Quarterly Letter — Q4 2022
Dear Owner Partner —
I will let you in on my deep, dark secret that would horrify the average Clevelander.
I don't follow, know anything useful, or particularly care about professional conventional (football, baseball, and basketball) sports despite living in a "sports town." I never have and probably never will (but I do follow some non-conventional professional sports, i.e., F1, snowboarding, skateboarding).
This admission may be shocking for those who know me. You may have heard me sound somewhat "in the know" during these conversations. But you should know that my son assisted me as a co-conspirator. I rely on him to give me key talking points before I hang out with people really in the know or when I need to attend sporting events. He is an expert and can quickly distill down key trends and players for me.
Of course, I pay attention when things or athletes jump from professional sports into mainstream culture. Michael Jordan is a great example. While I don't recall ever watching him play in real-time, I know of his legend in basketball and retail arenas. His "brand" was everywhere while I was growing up during the 80s and 90s (except at my house because I could not afford the shoes!).
I never knew much about Jordan the person until my best friend and best book recommender recommended that I read Michael Jordan: The Life by the great sportswriter Roland Lazenby. After reading the book, I can't stop thinking about Jordan's next-level/out-of-this-world competitiveness, mental toughness, loyalty, and devotion to craft. Anyone who wants to compete effectively or improve their vocation can learn something from Jordan's process and approach to playing basketball.
One of the most interesting things about Jordan's economic success is how his Nike shoe deal came together. Before he even played a second of professional basketball, he signed the largest - by far - shoe deal in the history of sports at the time. Nike's standard deal terms were giving pros $10,000 or so a year to wear Nike basketball shoes (only one player, Kareem Abdul-Jabbar of the Los Angeles Lakers, was thought to be making even $100,000 a year from his shoe deal). In Jordan's case, Nike took their whole budget for the 1984 season and gave it to him along with a massive 25% royalty on every Air Jordan sold! From Nike's perspective, it was a massive bet on Jordan's future; from Jordan's perspective, it was a huge bet on Nike's commitment to his future. And don't forget - in 1984, Nike was big but not the financial behemoth it is today.
From my perspective, the deal perfectly exhibits the two sides going "all-in" for a "win-win" outcome. No surprise that Jordan's shoe deal is still in place and thriving today.
At North Beach, we work extremely hard to achieve those two ideals daily. Whether with our employees, customers, or you, our Owner Partners, we try our best to structure each relationship so that we go all-in for win-win situations. As a reminder, both Dillon (our Director of Private Investments) and I have gone all-in: almost all of our families' investment capital is aligned with your investment in North Beach. As a result, we have something material to lose that should optimize our behavior favorably, and there is no conflict of interest. Furthermore, all key employee compensation packages are built around material incentive-based plans. As a result, we all win (or lose) together.
Our number one concern - above all else - is our employees, and we want them all-in in a win-win culture. But, unfortunately, one of the most significant blind spots in business and investing is a company focusing too much on superior returns and not enough on the all-in, win-win relationships with their most crucial counterparty: their people and the inherent culture.
We believe our intense focus on employees and culture helps North Beach lower risk and become "longer duration."
Importantly, we made progress on this front in 2022. We did a better job getting the right people in the right seats and the bus moving faster in the right direction. Within our organization, trust, security, caring, fairness, and reciprocation became more self-evident; as a result, our culture improved. Every day, we strive to go all-in and improve continuously to make working at North Beach or one of our operating companies so good that there is no alternate option for our employees; a true win-win situation. Today we recognize that we remain imperfect and still have a lot of vital work to improve culture in 2023.
KEY INVESTMENT "WAVES" STILL IN PLACE
As we mentioned in past letters to you and as a point of review as we start the new year, our investment process attempts to ride three huge waves into the future.
Private Company "Supply-Side Shock" Wave
The first focuses on what the U.S. Small Business Administration calls the most significant intergenerational transfer of private companies in history – worth an estimated $10 trillion changing hands over the next ten years. There are 33 million small businesses (defined as those with less than 500 employees) in the U.S. Many private companies are valued at less than $5 million and owned by folks over 55.
