Q3 2024 Investor Letter

Fellow Investors,

The third quarter of 2024 has ended, and our portfolio increased by 2.5% despite substantial volatility over the past three months. We continue to seek superior returns by focusing on “off the beaten path” investments in small companies. To this end, if you were to fully acquire every company in our current portfolio, it would cost a bit over $10B. That’s 1/300th of Nvidia or Apple. We’ll continue to spend our time in the corners of the market that fail to garner the attention of larger securities.

Kingdom Capital Advisors (KCA Value Composite) returned 2.51% (net of fees) in the second quarter, vs. 9.27% for the Russell 2000 TR, 5.89% for the S&P 500 TR, and 2.12% for the NASDAQ 100 TR.

We began Q3 setting new all-time highs throughout the month of July. Mike and I headed to Coeur d’Alene, ID to attend the annual MicroCapClub Investment Conference and scout new ideas for the fund. Unfortunately, that’s when the trend reversed. In the first week of August, a surprise rate increase from the Bank of Japan caused the rapid unwind of the Yen “carry-trade” which briefly shook markets.  We gave back our gains for the quarter as fears of a recession increased, hitting energy and commodity names especially hard. We rallied with the market at the end of September (after the Fed’s long-awaited rate cut), and closed the quarter with a slight gain. Year-to-date, our performance remains ahead of our benchmark, the Russell 2000.

Our top contributors to Q3 returns were Net Lease Office Properties (NLOP), United Natural Foods (UNFI), and Galaxy Gaming (GLXZ), while ComScore (SCOR) and Valaris (VAL & VAL.WS) were our largest detractors.

Positioning Updates

(David presenting his NLOP thesis in Coeur d'Alene)

Our largest position remains Net Lease Office Properties (NLOP). The company continues to sell properties and extend leases, executing on the orderly liquidation they promised. We invested in NLOP confident the stock was undervalued, EVEN IF leases were not extended and the current properties were only worth the present value of their remaining rent payments. Yet, NLOP extended four leases in Q2 alone, and their most recent property sale (a CVS campus in Arizona) sold for less than a 6% cap rate - far above our estimate of value. NLOP appears very close to paying off their remaining debt and returning cash via dividends, which we expect will be the next catalyst to move the stock higher. I had the opportunity to present the idea at the annual MicroCapClub conference, a private investors forum where I first profiled the stock before the initial sales announcements.

Warrior Met Coal (HCC) finished the quarter mostly unchanged despite significant volatility due to fear in Chinese steel markets. We invested in Warrior, and smaller peer Corsa Coal, on the premise that the premium metallurgical coal market is undersupplied. While you could certainly take our word for it, I think there were three events in Q3 that really drove home how acute the shortage will be:

• Nippon Steel and JFE Steel, the two largest Japanese producers, participated in a 30% buydown of the Blackwater mine from Whitehaven for $1.08B. This mine produces approximately 12m tons of coal per year, valuing the production at ~$300m per million tons of annual production. In their first quarter of ownership, Whitehaven generated about $58/ton in margins from this asset, about 10% lower than what Warrior generated in the same quarter. Warrior’s margins are set to expand further post-Blue Creek, and this transaction suggests significant upside potential for their valuation without adjusting for the expected improvement.

• India’s JSW Steel invested in the recent $1.65B takeover of South32’s Illawarra coal mines, which produce about 5m tons of coal annually at higher costs than the new Whitehaven assets. This purchase again shows a multinational steel producer valuing a million tons of annual metallurgical coal production above $300m.

• In case you thought we were finished, Chinese-controlled Yancoal abruptly suspended their dividend in Q3, with the expressed goal of bidding on Anglo American’s met coal portfolio. This sale is complicated by a fire that took one of their mines offline indefinitely this summer, but is still expected to result in $3-4B of proceeds for about 12m tons of unaffected production, with production margins once again worse than Warrior in the first half of the year, before the fire impacts.

