Quarterly Letter — Q3 2022
Dear Owner Partner —
I made an incredibly bold statement in our 2021 first quarter letter to you where I said the 1995 film Heat, directed by the great auteur Michael Mann, is the greatest film of all time. In the film, Robert De Niro stars as Neil McCauley, a rational, high-level thief conducting heists around L.A. while chased by Vincent Hanna, a seasoned police detective played by Al Pacino. They are mirror images of one another with a singular existential focus on their respective crafts.
The debates that followed my proclamation were epic and heated (no pun intended!). But Heat is still the greatest film of all time, and nobody will convince me otherwise.
While I don't want to open up yet another can of cobras, I want to highlight another phenomenal scene in the film as it pertains to a topic I want to discuss.
In the second-best scene of the film (see it here!), McCauley and his crew are breaking into a highly secure vault at Investment Grade Metals, Inc., a precious metals repository located in industrial L.A. Using a powerful drill, McCauley's crewmate is drilling through the vault door, and, at the same time, McCauley stands in the shadows outside on watch. Hanna and his crew are all over them with big-time surveillance across the street in a fenced-off lot in the back of a parked delivery truck and on nearby rooftops. One of Hanna's police officers leans down in the truck and bangs his rifle against the interior truck wall. McCauley hears it and immediately senses something is not correct. He runs into the repository and calls off the heist despite being only millimeters and seconds away from a sizable payoff. Keeping to their process and discipline, they drop everything and walk. Hanna also adheres to his process and discipline and lets them go because they did not steal anything, and popping them on a two-bit breaking and entering misdemeanor is not worth it. Instead, he wants to take them down on something big.
Like McCauley and Hanna, we walked away from acquiring our fifth private operating company at the last minute this past quarter. Led by Dillon Thompson, our Director of Private Investments, our team spent countless hours examining the company's financials, operations, and personnel, only to decide to walk away from a great service company. In this case, the breaking point came during a final meeting with the selling company's owner before we signed a letter of intent to purchase the company. Without getting into too much detail, we learned new information contradicting previous information we collected, directly affecting the valuation multiple we would pay.
So we walked.
This has happened before, and it will happen again. However, it is very hard not to get emotional. After spending all that time and energy, it isn't easy to walk away. But, ultimately, it was the right decision on a gut check. The good news for us is our private company pipeline has never been better (see below for more details).
Following Warren Buffett's "price-is-what-you-pay-value-is-what-you-get" guidance as a critical part of our investment process and discipline, we never want to overpay for a company. Our definition of overpaying is paying a price for a company (private or public) without having an adequate margin of safety built into the purchase price. Suppose we don't have a sufficient margin of safety when something goes wrong, or our thesis does not prove out; we do not want to suffer a permanent loss of capital measured by selling below our purchase cost or the opportunity cost of better capital outlays.
Despite the setback, our purpose and path forward are built on our business model's resilience and our team's collective focus and energy. That purpose and path forward are acquiring attractively priced, well-run small private and public niche essential service companies that can deliver free cash flow growth for a long time. We believe there is no fundamental difference between owning an exceptional private operating company and owning the common stock of an outstanding public company. Therefore, we protect, enhance, and deploy our hard-earned and sacred permanent capital in a durable, concentrated, and differentiated collection of superior companies. These companies are run by able and honorable entrepreneurs and possess significant and unique long-term competitive advantages so that free cash flow earnings are very likely to be materially higher many years from now.
HOLDING COMPANY UPDATE
The third quarter holding company's financial performance was, on the whole, primarily satisfactory on the two most important metrics. We did achieve 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 did not achieve 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 1.5% growth in equity book value per unit during the quarter and 5% growth year-to-date compares favorably to the S&P 500 Index's -6% and -24% contraction in value during the first quarter and year-to-date, respectively. However, our annualized 10% return on invested capital during the quarter does not compare favorably to our 20% objective, although it does match the S&P 500 Index aggregate return on invested capital of 10%, mitigating the shortfall somewhat
On the one hand, this comparison is 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.
