180 Degree Capital Corp. (TURN) Earnings Call Transcript & Summary

Good morning. And welcome to 180 Capital Corp.’s Third Quarter 2023 Financial Results Update Call. This is Daniel Wolfe, President and Portfolio Manager of 180 Degree Capital. Kevin Rendino, our Chief Executive Officer and Portfolio Manager, and I would like to welcome you to our call this morning. [Operator Instructions] I would like to remind participants that this call is being recorded and that we will be referring to a slide deck that we have posted on our Investor Relations website at ir.180degreecapital.com under Financial Results. Please turn to our safe harbor statement on Slide 2. This presentation may contain statements of a forward-looking nature relating to future events. Statements contained in this presentation that are forward-looking statements are intended to be made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to inherent uncertainties in predicting future results and conditions. These statements reflect the company's current beliefs, and a number of important factors could cause actual results to differ materially from those expressed herein. Please see the company's filings with the Securities and Exchange Commission for a more detailed discussion of the risks and uncertainties associated with the company's business that could affect the company's actual results, except as otherwise required by Federal securities laws, 180 Degree Capital Corp. undertakes no obligation to update or revise these forward-looking statements to reflect new events or uncertainties. I would now like to turn the call over to Kevin.

Thank you, Daniel, and good morning, everyone. I want to leave you with a few key thoughts this morning. Our business transformation is essentially complete. After this past quarter, 97% of our assets are now in public companies. While it took over 6 years to get to this point, it is over. For those that are keeping track, since I arrived and 180 came to be in 2017, we have generated nearly $3 per share or specifically $2.77 in gains from our new strategy. We have had losses over the same period of time of $2.28 from the historic legacy positions of Harris & Harris. To be candid, this business probably wouldn't exist if we hadn't changed our stripes in 2017 and while the last 7 quarters have been a challenge for our public holdings, the market and specifically the Microcap Indices, we now have a liquid, easily transparent balance sheet to be able to understand our NAV to calculate. Therefore, as we said from day 1, the discount our stock trade debt relative to our NAV should be far less than it was when our book was 80% private. To that end, we announced a discount management program that Daniel will speak to later in this call. It's important that the reality of our discount mirror the fees we had for it when we first started. To be clear, the most important thing we can do is invest in companies that rise in value, so the absolute value of our NAV clients. There is a reason our stock traded at close to $9 per share at the end of 2021. It was because we grew our NAV to over $10 per share from where it was when we started. And while the last 7 quarters have been a challenge for our holdings in the microcap index in general, we believe this period has set us up to once again grow our NAV as we look beyond this incredibly volatile and bearish market. In fact, we're going to use the rest of this call to show you an illustration for why we believe this is the right time to be invested in Microcaps, and as a result, turn. We're going to show you a series of charts and data that highlight just how undervalued we believe our investment universe is and therefore, how much upside we believe there actually is for the companies that we own. I think this is one of the better buying opportunities for what we do than at any time since I've been here. The rest of this call will offer the rationale for why I think that is the case. As for the topics that we normally discuss on these calls, I recommend reviewing our shareholder call slides that are posted on our Investor Relations website. I won't speak to every chart included in this presentation, but I'll speak to a bunch of them and encourage you to flip through the presentation and shareholder letter for a complete discussion. On Slide 4, this shows that the ratio of the U.S. small cap performance to large cap performance is it at the lowest level in almost 1/4 of the century. And yet at the same time, this level of underperformance is nothing about the fundamentals of the businesses that comprise each index, given the fundamentals have actually held up better for many microcap companies than the index performance would suggest. On Slide 5, this argues that not only have the stocks of smaller companies underperformed, the relative price to earnings ratio are back to levels not seen since 2019 ‘78. What's interesting about 1978 was that was also a time of inflation as has been the case in the last few years. The question for us is, has the CPI peaked? And are we at the end of the Fed tightening cycle? The answer that we have for both of those questions is yes and yes. I do know the CPI has gone from 9.1% to 3.7% and perhaps like 1978, which was the bottom for small caps, this is the bottom for small caps today because the CPI has long passed peak. You can review the CPI numbers this morning are a little softer than expected. Slide 6 shows that not only our small-cap value and small-cap core equities, the cheapest segment of U.S. equities on a relative basis -- it's also remarkable that these 2 categories are the only ones that are below their 20-year, 25-year average valuation. Every other index in this chart shows that those indices traded premiums to the 25-year averages, but small caps don't. Slide 7 shows that small caps trade not only at a discount to the large-cap peers, but the discounts are incredibly high. For example, the performance cap was 41% on a trailing PE, 39% on price to book and 30% on price to sales. This is neither normal nor justified based on the actual performance of the company's fundamentals. Slide 8 shows the historical returns of market indices, -- at least in 2008, when the economy actually did melt down, most indices were down about the same amount. Back in 2008, the S&P 500 Index was down 37%, the NASDAQ Composite Index was down 40%, there also 2,000 indexes down 34%, and the Russell Microcap index was down 40%. How is it that today, the NASDAQ 100 can be up 37%, while the Russell Microcap index is down 10%. How can the S&P 500 be 3% from its all-time high, while the Russell Microcap Index is down 38%, and the Russell Microcap growth in that is down 49% from the high? While we understand the bearish effect of today's world of higher interest rates, it has had a significantly greater effect on small caps relative to the 2008 economic environment, where nearly $1 trillion of losses occurred from categories of loans and related securities issued in the United States, secured primarily by residential real estate. 