It has been just over 2½ years since the January 31, 2011 inception of the BluMont Innovation PE Strategy Fund (BIPES, or ‘the Fund’). Although returns have been volatile, I believe that what has occurred so far in both the Fund and the broader markets speaks to the importance of using a venture capital structure and approach to manage investments in this asset class, and to the value-add that the Advisory Board brings to the table: as of July 31, 2013, BIPES is up 46.4% since inception (including distributions); during that same timeframe (January 31, 2011 to July 31, 2013), the S&P/TSXVenture Composite Index declined by 59.7%; the S&P/TSX Composite Index declined by 7.9%.
The returns as of July 31, 2013, are set out below:
*Inception date: January 31, 2011. Return is on an annualized basis, including distributions.
The months since the last letter was written have been eventful for many of the companies in the Fund, with the tragic explosion at Neptune’s Sherbrooke plant casting a long shadow, but also with many companies hitting key value-creation milestones.
Just over 2½ years into the six year life of the Fund, the portfolio is now essentially ‘fixed’ (i.e., no new investments will be made) and fully invested. In this letter, I will cover the 6 positions which currently make up about 80% of the market value of BIPES. (In the next letter, I will cover the 6 positions which currently make up about 20% of the market value of BIPES.) Given that the portfolio is now fixed, and now has 3½ years left in its life, I will also give some indication of where I expect each stock could be within a 3-year time horizon.
The Return Distribution for the Top 10 Positions in the Fund, and endorsing a more equally-weighted approach
For the period from inception to July 31, 2013, six of the Fund’s “Top 10 Day 1 positions” were up strongly (including one position up over 500%), and four were down. In late-stage venture investing (which is probably the best way to characterize what I do), a 60% ‘win rate’ is extremely high—indeed, it is widely acknowledged that a win rate of 60% is even uncommon in a portfolio of large cap stocks; in venture investing, a win rate of 10%-20% is the goal.
My investors know that the “Day 1” weightings of positions in BIPES were wildly unequal, stemming from the fact that BIPES was formed from the rolling-over of the former Northern Rivers Innovation Fund LP into the BIPES structure. In future funds, although we will continue to run concentrated portfolios, we will be taking a more equal-weighted approach to constructing the portfolios. This kind of portfolio construction is often accretive to returns. For illustrative purposes: if BIPES had been constructed on January 31, 2011 as having the top 10 positions equally weighted at 10% each, the return to BIPES as of July 31, 2013 would have been significantly higher than the already-strong +46.4% return that was achieved over the first two and a half years of its life.
FLYHT: many of Flyht’s major, long-term initiatives are coming together at the same time, and management has reiterated the company will be cash flow positive in Q4-13
Before addressing business developments, I am going to take a stab at addressing misperceptions around Flyht’s balance sheet, because what appears at first look to be horrifyingly bad is actually reasonably healthy. Here goes:
At March 31, 2013, the company reported negative working capital of $3,545,752—a scary number which has prevented many an investor from taking the time to look closer. However, as discussed in detail in the MD&A, both customer deposits and the current portion of “unearned revenue” are included as current liabilities, despite the fact that NEITHER of those items are refundable (i.e., neither of them are a potential liability in any sense of the word). So, adjusting reported working capital by taking those items out of current liabilities in fact gives a more accurate picture of the company’s situation, and results in a “Modified Working Capital” of negative $457,027. Although much better, this is still not a good number. However, this modified number includes something which management has publicly indicated will likely be resolved in Flyht’s favour in the near future: the outstanding accounts payable to Sierra Nevada Corporation (SNC) of $1,827,312. Of course, until it is actually legally resolved once and for all, this liability will still be there, but I am familiar enough with the history of the SNC relationship to believe that management’s confidence in the resolution of this dispute is not misplaced. If we then also take this item out of current liabilities, the March 31 “as if” working capital becomes +$1,370,285. And if we then add in the proceeds of the recent financing—now complete and closed—we are looking at a healthy working capital balance more in the +$3.3million range. I am looking forward to the resolution of the SNC situation before the end of Q3, so that investors new to the story won’t be so quick to run screaming from the balance sheet.
So why do I still believe that Flyht can be one of the big winners for the fund? The next 4 months promise to be the most exciting in the company’s history, with many of the long-term, game-changing initiatives beginning to bear fruit simultaneously.
