2013 Q1 Client Letter

April 2, 2013 

Dear Twinleaf Client: 

First quarter 2013 was a good one for equity investors as a number of factors -- the continuing low-interest rate environment, solid corporate earnings and balance sheets, an incipient housing recovery and some high-profile M&A activity -- drove stock prices higher. Your Twinleaf account outperformed most stock indexes in the quarter, rising in value by 15.57% on a gross basis and 15.28% after fees. Since inception on 2/7/12, your Twinleaf account is up 16.79% on a net basis, also ahead of most relevant indexes.

While our universe of small cap stocks is clearly not as inexpensive on a valuation basis as it was in 2012, we’re still uncovering ideas that meet most of our investment criteria. That is to say we seek decent businesses with some growth, competent management with stock ownership, mid-single digit valuation multiples of operating cash flow, positive free cash flow, capital that is being returned to shareholders and logical M&A candidates. A recent addition to your portfolio that meets not just most, but all of these hurdles is Kona Grill (KONA), a chain of 23 “polished casual” restaurants in mostly upscale mall locations in predominantly Sunbelt markets.

KONA trades at a steep valuation multiple discount to its restaurant peers, has a net-cash balance sheet, is prudently adding new units for the first time since 2010, has retired 13% of its shares since late 2011, has insider ownership of 34% and is a very manageable acquisition target for a larger restaurant group or private equity. As a bonus, KONA is an interesting play on the housing recovery, especially in Phoenix and Las Vegas, where the company generates nearly 25% of its revenue. After building the position, we posted a full KONA analysis on SumZero, a site for portfolio managers, and also on the Twinleaf web site.

The best performing name in your account during the quarter was Multiband (MBND), the nation’s largest installation and service contractor for direct-to-home satellite provider, DirecTV. MBND rose 49% in the quarter (though from near an all-time low) as a second activist investor acquired a large stake and expressed dissatisfaction with the company’s performance. MBND presents a challenging analysis about which we reach an ambivalent conclusion: on the one hand, the two activists control about 20% of the stock, are seeking a sale of the company and the stock still appears cheap (even after the 49% gain) at about 4.5x our 2013 estimate of EBITDA. Should the company adapt accounting treatment that allows it to capitalize its vehicle fleet leases rather than expense them, the stock becomes extremely cheap by most metrics. But there are flaws in the investment story: satellite installation and service is a very low margin business (as evidenced by the company’s enterprise value to 2012 revenue multiple of 0.29x), the company’s chronic undercapitalization has created a messier capital structure than we’d prefer and management hasn’t diversified away from DirecTV as smoothly as hoped. In summary, we’d like to see the activist shareholders engineer a sale of MBND soon as it is no longer a core Twinleaf holding.

Elsewhere in the portfolio, we remain enthusiastic about the prospects for companies navigating the emerging advanced television space. Consumers are demanding linear and time-shifted TV and IP-based streaming web video to screens beyond the primary TV and service providers are being forced to comply. Most service providers now offer a “TV Everywhere” product that allows authenticated tablet and smartphone viewing within the subscriber’s home and out-of-home viewing capability is coming as content licensing issues are resolved. But provisioning the second screen viewing experience is not so simple: there are a myriad of technological and economic challenges to overcome in converting cable- and satellite-delivered video to the second screen. The vendors that provide those solutions are where we are most highly focused.

Twinleaf accounts own the following names in the advanced television space: TiVO (TIVO), which has quietly gone well beyond its DVR roots to become the industry’s leading advanced television solutions provider; SeaChange (SEAC), which is supplying gateway software and second-screen dynamic advertising insertion capabilities to service providers; and Envivio (ENVI), which provides encoding software that enables the IP-based video product to stream seamlessly to devices around the home. We’ve been too early to invest in ENVI but we believe its value will be recognized by investors this year. Shares of TIVO and SEAC have performed well in recent months and we believe both companies are excellent M&A candidates as the category matures.

Thanks for your support.


Spencer Grimes