PRIVATE OPERATING COMPANY UPDATE
Our collection of private operating companies also had a satisfactory quarter in terms of profitability and free cash flow. Under new all-star CEO Mike Foran, the collection successfully navigated through a challenging macroeconomic environment (e.g., inflation and slowing pockets of business activity here and there). Tasked with a big "DYP" initiative ("Double Your Profits"/see our comments regarding cost control in last quarter's letter), the team improved the aggregate private company operating margin by attacking overhead costs and enhancing their mix of offerings with a focus on higher margin services. While we still have work to do here, it was an impressive win during the quarter.
As always, we value our outstanding employees who deliver excellent customer service. We are grateful for their dedication and amazed at their daily ability to do what they do.
ACN Solutions
Just when we think ACN could not be improved in terms of profitability, somehow Spencer Wirick, ACN's President, continues to deliver operating margin improvement on trailing four-quarter performance driven by both price increases AND cost control. In addition, Spencer has additional profitability enhancement strategies which he intends to pursue going forward.
Brahler's Cleaning & Restoration
In last quarter's letter, we predicted financial results here would improve. We were thinking of modest improvement over the coming quarters. However, Stacy Ignacio, Brahler's President, delivered the best quarter in the company's history (at least as far back as we can measure): a massive improvement in operating profitability and big-time free cash flow growth. Key to her free cash flow growth result is expanding the company's market share in both the fire loss and mold remediation categories.
Stacy's work during the quarter also included implementing a new project cost software platform, decreasing overhead costs (e.g., I.T. spending and office labor), and increasing field employees by three. Stacy also champions self-improvement via career advancement amongst the team by pushing her employees to get IICRC certifications (Institute of Inspection Cleaning and Restoration Certification, the certification and standard-setting organization for the inspection, cleaning, and restoration industries) with excellent results last quarter.
Finally, her work on getting the right people in the right seats on the bus continues to pay off in improving company culture. She remains hugely proud of her employees (and she should be!) and loves sharing examples of the organization's cultural excellence.
Hart's Ambulette
Kristy Summers, Hart's President, has stepped up to the challenge of the most significant business model change in the company's history. As the premier service provider in its local economy, the company has drastically reduced its lower-profit trips to focus on higher-profit trips after raising prices. This pivot has resulted in a lower trip count, lower loaded miles driven, and lower revenue, but it has maintained gross profit, which is a win. Over time this will reduce the wear and tear on our fleet and improve asset life expectancy.
Kristy's successful effort to maintain a daily presence in key areas and add new, more profitable trip broker accounts is key to this shift. In addition, Kristy is working on new "old school" marketing strategies that should continue supporting and growing business activity.
S&S Filter
Revenue growth during the quarter was solid, but profitability here was disappointing due to fewer higher-margin biogas projects and more industrial service work. Nevertheless, Dan Debellis, S&S's President, and the team delivered three non-financial wins during the quarter: (1) a new, upgraded safety program was rolled out; (2) great progress on new project cost and invoicing software implementation initiatives; and (3) meaningful improvement in old account receivable collections.
New Private Company Pipeline
One of the manifold benefits of bringing Mike into the mix as CEO is that Dillon can now focus more of his time and energy on finding extraordinary, enduringly profitable, niche service companies for us to potentially purchase. As a result, and as mentioned above, our pipeline opportunities have never been more exciting and rich.
Today the "Power Ranking" top three of his pipeline are as follows:
An industrial service company with great assets and personnel is located close to our own S&S Filter in Austintown, Ohio; this would be a complimentary add-on to S&S's industrial service line of business.
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.
A healthcare asset recovery service company operating in an obscure government niche that seemingly has the same business model qualities as ACN Solutions, which is very hard to find.
There should be no surprise that all three 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 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:
Our messaging based on Buffett's rules from last quarter bears repeating:
“The first rule of an investment is don’t lose money. And the second rule of an investment is don’t forget the first rule. And that’s all the rules there are.”
Though our aggregate public company collection is down in market value over the trailing twelve months, it continues to outperform the other indices. We don't pay much attention to our performance over short periods. We fully believe we will add material value and outperform over long periods 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 shares is skewed materially in our favor.
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. Today's valuation level, however, is still nowhere near the attractive valuation levels between 2008-2011:
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.
…
Despite walking away from a private company acquisition we were very positive about, we remain focused on growing 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.