2008 was an economic Pearl Harbor as Warren Buffett said, and 2023 is not the same economic calamity. The disparity of performance between the size of companies is the widest it has ever been and makes no sense to us. This is not 2008. Skipping ahead to Slide 10, the above chart depicts bearish sentiment. Are there problems in the world? Yes, there clearly are a number of pressing issues, higher interest rates, the war in Ukraine, now a war in the Middle East, inflationary pressures, there's many concerns. But bottoms in stock markets nearly always occur when bearishness is at its highest levels. And the opposite, of course, is true of tops and markets. We are near the high end of their sentiment as depicted in this chart. Skipping ahead to Slide 13, this shows the historical PE ratios of the Russell 2000. It isn't only about relative valuations of one asset size to the next, the above chart from Royce Investment Partners shows that the actual PE for the Russell 2000 has gone down measurably over the last few years. Now one would expect that higher interest rates would lead to lower PE multiples, but the multiples are now lower than the long-term growth rates arguing for an inexpensive asset class. Additionally, given we believe that the Fed is likely near the end of its interest rate hiking cycle, it is possible that rates have hit or are close to hitting a peak and therefore, multiples should be close to or at a trough. Again, referring back to my prior comments, while one would expect multiples to be given lower -- to be lower given interest rates are higher. Why is it that the only small cap -- why is it that the only indices, the small-cap universe has lower multiples, why every other asset size company has higher multiples based on its 25-year average. That is completely in congruent. Slide 16 shows flows and different EPS for 2023. Never underestimate the effect of flows of investor capital on the value of public market assets, especially equities. As you can see above, there was $5.1 billion of inflows into the iShares core S&P 500 ETF and the Vanguard S&P 500 ETF, while at the same time, there was a combined outflow of $1 billion from small-cap loans. In the case of the Russell 2000 value ETF, the outflow has been a staggering 11.4% of the entire asset base. There is almost no question that the price dislocation that we have seen in the small-cap universe is a direct result of indiscreet selling by ETFs and other funds facing redemptions Again, this trend is normal for equity market bottoms, not tops. Slide 17 shows U.S. indices returns by size. And in this chart, you can see the effects of the outflows on specific performance of stocks based on size. During September 30, 2023, there is a historically large 3,000 basis point disparity between small and large industries. I've yet to see that in all my career of investment. Slide 18. What is -- the most important explanatory power, sorry about that, over long-term returns for an index. We have long stated that the price you pay for the business you buy is a key factor in determining one ultimate success in our investment -- if you buy a good business at the wrong time, you may lose money. If you buy a less than good company at the right time, you may make money. The above chart was published by Bank of America and shows that while valuations tend to be a poor short-term timing indicator, they do matter for longer-term returns. Note that this chart represents the relationship between the relative PE for the Russell 2000 versus the Russell 1000 and subsequent rolling return differentials. Simply put, valuation has the highest explanation power over long-term returns. And we know today that small caps are historically attracted using that metric. And finally, on Slide 20, the above chart above and commentary below is again attributed to Royce's investment partners. I love any statistic, which has a 100% success rate and this one does. Small caps historical return patterns show that below average return periods have been followed by those with above-average return periods with a much lower than average frequency of negative return periods. Specifically, the Russell 2000 had positive annualized 3-year returns 100% of the time. That is in all 86 period, averaging an impressive 17.5% following 5-year periods of less than 5% annualized returns. At the same time, 5-year returns had positive annual returns, 100% of the time that is in all 81 period, averaging 14.9%. So while the future may be different than the past, it's hard to ignore this trend given its accuracy to date. We can debate opinion, but we can't debate the facts. Every chart depicted above shows historically low valuations and significant underperformance for small-cap stocks. While -- we are very comfortable with our view that our stocks have discounted a lot of bad news that quite simply has not occurred in 2023. Maybe the news will come next year and maybe they won't. Either way, we expect the management teams of the companies we own to adapt to whatever environment we are in, and we will use our collaborative and collegial activism need be in an effort to unlock value for all our stakeholders. We are not naive enough to not be aware that there are bar cases for why small cap companies will underperform for the next decade. I am sure there are myriads of investors who have charts that bolter their bearishness. I've often told you that the price you pay for the business you buy is the first and key factor in determining whether or not will be ultimately successful in that particular investment. It would be an understatement at this point to say that we make -- that we own many companies whose stock prices and valuations, we believe, materially understate the true values of those businesses. The starting point is price, and we believe the price is right for the potential for material upside in our portfolio. If you believe I'm right, you should own turn in your portfolio. If you don't, then you shouldn't. I currently own 680,000 shares and Daniel currently owns 229,000 shares. You can certainly expect that our ownership levels will continue to grow in the future through open market purchases. One day, I hope to be able to reference this call at the bottom. As always, thank you for your support. I'll now turn the call over to Daniel.