Some of these baby boomer owners are "distressed" sellers. No, they are not bankrupt or going in that direction. It is quite the opposite. These folks own very financially viable businesses. However, they must sell due to forced retirement (by their spouse who wants them to relax or move to Florida or both!) or health reasons and do not have a succession plan. Their children do not want their business, and/or there is no employee or group of employees with the financial wherewithal to buy the company. Sophisticated professional buyers (e.g., private equity firms) are primarily interested in private companies valued at $5 million or more. There are not enough qualified individual buyers for companies valued at less than $5 million. As a result, these small companies are being sold at very compelling valuations compared to the broader U.S. stock market measured using free cash flow yields (higher, the better):
We want to ride this long-term selling wave by buying competitively advantaged small private service businesses that fit our investment criteria.
Public Micro-Cap Company Valuation Wave
Another wave we want to continue to ride is the relative value opportunity in micro-cap and small-cap public companies compared to large-cap public companies. The orange line in the chart below simply shows the price ratio between the Wilshire U.S. Micro-Cap Index (a collection of the smallest public companies in the U.S.) and the Wilshire U.S. Large-Cap Index (a group of the 750 largest companies in the U.S.):
When the line is moving up, micro-caps are outperforming/large-caps are underperforming, and vice versa. Like a lot of trends, the ratio exhibits a "reversion to the mean" tendency and has shown three distinct phases since the mid-1980s: (1) after peaking in July 1983, micro-caps underperformed large-caps until February 1999 during the Dotcom Internet Bubble; (2) micro-caps then outperformed large-caps through March of 2006; (3) since then, micro-caps have underperformed. Some day we may enter a new phase, and micro-caps may outperform large-caps. We want to own high-quality small public companies and ride this wave.
Compounding Wealth Wave
The most powerful (and unending) wave we want to ride is what Albert Einstein reputedly called "the 8th wonder of the world" = the power of compounding our investment capital. Our investment hero, Charlie Munger, said, "the elementary mathematics of compound interest is one of the most important models on earth." However, the human brain has difficulty comprehending compound growth, also known as exponential growth. A simple exercise: if you invest $1 at 10% for five years, you will end up with $1.61. If you invest $1 at 10% for ten times as long (50 years), you do not end up with $16; you end up with $117.40!
As part of our investment process flywheel, we want to continually reinvest as much of the free cash flow we receive from our investment holdings as possible to grow equity book value per unit and compound our investment capital for decades to come:
ENDURING PATH FORWARD
Tis the season for new year resolutions and creating goals and plans and such. But here at North Beach, we don't do those things. Instead, we channel Henry Singleton, the co-founder of Teledyne, Inc. and one of the all-time best capital allocator CEOs (curious? Check out the classic book, The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William Thorndike). His response to a question from a journalist about his master strategy for Teledyne was classic:
"My only plan is to keep coming to work every day. I like to steer the boat each day rather than plan ahead way into the future. I know a lot of people have very strong and definite plans that they've worked out on all kinds of things, but we're subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible."
We have no master strategic plan or need to proceed in some ordained or conventional fashion. We work daily to improve our investment, operating processes, and culture. By remaining flexible and keeping our investment and operating options open, we decide what makes long-term sense to try to grow equity book value per unit for you, our Owner Partners. Maybe the closest thing we have to a plan is that we would like to buy at least one private operating company per year. We did not do that in 2022 and are perfectly ok with that outcome because we abide by the discipline our process enforces.
As a result of all this, we spend time focusing on the things we can control and not the stuff out of our control, like macroeconomics, geopolitical machinations, or the volatile price of commodities. The future outcomes of those things are important but unknowable. We are not macroeconomic pundits, geopolitical scientists, or commodity strategists. We don't focus on predicting the direction of inflation or interest rates, the outcome of wars, or where the price of tradable but not investable commodities will be in the future. Those pursuits are a waste of our time.
Howard Marks, co-founder and co-chairman of Oaktree Capital Management and one of our favorite investment thinkers and authors (his intermittent memos and his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, are must-reads), recently channeled the same theme in his must-read memo, "The Illusion of Knowledge:"
"In order to produce something useful – be it in manufacturing, academia, or even the arts – you must have a reliable process capable of converting the required inputs into the desired output. The problem, in short, is that I don't think there can be a process capable of consistently turning the large number of variables associated with economies and financial markets (the inputs) into a useful macro forecast (the output)."
For us, it is more beneficial to try and understand what is happening now in the areas we can control. We are business analysts and operators and stay within our tight circle of competence. We focus on finding outstanding small private and public service companies at sensible prices - not mediocre companies at bargain prices. We work hard to understand them deeply from the bottom up and allocate capital accordingly. We then strive to operate our owned private companies well and be an excellent partner to our owned public companies.