Perhaps the most significant from an industry standpoint is the beginning of assembly line installation at Airbus in Q3 (under the L-3 contract), with shipping from the Airbus factory to commence by the end of 2013. An equally significant opportunity is for the retrofit of existing Airbus fleets at major airlines: during the Q1 conference call on May 8, management was very specific that they expect to announce 2 fleet retrofits by the end of 2013; during the Q2 conference call, management stated that there are more than 2 such opportunities, and that, specifically, the 150+plane opportunity with a South American operator (discussed on the Q1 conference call) was “secured” with respect to the L3-to-end-customer side of the equation, and that the PO to Flyht would come “in due course”. As to what Airbus’s future plans might be for the AFIRS system on the Airbus assembly line, a November 14, 2012 speech by Mr Marc Ballion (International Safety Program Director at Airbus) gave a tantalizing hint. He was quoted by a Nigerian newspaper, as follows: “Mr Marc Ballion said AFIRS would automatically be fixed on all Airbus planes from 2015…He said...’We have to be predictive and pro-active in our approach to the safety of airplanes and passengers…We don’t have to wait for an accident to occur before we take steps.’ ”1
Another game-changing initiative of Flyht’s that is coming to fruition is in China. The developments in China have been dramatic, with the Civil Aviation Administration of China (CAAC) firming up the timelines for their satcom mandate first published in October 2012:
From the link above: “According to the plan, Chinese airline companies should install the [satcom] system on 20% of its fleet by the end of 2013. And by the end of 2016, all commercial aircraft should have such equipment.” We now know that the CAAC has reaffirmed the 2016 deadline for full-fleet installation, and has imposed a deadline of November 30 2013 for the airlines to have their roll-out plans submitted to CAAC, with installations mandated to begin in early 2014. One of many good things from a Flyht perspective is that for installations to begin in early 2014, a PO will have to be issued to Flyht well before the end of 2013.
By the end of 2016, China’s commercial fleet will have over 1,900 aircraft that will be mandated to have satcom equipment on board. There are 2 reasons I am expecting Flyht to achieve well over 50% market share for these installs:
1) only two types of satcom equipment have been approved for installation in China (the Iridium/AFIRS system and systems that use the Inmarsat satellite network), and the Iridium/AFIRS system is significantly smaller, lighter and cheaper (both on an upfront and ongoing data/voice charges basis) than systems using the Inmarsat network;
2) because of the Airbus/L-3 relationship, Flyht should expect to get 100% of the Airbus installs. (Airbus had about 45% market share of the commercial fleet in China as of September 2011.)
Encouragingly, six of the major Chinese airlines have already done initial installations, and are setting up procedures for pilot training and large scale installations in 2014. I am hoping to see the first large PO from China in late Q3 or Q4 of this year. Of course, one of the many positive knock-on effects of the China mandate is that many OEMs will likely be forced to accommodate installation of the Iridium/AFIRS system, both on the assembly line and in the after-market. Bombardier was forced into assembly line installations in 2012, as per the following press release:
It would be reasonable to expect that other OEMs (such as Boeing, Embraer and Dassault) will be forced to likewise accommodate installations of the Iridium/AFIRS system for the Chinese market, and maybe—just maybe—this forced adoption will end up convincing them of the merits of the system so that they end up being proponents and willing adopters—like Airbus.
On the NetJets front, Flyht management indicated at the May 7 AGM that the interruption caused by the bankruptcy of Hawker Beech is finally over: the first jet in the NetJets Europe fleet went live on May 6, and now all 10 of the installed units are live. Although the Hawker Beech bankruptcy has changed the trajectory of the adoption process, with many customers’ own evaluations showing that Flyht’s AFIRS system demonstrates savings of over $100,000/plane/year, I would expect to see this program gain momentum, both at NetJetsEurope and NetJets USA, over the next two years.
A smaller but still significant and very visible opportunity is in Nigeria: a mandate to have AFIRS installed on all planes operated by Nigerian airlines means that another 80 planes will have the AFIRS system installed and running by the end of 2014. Developments such as these above, as well as developments with operators of C-130 fleets, have reinforced my confidence that we will see Flyht’s stock somewhere in the $1-$3 range within 3 years; shorter-term, I think we’ve got a good shot at the $0.40-$0.60 range by yearend.
I am very pleased that BIPES’ “private equity approach to public equities” strategy has been proving itself to be a significant contributor to value creation. The Advisory Board has been a real contributor and value creating part of the team. I can confidently say that if I had approached this portfolio of stocks in the same way as a conventional portfolio manager, the portfolio would not be performing as well. This fund was, in some ways, an experiment, to see if a truly new approach to structuring and managing a portfolio of small and micro cap publicly traded equities could solve the inherent difficulties presented by such a portfolio. I and the team at BluMont Capital and IAM are pleased to report to you that the results from the first 2 and ½ years of this experiment look very promising indeed, and we look forward to delivering more “proof of concept” in the coming months and years.
Hugh Cleland, CFA
Sub-Advisor to the BluMont Innovation PE Strategy Fund
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