The largest steel producers in the world are telling you that now is the time to secure access to premium coking coal, at prices that exceed the valuation currently attributed to Warrior, on mines which generate similar or inferior margins. The good news is the market is allowing us to invest in the low-cost, high-quality US producer at an extremely attractive valuation, and we are taking that opportunity. It’s also allowing us to invest in Corsa’s 1m tons of annual production for about a tenth of the above valuations, which we hope will be bolstered after recent operational adjustments reduce Corsa’s cost profile to match other Appalachian producers.

One of our smallest positions, Galaxy Gaming (GLXZ), announced they are being acquired by primary customer Evolution (EVO) during Q3, which nearly doubled the stock price. This was a great result from our initial purchases this year; however, we struggled to make this position larger given the low liquidity in the stock. Galaxy has been trading at a single digit multiple of EBITDA and posting improved revenue growth, and we think EVO is getting a good business at an attractive price.

We established a new position in United Natural Foods (UNFI) during Q3. This stock is new to the fund; however, it was a substantial winner for me in 2019/2020 as the demand for grocery into Covid shutdowns significantly accelerated their earnings. I have watched this stock waiting for a good re-entry, and I believe they are turning a corner after several quarters of disappointing results. The company validated our trust on the first day of Q4, posting improved margins, rebounding sales volumes, and providing a roadmap to further bolster their balance sheet. We particularly like the new CFO and his focus on cash flow generation, a theme we expect to play out in the coming quarters.

We continue to own a few names in the restaurant space, having added Red Robin (RRGB) to our existing positions in Good Times (GTIM) and GEN Restaurant Group (GENK). Of course, we had to make a diligence visit to Red Robin to make sure the burgers were up to par. We love GTIM and GENK for their cash generation abilities and think Red Robin is taking the right steps to join them. Good Times trades near a 20% free cash flow yield, and GEN is self-funding an aggressive rollout plan that should double their footprint in 24 months. We expect Red Robin can return to profitability in FY25, at which point the stock would appreciate substantially.

On a more disappointing note, we mentioned in our last letter that we expected Superior Industries (SUP) to secure a refinancing deal, which they did, but the market did not care. It seems the company will need to showcase margin improvement from their expanded Poland operations before the stock can catch a bid. Despite the lack of response to the refinancing, it accomplished a key objective by giving Superior leverage over their preferred stockholders. We expect the market hasn’t fully digested this development, which should allow Superior to keep this security outstanding as low-cost capital, while eventually exiting the security on attractive terms to common shareholders.

We were disappointed with ComScore (SCOR)’s results in August, which delayed promised revenue growth once again, sending the stock to all-time lows. This reaction seems a bit unfair given the margin improvement that has taken place inside the business, and the continued expansion of their Proxemic offering. We understand the market’s frustration at a “kitchen-sink” quarter and hope our patience will be rewarded by not throwing in the towel at what (we hope) is peak frustration.

In the “oddball” bucket, we bought shares in ECC Capital (ECRO) during Q3. This funny little shell acquired a coal mine in Wyoming back in April, which upon further digging revealed an operation that historically has generated healthy margins from sales to a local power plant. Based on public data, we think this mine might still be generating close to $20m of annual cash flow, despite ECRO trading below a $10m market cap. The local power plant has announced plans to convert from coal to natural gas by 2026, which introduces terminal value questions for the coal mine. However, there are two local initiatives, a cosmetics plant and an ammonia plant, which could provide ongoing offtake to protect the mining jobs and maintain margins. Given the valuation, we’re willing to come along for the ride. An ownership limitation exists preventing us from going over 2.5% ownership, or we would have invested more.

Business Update

Mike relocated to Richmond, VA, over the summer to be closer to family. If you find yourself in Richmond or Fairfax, we’d love to connect. We continue to grow our assets under management and we are extremely grateful to those that have referred potential investors to help us grow! We continue to publish research online, participate in occasional podcasts, and network with likeminded managers in the quest for our next great investment.

Thank you for trusting us to steward your funds wisely. As always, reach out with any questions.

Sincerely,

David Bastian

Chief Investment Officer

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