Our path forward endures. Again: acquire, operate, and partner with attractively priced, well-run small private and public service companies that can deliver free cash flow growth for a long, long time. There is no fundamental difference between owning an exceptional private operating company and owning the common stock of an exceptional public company. We protect, enhance, and deploy our hard-earned and sacred permanent capital in a durable, concentrated, and differentiated collection of superior service companies. These companies are run by able and honorable entrepreneurs with important and unique long-term competitive advantages, so free cash flow earnings are likely to be materially higher many years from now.
HOLDING COMPANY UPDATE
Since our last report to you, we have finalized (finally!) our private operating company's "mark-to-market" quarterly pricing policy and procedure. Please note, on reports to you in the past, each private operating company's asset carrying value on our balance sheet did not change since purchase. Starting this quarter and each quarter in the future, we will adjust the value of each private operating company by simply multiplying the trailing two-year (then two-and-a-quarter-year, then two-and-a-half-year, and so on) average adjusted earnings value by the multiple of earnings we paid at the time of purchase (between 3-4 times for each company in the collection). Once we achieve a three-year track record in 2024 for each private operating company, we will use a trailing three-year average adjusted earnings value from that point forward. Our policy states that we will not change the adjusted earnings multiple used unless the very small private market multiple (shown in the private company valuation table above) materially changes or our private operating company grows into a different size category.
Please note that we delayed implementing a private operating company pricing policy and procedure to better understand the underlying volatility of the collection's financial performance. We wanted to create a very conservative pricing policy that was accurate, robust, and, most importantly, fair to both you, our Owner Partners, and us when serving you as Managing Member.
Incorporating the above policy and procedure, our fourth quarter and since inception financial performance was, on the whole, satisfactory on the two most important metrics we track. We achieved growth in equity book value per unit (the increase in NBH's equity value, which is assets minus liabilities, divided by the number of outstanding NBH membership units). We also achieved our targeted return on invested capital objective (NBH's earnings adjusted for interest expense divided by the total value of equity and debt capital used in the business).
As a frame of reference, NBH's 6% growth in equity book value per unit during the quarter and 82% total growth (35% compounded annual growth) since inception (01/01/21) compares favorably to the S&P 500 Index's 8% quarterly return and 5% total growth (3% compounded annually) since inception. It is important to note that a rough since-inception performance attribution shows equal contributions from the underlying cash operating performance of the private company collection and their aggregate unrealized gain in overall value. The public company collection had a minimal positive performance contribution, given its small relative size to our overall asset base.
Additionally, our annualized 32% return on invested capital during the fourth quarter does compare favorably to our 20% objective and the S&P 500 Index aggregate return on invested capital of 10%. Alternatively, an even more straightforward way to characterize our performance since inception: your holding company received cash dividends from the private operating and public companies, equating to 57% of our aggregate purchase cost.
On the one hand, these comparisons to the S&P 500 Index are somewhat forced: our asset collection is primarily small private companies with a small allocation to public companies vs. the S&P 500 Index of large public companies. But, on the other hand, you choose how to allocate your capital, and the S&P 500 Index, as an investment option, could be considered your most practical and best alternative.
We continue to believe we will be the better option over the long term though we expect our growth rate to slow in the future.
PRIVATE OPERATING COMPANY UPDATE
Our outstanding employees once again delivered excellent customer service throughout the quarter and 2022. We are grateful for their dedication and amazed at their daily ability to do what they do day in and day out. We appreciate their commitment and "all-in-ness." Hats off to our operating company Presidents and both North Beach CEO Mike Foran and "Chief of Staff" Nikki Salas for continuing to improve our culture. As a result, our collection of private operating companies also had a satisfactory quarter and year in terms of profitability and free cash flow. In addition, our collection successfully navigated a challenging macroeconomic environment (e.g., inflation and slowing pockets of business activity here and there).
ACN Solutions
Spencer Wirick, ACN's President, and his team executed all year with a consistent playbook of price increases, cost cuts, and marketing investment. As a result, ACN delivered a record number of filings on the SEC"s EDGAR system and better than 20% growth in both revenue and free cash flow. The simple plan for 2023 is more of the same.