Thank you, Kevin. Please turn to Slide 22. While many of 180 degrees current portfolio companies have generally been swept up in the recent vicious market selling, particularly for microcap companies. We do not believe the businesses and the balance sheets of many of these holdings reflect the distress that their falling stock prices indicate. This slide provides examples of some recent announcements from our portfolio companies that show -- that clearly show in our view is that these companies are continuing to execute on their business plans, and we believe are set up well for value creation for their shareholders, including 180 Degree Capital. For example, Potbelly announced a new shop development agreement for 36 shops and 4 refranchise shops that brings its new contracted franchise shops to 150. It also announced record average unit volumes and continued growth in shop-level margins and gain in market share. Synchronous sold its noncore assets and now is a pure-play cloud service company that is currently expected to generate material positive free cash flows and 25% EBITDA margins in ’24. Arena Group signed the definitive agreements to merge as Bridge Media, a company owned by the founder and owner of 5-Hour Energy that will result in a combined company with 100 owned and affiliated stations open top partnerships across 46 states on top of the assets that Arena brings to the combination. Intevac is in the final stages of certification for its New Trio tool with its partner, Corning. Lantronix announced that it’s beginning volume production of a smart meter products for grid parties or e-mail that is expected to drive 30% plus organic growth and material profitability in 2024. In summary, these are all positive news for each of these companies. While our performance has been challenged over the past 7 quarters after 5 years of strong performance. The notes above are just a portion of the reasons we believe our portfolio is positioned well for the creation of value for shareholders in '24 and beyond. We will use this period to ramp up our collegial and constructive activism. We are keenly aware that hope is not a strategy, activism is. As Kevin noted earlier in this call, and we announced in the press release yesterday, 180's Board has initiated the discount management program with an initial 2 measurement periods beginning January 1st of ‘24 to the end of '24 and January 1st of ‘25 to June 30th to '25. Should 180 Capital's common stock traded an average daily discount to NAV of more than the current average trading discount of other equity closed-end funds, which is about 12% during either of these measurement periods, then 180 Degrees board will consider all available options, including, but not limited to, significant expansion of our buyback program, where one repurchases stock through open market trends, cash distributions in the forms of dividends or returns of capital depending on in your gains or a tender offer where shareholders will be able to decide if they wanted to sell a portion of their holdings back to 1.80 at a price per share that is set by 1.84. To be clear, any decision regarding actions taken at the end of each measurement period as a result of this program remains with the 180 Capital's Board and has not been made today. We believe that the existing food program and its associated measurement period demonstrates the continued focus of both 180's board and management team on taking active steps to minimize any persistent discount in 180 share price. In the future, 180 may or may not determine to extend the program beyond June 25. During these measurement periods, as Kevin mentioned, we fully expect the management will continue to purchase Turn stock in the open market. To be clear, and I reiterate what Kevin said, the most important thing we can do is find investments to materially increase value to that NAV -- as a result, NAV increases from its current values. Our -- we believe that we will have the most impact -- that will have the most impactful effect and positive effect on term stock price and returns to our shareholders. Lastly, I would like to note that we included the slides we normally present these calls in an appendix at the end of the slide deck on our website. We're not going to discuss them on today's call, but we'd be happy to answer any questions on them any time. We would now like to open the line for questions.

