However, this will likely carry more headline than practical risk. The real point of contention is whether it is logistically efficient for firefighting agencies to use multiple, non-compatible fire-retardant solutions.”

Perimeter’s shares sold off over 10%. We agree that the risk is more in the headline than risk to the underlying business and market share.

We believe there are a few reasons the stock continues to trade where it does today:

The risk of a competitor taking market share is unlikely. Perimeter is currently the only supplier with USDA approval. While it is likely Fortress will be approved in the near-term, Perimeter’s infrastructure and integration into the supply chain provides a lasting competitive advantage to help maintain market share. This, combined with the fact that Perimeter’s product represents only ~3% of customers suppression spend, makes it challenging and unlikely for Federal and State agencies to switch providers.

We understand fire seasons are not perfectly linear but the overall trend in acres burned continues to support unit growth. We believe there was some misunderstanding of the fire suppression market this year. This year’s fire season had a large number of acres burned in Alaska. Since fire retardants are not often used in remote locations where the fire is not a threat to humans or infrastructure, this did not provide support to Perimeters volumes.

In our view, if it’s a clearly defined plan and you can model it out, you can account for it going forward. We like a management team that is paid to perform and has skin in the game.

Revenue should be able to compound around 10% from a combination of increased volumes and mid-single digit price increases. Volume growth will be fueled by continued increases in acres burned, larger fires, and further stretched out fire seasons. Outside of its North American Fire business, additional growth should come from underpenetrated international markets and the Specialty Products segment. International is currently around 20% of revenues and gaining traction. The second leg of Perimeter, which gets less focus and represents 1/3rd of revenues, is Specialty Products which, as of the third quarter, has grown year-over-year revenues 40% and has more than doubled EBITDA.

Based on our 2023 projections, at the current share price of around $9, Perimeter is trading around a 6% free cash flow yield. That is for a business with considerable competitive advantages that should grow free cash flow per share by over 25% per year for the next two years at least. This is a business mostly uncorrelated to economic cycles and we believe there is limited downside to normalized earnings. We see a path to near $1 per share of free cash flow by 2025.

Verra Mobility is a leader in transportation technology and operates in three segments: commercial, government and parking. The commercial and government segments represent 85%+ of revenues. Verra is an attractive business with mid-to-high single digit revenue growth and sustainable competitive advantages.

Commercial services provide tolling services and violation management for commercial fleets (i.e., rental cars). Verra is integrated with tolling authorities and has a revenue split with rental car operators. The business should benefit from two key tailwinds including the continued shift from cash to cashless tolls and conversion of highways to toll roads. Currently ~65% of toll booths are cashless and that is expected to grow to over 80% over the next few years. Verra is highly integrated into the rental car system with long-term contracts and technology that would be expensive to replicate. The market consensus is Verra’s rental car business has recession risk as it is tied to travel demand. In addition, there is commentary that ridesharing and autonomous driving is a risk to terminal value. We view growth of ridesharing and autonomous driving as a positive long-term catalyst for the fleet management business.

The Government segment offers solutions to cities and school districts including red-light, speed and bus lane camera enforcement. Most of these relationships are revenue shares and Verra maintains ownership of the hardware/cameras. Future growth will come from expanding offerings to states with limited current enforcement (i.e., only have red light cameras) and breaking into the 17 states with no photo enforcement. While NYC is the crown jewel, and adoption in California, Florida and Connecticut would significantly move the needle, the quality of fragmented relationships with smaller cities and municipalities is underappreciated. In a recession, government revenues should be durable along with most of Parking. Most government relationships are revenue shares and Verra maintains ownership of the hardware/cameras.

On November 2nd, Verra share price had a negative reaction to its third quarter earnings, falling over 15%. We believe there were high expectations as a result of its strong second quarter, especially for the Commercial business. We identified three reasons for the strong second quarter and weaker than expected third quarter:

Volumes grew 26% from the first to second quarter and grew only 1% in the third quarter.[21]

TSA data remained strong in the fourth quarter, up ~14% year-over-year but an ~3% decline from the third quarter. Based on our projections for 2023, Verra trades at over a 7.5% free cash flow yield.

From our fund’s inception in April 2022 to the end of July, we were short Ranpak Holdings. We no longer have a position. The position was one of our greatest contributors to performance during

2022. In our Second Quarter letter we highlighted this “Industrial Short” as “an industrial packaging business that has experienced significant tailwinds from growth of e-commerce.” We would like to highlight Ranpak as an example of a prior short position.

Ranpak is a 2019 vintage SPAC that manufactures machines and paper products and sells them though a razor/razor blade model. Think of the paper filler in your Amazon packages. Ranpak would provide customers its machines for free or a small cost and sell those customers its paper products. In April 2022, the Company had an ~$1.6 billion market capitalization.

There were signals of market share declining as growth trailed e-commerce. Increased competition from competitors entering paper products (i.e., Sealed Air, SEE) and innovations such as right-sized-packaging. We believe management lacked confidence due to an increase in insider selling.

Consensus saw continued e-commerce tailwinds and partnerships with companies including Amazon would fuel 10%+ organic growth. In addition, Ranpak’s paper products offer an advantage with ESG conscious customers compared to plastic bubble wrap alternative.

We expected growth to normalize back to mid-single digits as covid e-commerce tailwinds lapped and channel checks showed declining sales with Amazon, its largest customer. Rising inventory levels and declining margins despite the growth of e-commerce confirmed this thesis. On the ESG front, our expert calls uncovered shifts to “right-sized” packaging as the most ESG friendly solution.

Ranpak traded at over 25x peak EBITDA, expensive on an absolute basis and more than 2x its closest, more diversified competitor Sealed Air. Ranpak’s GAAP peer set leading EBITDA margin of 31% was misleading due to capitalizing of machine costs. This resulted in an ~10% benefits to reported EBITDA. Shortly after going public, the Company raised money at $5 per share, before seeing their share price top out above $40. We exited our position around ~$5 per share.

In December, I was interviewed by Hidden Value Stocks, a spin-off newsletter from ValueWalk. I was the first long/short fund featured. We discussed Tourlite’s investment strategy and a few of our holdings. A transcript can be found on the documents section of our website.

This puts an end to our rookie year. In Ty Cobb’s 1905 rookie campaign, his .238 average sat near the middle of the pack in professional baseball. The Hall of Famer’s career .366 average remains baseball’s all-time record. Like Cobb, we feel our first year was a learning year, and we delivered solid results relative to peers in a challenging market environment.

Thank you for your trust and support. Please feel free to reach out to me with any questions.

Sincerely,

Jeffrey G. Cherkin

Originally Posted on Reddit.com

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