Brahler's Cleaning & Restoration
After a rough start to the year on many fronts (uneven financial performance and heavy personnel turnover), Brahler's second half of 2022 performance was one for the record books. Stacy Ignacio, installed as President at the very beginning of Q3, and her team fielded a record number of emergency "loss" calls in both Q3 and Q4 (the polar vortex freeze fest during Christmas was a huge boon for business). In many cases, these calls came way after hours and on holidays when most of us slept soundly or had fun. The Brahler's team deserves a massive shout-out for their execution, teamwork, and culture awesomeness in 2022. As a result, the company put the best two-quarter performance together in terms of revenue and free cash flow in its history.
As mentioned last quarter, Stacy champions self-improvement via career advancement by pushing her team to get IICRC certifications (Institute of Inspection Cleaning and Restoration Certification, the certification and standard-setting organization for the inspection, cleaning, and restoration industries). In 2022, the team obtained 19 additional certifications and has plans for more this year.
Hart's Ambulette
After a challenging fuel cost environment for most of the year, last year finished strong with record free cash flow in Q4. This outcome resulted from the most significant business model change in the company's history. As the premier service provider in its local economy, the company drastically reduced its lower-profit trips and now focuses on higher-profit trips after raising prices. Hart's President, Kristy Summers, executed this transition beautifully in the second half of 2022. By design, this resulted in a lower trip count, lower loaded miles driven, and lower revenue, but increased gross profit.
Kristy's successful effort to maintain a daily presence in key areas and add new, more profitable trip broker accounts is critical to this shift. In addition, Kristy continues to work on new "old school" marketing strategies that support and grow business activity.
S&S Filter
Despite flattish revenue growth in 2022, profit margins improved due to a focused effort on cost control in the second half of 2022. In addition, the company's municipal water plant and landfill divisions were solid last year. Still, the industrial segment - the most economically-sensitive portion of the business - was softer than initially expected. The team has several sales & marketing initiatives underway, which should start to bear fruit in 2023.
Additionally, at the end of the year, we decided to part ways with the company's President, Dan Debellis. We thank Dan for his incredible work and drive, taking S&S Filter from our initial acquisition to the potential growth machine it is today. We wish him well in his future endeavors. In the meantime, the management bench is deep: the S&S operating legend and the original "OG," Jon Eash, is masterfully running the show in the interim until we find a permanent leader.
New Private Company Pipeline
Dillon Thompson, our lead man on all things private companies, focuses 100% of his time and energy on finding extraordinary, enduringly profitable, niche service companies for us to potentially purchase. As a result, our pipeline opportunities have never been more exciting and rich; however, the number of potential targets has dropped since the summer of 2022.
Today the "Power Ranking" top three in his pipeline are as follows:
(1) An industrial service company with great assets and personnel that would be a complimentary add-on to S&S's industrial service line of business. We believe we made a successful indication of interest and are now looking forward to executing a dual-signed letter of intent soon.
(2) A landfill compliance service company; this is an industry we have some expertise in given our experience with S&S Filter (one of their primary end-markets and growth massive growth opportunities is servicing the biogas filters landfill operators use to recover natural gas); however it would not be an add-on company for S&S's biogas segment.
(3) A grant and loan management software and service company providing monitoring, inspection, compliance, and portfolio management solutions to the public service sector.
It should be no surprise that all the companies mentioned above adhere to our checklist: they provide essential niche services, have high recurring revenue, and are divorced from the economic cycle.
While we are not yet in the "Letter of Intent to Purchase" phase for any of them and thoroughly understand the very low base rate of successful acquisitions, we remain excited to learn from these incredibly talented entrepreneurs. They built unique businesses and are now looking for proper transition plans and suitable homes for their companies. We hope to help them.
PUBLIC COMPANY INVESTMENT UPDATE
Our public company collection total return performance compares favorably to standard benchmarks:
Though our aggregate public company collection is down in market value over the trailing twelve months, we don't pay much attention to our performance over short periods. We fully believe we will add material value by owning public companies with the following attributes:
(1) Broad insider ownership where the management teams we partner with are aligned with us on a very long-term basis;
(2) Impeccable balance sheets for maximum financial flexibility;
(3) High and stable returns on invested capital;
(4) Long-term revenue growth runways; and
(5) Most importantly, the trade-off between durable competitive advantages and the price we paid for our ownership is skewed materially in our favor.
In 2022, we connected with our company management team partners via one-on-one meetings, attended annual general meetings and investor days, and enjoyed hearing each team's capital allocation approach. For the most part, since inception, our partners have carried themselves admirably and allocated capital intelligently. Most teams are reinvesting capital at high rates of return, and some actively buy back company shares at desirable discounts to intrinsic value. The teams were also open and responsive to our simple feedback on this front, though some more than others. Of course, we have made mistakes in assessing some management teams' ability to be rational and do the right thing. In those cases, we have sold our full positions and moved on (sometimes at a loss).