[Operator Instructions] [ Oliver ]? Okay. Sorry, we'll move to our next question. [ Dennis ]?

Sorry. Since there's been a large decrease in the value of AgBiome short period of time, could you please just go over what happened there?

Yes, [ Dennis ]. I'll be happy to provide some additional detail. As you know, the venture industry is in somewhat of disarray, especially with follow-up financings of later-stage companies. AgBiome raised a significant amount of capital in it was just ‘21 or ‘20 -- and they have a business that requires a substantial amount of capital to continue operations. They embarked on a concerted effort with a bank to raise capital and thus far, that has not been successful. There were indications that they -- in mid-year year that they were making progress on that effort. We did actually -- the valuation has come down significantly since the beginning of the year, reflecting both status of their business as well as the financing environment. And recently, they also put out a press release or in process that to a government filing regarding the potential they may need to downsize. And so our valuation reflects the risks that the company now faces in light of not being able to raise capital at this time.

I would add that this is exactly why we are not in that business anymore. We were too small. We did not scale. We had no controlling stakes. We couldn't control outcomes and as a result, what you've seen since basically, I came out of retirement to do this with Daniel is that we've had over $20 million worth of losses in that portfolio since we arrived because we can’t affect outcomes. And what you get in this kind of environment is when companies need to raise money and you're trying to raise money in this kind of environment, the valuations can get squeezed. So I have competed dead horse on this topic because I'm not -- I don't believe in constantly harping on the same thing over and over again, but it is true. I'm not sure we would be here today if we didn't change our stripes. We would have run out of cash and before to liquidate many of these holdings at prices that would have ended up, unfortunately, resulting in potentially term stock going away or Harris & Harris stock going away. So it's been a struggle to get to this point. We've never been able to make appropriate investment decisions or strategic decisions really until now because now 7% of our assets are in the strategy and in public companies that we can control. We have permanent capital so in a year like this year, while there are liquidations and people selling and tax loss selling, we don't have to sell. And so I'm not happy that we got to the end of our transformation with that volume getting written down this quarter, but it is what it is. I signed up for this when I got here in 2017, and it's over now. I don't have to worry about it anymore because like I said, 97% of the assets are on our public company. So we have other things to worry about, but the private portfolio is not one of those anymore.

Zach, go ahead.

Can you hear me?

Yes.

Great. I appreciate the conviction in the strategy and the cheapness of the asset class. I guess my question is, what, if anything, is the Board doing are you guys doing to help with the scale problem? So I see now we have a 5% risk free, you got a 5% expense ratio include these bonuses, and that's a big hurdle even if this asset class in your performance turns up. So I'm curious, is the Board looking at trying to find partners to merge into the possibility of a rights issue or anything else where you guys can actually act on the conviction for shareholder benefit because this hurdle seems very high for you guys to clear.

So I think you know that when we -- if you know, when we first got here, we meaningfully cut our expenses overnight. We moved out in Manhattan. We let a lot of people go, I don't have an administrative assistant. Our T&E budget got cut by 95%. We've done everything that we can do on an absolute level to reduce our expenses. And the ratio now is, to your point, it's dependent upon our ultimate level of assets. So a year ago, the ratio that you referenced was half of what it is because we had more assets. So as you would think, and we just had a Board meeting last week, the Board is actively engaged in discussing with management ways to increase our assets, whether that's our ability to fundraise on the outside, which we've done. As you know, we had a one gigantic pension fund that we managed that unfortunately has been redeeming because rates have gone from basically 0% to 5%. So their asset allocation strategy has changed. So what I think the peak than we had maybe $35 million or $40 million, $40 million in outside capital and they decided that they no longer want to own equities. There's nothing we could do about that. So we're always looking for ways to raise capital and we'll continue to do that, and from a strategic perspective, we're a public company, if somebody wants to own us, they can certainly give us call. I think you know we're shareholder friendly. We can certainly entertain merging with anybody to gain greater assets. But remember, a lot of those transactions have to be done in NAV because of the 40 Act funds require that other than -- because we have to get a shareholder vote. So those mergers between closed-end funds historically or BDCs has been you are far between. Daniel, would you…

