Alta Fox Bearish on Keywords Studios, Bullish on One Group Hospitality

Alta Fox Capital Management, LLC released its 2019 Q3 investor letter – you can download a copy here.

According to the letter, the fund lost 2.21% gross and 2.10% net in the quarter. The returns compared favorably to the -2.40% return for the Russell 2000 and -5.4% return for the Russell Microcap index, but unfavorably to the S&P 500’s 1.70% return.

In detailing its results, the fund offered commentary on a number of its positions. One of the positive contributors for the quarter was Koru Medical (NASDAQ: KRMD) — a medical device company that has a razor/razor blade model. The company recently changed its ticker and company name from Repro-Med (REPR).

The fund had the following to say regarding the company in its investment letter:

“KRMD was the biggest winner in the portfolio in Q3. It is a medical device company that has a razor/razorblade model that enables patients with primary immunodeficiency disease (“PIDD”) to self-administer plasma-derived treatments through subcutaneous infusion. There are roughly 270,000 people with PIDD in the U.S., but only ~70,000 (36%) are currently being treated. The primary reason for this large gap is that PIDD is difficult to diagnose, but awareness has been increasing. As a result, while the population with the disease is growing ~2% per year, the percentage of patients treated is growing closer to 10% per year. However, the story gets better for KRMD. Of the 70,000 patients currently being treated for PIDD, nearly 2/3 of those patients are being treated through intravenous therapy typically with one large dose per month in either a hospital or specialty clinic. This is suboptimal in several ways: it is inconvenient for the customer who has to go to the clinic and then receive a large dose through an IV, it is a high dose of a drug administered all at once (many patients feel sick afterwards and the effectiveness of the drug drops off significantly after a few weeks), and finally, it is very expensive for the healthcare industry since a dedicated facility and nurse are required. This is where KRMD’s solution enters the picture. KRMD’s subcutaneous infusion pump allows the patient to self-administer therapy at home, typically in smaller doses about once per week. The company currently has ~80% market share of the PIDD subcutaneous market— a market that is growing double digits and offers stable, recurring revenue. I know the drivers of this market fairly well given my previous work on PaySign Inc (PAYS). KRMD is in a different part of the plasma supply chain than PAYS, but nonetheless benefits from double digit secular growth in patient count. I believe the company is undervalued based on their current PIDD and CIPD indications due to 20%+ sustainable revenue growth, 70% gross margins, and significant operating leverage. Moreover, there is a chance that the current management team and board, which is impressive for a micro-cap, can create value by extending the use of their pumps for other emerging subcutaneous drugs. If I am right, the stock could have multiples of upside from current levels.”

Elsewhere in the investor letter, the fund offered commentary on One Group Hospitality Inc (NASDAQ: STKS):

“This restaurant owner and operator of the “STK” steakhouse chain had a busy third quarter and is worth revisiting. The company made a transformational acquisition by acquiring 24 “Kona Grill” stores out of bankruptcy for $36M in total consideration. This was a surprise, and I did significant diligence on the Kona acquisition to become comfortable with the changing investment thesis. Kona Grill is an interesting case study. In 2015, the market cap of Kona was greater than $300 million. The previous management team managed to take a healthy chain of 23 stores in 2012 that generated over $11M in reported EBITDA and $18M in 4-wall EBITDA (pre-corporate expenses) with growing same store sales to bankruptcy just seven years later. This was a classic case of overexpansion. Kona’s previous management team increased the store count from 23 stores in 2012 to 46 by 2017. They spent over $129 million in capex during that time period (wow!) and margins were crushed as the company tried to appease the equity market by showing high unit growth—even though it meant the company was expanding into locations that had exorbitant rent costs and were not realistic venues for the brand. STK swooped in and bought the best 24 stores out of bankruptcy for a total consideration of $36M. Considering these stores cost over $3M/store to build and most have been renovated in the last several years, STK is buying at a substantial discount to asset value. Of course, this is irrelevant if the company cannot generate a decent return on that invested capital—but they are. In fact, even before the company went under and shuttered their money-losing stores, Kona generated $17.9M in restaurant operating profit in 2018 (11.4% restaurant operating margin), had $11.4M in G&A, and generated reported EBITDA of $6.5M. The 2018 profitability was achieved despite having a large number of stores that were highly unprofitable. The remaining 24 Kona Grill stores that STKS purchased generate ~$100M in annual revenue at a mid-teens restaurant operating margin— implying around $15M of restaurant operating profit. The relevant questions are how much G&A will be required to support the brand and what is the trajectory for average unit volumes? In 2012- 2013, when Kona had the same size store base (2/3 of which I estimate are part of the 24 STK is acquiring), the corporate G&A required to support the stores was $7-$8M. However, this number included a separate management team, as one ex-employee described “the Taj Mahal” of corporate offices, and a separate marketing and training team. STK will have significant G&A synergies and should be able to cut annual G&A expenses to the ~$5M range. This would imply ~$10M of Kona EBITDA. Combined with the expected contribution from the core STK brand of ~$15M in EBITDA next year, the business should do ~$25M of Adjusted EBITDA next year, consistent with management’s new guidance. Applying a high-single digit EBITDA multiple can result in nearly a doubling from the current price without any improvement in Kona unit volumes. However, I think the reason to be excited about this opportunity is that the Kona Brand is far from broken, there is low hanging fruit for STK to significantly improve average unit volumes at high incremental margins, and the CEO of STK has a proven playbook for executing this turnaround. Manny Hilario took over as CEO of STKS in Q4 of 2017. Almost immediately, he took same store sales for the brand from flat/negative to up high single digits for the past seven quarters. He did this while cutting SG&A in absolute dollar terms. The most important aspects of his playbook have been: a) to invest to improve the food quality and focus maniacally on the guest experience b) to increase corporate events and parties, and c) to develop a robust digital marketing effort. I expect Manny to execute a similar playbook at Kona Grill. I talked to many ex-Kona employees, from high level executives to store managers. A surprisingly clear narrative emerged from this diligence that suggested there was nothing wrong with the brand of Kona Grill and that under the right management, unit volumes could return to previous peak levels. If Hilario can execute a similar turnaround at Kona as he did with STK, the upside is much more than a double from current prices. Of course, this investment is not without risk. Restaurant turnarounds are hard, the company is levered, and operational leverage works both ways. However, I think the risk/reward is in our favor, it is appropriately sized in the portfolio given the level of risk, and I am excited to see what the STK management team can do with the Kona Grill brand.”

Interestingly, Alta Fox commented on STKS in its second-quarter letter as well, you can read our coverage here.

Apart from the above-mentioned two stocks, the company offered commentary on Keywords Studios PLC (LON: KWS), an IT service management company that works with video game companies.

Disclosure: None. This article is originally published at Insider Monkey.