We continue to remain relatively unexcited with the aggregate public company investment opportunity set because the broad public company market valuations are still too high based on our preferred valuation metric: free cash flow yield (total dollars left over after company expenses and maintenance capital investments divided by the total enterprise value for all of the companies in the S&P 500). That said, the S&P 500 Index's free cash flow yield has improved some compared to valuation levels since the beginning of 2022 (as shown in the chart above). Today's valuation level, however, is still nowhere near the attractive valuation levels between 2008-2011 or even the depths of the pandemic sell-off in March 2020.
Call us weird, but we get really excited when public company market values go down so that we can acquire outstanding companies at great prices. We are increasing our time devoted to public company research to add new companies to our collection that may make long-term investment sense given a practical and tight circle of competence.
Other than our positions in AmerisourceBergen Corp, Berkshire Hathaway Inc., Criteo S.A., and Graham Holdings Company, we will continue to refrain from publicly identifying the other eight companies in our collection since we may add to our positions at any time. Sometimes, these are illiquid, "trade-by-appointment" situations in very small public companies.
…
After a solid year in 2022, we plan to continue to come to work every day to improve three things: (1) our investment and operating processes; (2) improve our culture to get to the "all-in"/" win-win" model set by the Nike + Jordan partnership; (3) grow the equity book value per unit of North Beach all day, every day, in any way possible. We will push hard on our investment strategy's self-sustaining flywheel, which is simply owning enduringly profitable companies that generate free cash flow that we will use to own more and more enduringly profitable companies that generate more and more free cash flow. This effort is our purpose and our indomitable will.
As always, thank you for your continued ownership of North Beach Holdings.
Best regards,
Russell P. Moenich
Executive Chairman, North Beach Holdings
President & Chief Investment Officer, RPM Capital LLC (North Beach Holdings LLC's Managing Member)
Disclaimer:
The views expressed represent the opinion of RPM Capital LLC (RPM) and North Beach Holdings LLC (NBH). The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment.
Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While RPM and NBH believe the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and RPM's or NBH's view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance, or events may differ materially from those expressed or implied in such statements.
Forward-Looking Statements:
Certain statements in this communication constitute "forward-looking statements" within the meaning of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended (the "Acts"). Any statements contained herein that are not statements of historical fact are deemed to be forward-looking statements. The forward-looking statements in this presentation are based on current beliefs, estimates, and assumptions concerning the operations, future results, and prospects of RPM, NBH and its operating companies. As actual operations and results may materially differ from those assumed in forward-looking statements, there is no assurance that forward-looking statements will prove to be accurate. Forward-looking statements are subject to the safe harbors created in the Acts.
There are a number of important factors that could cause our results to differ materially from those indicated by such forward-looking statements, including, among other factors, risks inherent in private equity investments, competitive markets for investment opportunities, no assurance of profit or distributions, illiquidity of investments, economic and market risk, inflation and interest rate risk,lack of liquidity, lack of diversification, and conflicts of interest.
RPM and NBH undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information or future events.
Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. Past performance is not an indication of future results.
This letter does not contain all the information that is material to a prospective investor.
Not an Offer – The information set forth in this letter is being made available to generally describe our investment outlook and process. The letter does not constitute an offer, solicitation, or recommendation to sell or an offer to buy any securities, investment products, or investment advisory services. Offers are made only to accredited investors by a confidential offering memorandum and related offering materials, which will contain important disclosures regarding the terms and risks of investment, and in accordance with the terms of all applicable securities and other laws. To obtain further information, including a confidential offering memorandum, you must complete our investor questionnaire and meet the suitability standards required by law. The information published and the opinions expressed herein are provided for informational purposes only.
Not Advice – Nothing contained herein constitutes financial, legal, tax, or other advice. RPM makes no representation that the information and opinions expressed herein are accurate, complete, or current. The information contained herein is current as of the date hereof but may become outdated or change.
Risks – An investment in NBH is speculative due to a variety of risks and considerations as detailed in the Confidential Private Placement Memorandum dated April 2022, and this letter is qualified in its entirety by the more complete information contained therein and in the related subscription materials.
No Recommendation – The mention of or reference to specific companies, strategies, or instruments in this letter should not be interpreted as a recommendation or opinion that you should make any purchase or sale or participate in any transaction.