Yes. I mean they're not very -- they don't happen extraordinarily often because of all the hurdles that Kevin mentioned the fact that most -- almost all of them trade at some level of discount, they can vary transactions would have to take place at NAV. And then you also have the issues that a lot of the externally managed to close-end funds, we've actually reached out this one of the externally managed funds because there's only 4 internally managed. And we reached out to some of the smaller ones to see if there is interest in maybe doing something and there's very little -- there's very little inertia for those funds and those managers to give up that management fee. And so it's -- those conversations really haven't gone anywhere, but we continue to explore a variety of different options. So the -- we're shareholder-friendly around here. I mean I don't own 700,000 shares for cannot create some not create value. I will say that despite the fact that in the last -- in our first 5 years, despite the fact that we had almost $3 a share of losses from our climate portfolio, we more than doubled our equity price. So it's not like we can't do that again. We can. And now we don't have the headwind that we had 7 years ago because our portfolio is all public companies at what we think are ridiculous prices. So our ability to meaningfully generate a return for our shareholders in the next 3 years is higher today than it was 7 years ago. But you can expect our Board to be actively engaged in all discussions around how to create value, whether that's inorganic growth or organic growth. Thanks, Zach. [ David ]?

Daniel, can you help us understand the discount management program, how it actually work? Is it at each quarter? And then you judge how far the discount is? And then what are you likely to actually do?

Yes. Thanks, [ David ]. So the way that we've designed it is really looking over a period -- the first period would be ‘24, and I think historically, if you look at 180, one of the big problems was that you didn't have -- you had all these privately held investments that were really hard to understand. And you had fair values, but you didn't know where they moved on a daily basis, and you didn't have a reference in the public markets. And so -- and also, you didn't have liquidity, right, that you could count on from those to be able to take any type of action that we're talking about. So we are now in a position from an asset base that we've never been in before. And so it will be interesting to see how the discount performs during that period. And so we'll be looking actively at that on a daily basis over the next year -- through the end of next year. And then at that point, the Board will determine what the steps are -- the first steps will be to address the discount if it's greater than 12%. The reason that the Board didn't lock in on something right now is because, for example, if you were to say we plan to tender at the end of a discount management program from the point when you see that to the point when you actually do the tender, you -- the company is not allowed to buy back stock, but even worse in our view is that management is not allowed to buy stock in the open market. So to basically restrict the management from, which I think is shareholder friendly from being able to buy stock in the open market and show their support and continue to increase their holdings of the company given we cannot issue equity as compensation. They were not allowed to under the 40 Act, that, that didn't seem appropriate. And then also, if you say all we're going to do a dividend or a distribution, well, the issue there is that depending on where we're at in year in terms of gains or losses, if we were in a gain position, then that return -- that distribution could be a dividend rather than a return of capital. And it also depends on if we're a rent or not regularly investment company for tax purposes or if we end up being taxed as a C-Corp. So there's a lot of complexities in there to lock in what will happen at the end of the first measurement period. But I think you can be confident that everyone is aligned to have the discount be as narrow as possible and to generate as much value for shareholders as possible. Kevin, is something you want to add?

So one, we got to find just like we have done for the first 7 years, not expand in the last 7 quarters, find companies whose stock prices materially rise. Our NAV will rise on an absolute basis. The most important thing we can do. I've said it in 27 quarters that you do here that the discount should be narrow or if you've got more liquid public transparent balance sheet, of public companies versus what we have when we got here. And if that's not the case in a year, then we need to take action on the discount. But again, that's just -- and if people want to potentially think we're going to tender at a 5% discount or something like that, then they can orbit. And the discount is going to narrow between now and then. And we're serious about creating value for our shareholders on an absolute basis and we're also serious about the discount. We're serious about both. And so we'll make sure that in a year's time, we'll look at it and see if my thesis is right. In other words, we should trade at a narrow discount because everyone understands what our NAV is on a regular basis versus what they thought they thought the NAV was before. I mean, anybody could have valued our product. I mean we got our privates properly, but I think it was hard for investors to really understand what we own. So we'll look at it in a year, and then we'll look at it 6 months from now, and we are serious about it.

I think that is the end of the call.

So thanks, as I said earlier, this -- we went -- did a little different way of doing this call where you can look at the appendix at the end of our presentation to get a full understanding for the quarter. We do think this is a unique time in the marketplace for what we do for living, both in terms of the indices and the names that we own to Daniel's point about Hope is not a strategy. We are not going to sit around and hope for eventual outcomes. I think you'll see over the next few weeks, few months, how we will engage with the companies that we own to hopefully create value for their shares and as a result, create value for Turn shares. So we look forward to speaking with you when we report Q4, we wish you nothing but the best of investing for the next 1.5 months, and we'll speak to you in a few months. Of course, if anybody has any questions that they want to discuss about this quarter, the program that we announced this morning, feel free to reach out.

Thank you all very much. You can now disconnect.