Quarterly Letter — Q2 2022
Dear Owner Partner —
Given the commercial success of the Top Gun film franchise, by now everyone knows who fighter pilot Pete “Maverick” Mitchell is. But do you know who the original, real-life Maverick was?
John “Forty-Second” Boyd.
During the 1950s, Boyd was an instructor at the Fighter Weapons School, the Air Force’s advanced tactics school that the Navy’s Top Gun program was later based on. While there, he became an elite fighter pilot and laid down a challenge to all students, Air Force, Marine and Navy pilots, and pilots from a dozen countries attending the FWS. Boyd’s challenge was this: he would maneuver from having you on his “six” to being on your six and winning the battle in less than forty seconds. It only ever took him twenty seconds, and Boyd never lost. Ever.
Boyd did extraordinary things, including designing fighter aircraft (F-15, F-16 & F-18) and evolving how America dominated enemies in the sky. However, his most significant accomplishment is developing a theory of combat engagement that those who know say is the most significant contribution to warfare since Sun Tzu.
Vice President Dick Cheney, Secretary of Defense at the time, said Boyd was responsible for America’s swift and decisive victory in the Gulf war. In a tribute written after Boyd’s death, Marine General Charles Krulak described him as “A towering intellect who made unsurpassed contributions to the American art of war. Indeed, he was one of the central architects of the reform of military thought…From John Boyd, we learned about competitive decision making on the battlefield - compressing time, using time as an ally.” (I offer two sources for more detailed information on Boyd’s contributions. First, for those looking for a quick hit, here is his Wikipedia entry. For those interested in diving deeper into Boyd’s life, the book Boyd: The Fighter Pilot Who Changed the Art of War is incredible and a must-read!)
One of my favorite Boyd teachings is his concept of the dichotomy between “being somebody” or “doing something.” His unwillingness to tolerate institutional bureaucracy during his time in the Pentagon was legendary. As a result of continuously choosing to do the right thing for the good of the country over advancing his rank by kissing ass, he made many administrative enemies. He was never promoted to General despite his clear qualifications for the role. He would tell those working closely with him that:
“One day you will come to a fork in the road and you’re going to have to make a decision about which direction you want to go. If you go that way you can be somebody. You will have to make compromises and you will have to turn your back on your friends. But you will be a member of the club and you will get promoted and you will get good assignments. Or you can go another way and you can do something — something for your country and for your Air Force and for yourself. If you decide you want to do something, you may not get promoted and you may not get the good assignments and you certainly will not be a favorite of your superiors. But you won’t have to compromise yourself. You will be true to your friends and to yourself. And your work might make a difference. To be somebody or to do something. In life there is often a roll call. That’s when you will have to make a decision. To be or to do? Which way will you go?”
Here at North Beach, I believe the team and I have an overwhelming, all-encompassing desire to “do something.” I want our holding company to work for me, my family, you, my Owner Partners, our employees, our customers, and the communities we serve. I want North Beach to be a free cash flow engine and a vessel of awesomeness.
Speaking of the team, I am incredibly grateful Mike Foran is “doing something,” and helping to make a difference with us by becoming our new Chief Executive Officer!
As we mentioned in the early June announcement, this appointment is a huge step and will be massively positive for our organization. Mike is here to help grow free cash flow and the equity book value per unit of North Beach in ways Dillon and I cannot.
Most recently, Mike was Chief Operating Officer and Co-Founder of Market Garden Brewery. He brings over 17 years of deep operational experience, additional investment know-how, and a broad curiosity to learn more about our organization. As a member of our Advisory Board, Mike added big-time value to our operating companies and demonstrated extreme alignment with our core principles and values. As an example, he truly believes that incentives matter: similar to Dillon and I, his compensation will be 100% based on the operating results of North Beach and will not have a fixed salary component.
Since his start at the beginning of June and from now on, he has been focusing his time on three fronts: (1) operational oversight; (2) helping Dillon find, analyze, and integrate new companies; and (3) assisting me in outside capital raising and business development. Needless to say, but I will say it anyway: Dillon and I will continue to be 100% available to you and deeply involved in everything that is North Beach.
With all your support, Mike is ideally placed to lead North Beach with great energy and focus through its next development stage. He is here to make North Beach even better than it is today. We are very excited to see the results; you should be too.
Mike fully embodies our collective purpose and path forward: acquiring attractively priced, well-run small private and public essential service companies that can deliver free cash flow growth for a long time. Collectively, we believe there is no fundamental difference between owning an exceptional private operating company and owning the common stock of an outstanding public company. 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 important 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 second quarter holding company’s financial performance was unsatisfactory on the two most important metrics. First, we did not 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). Second, we did not achieve an adequate return on invested capital (NBH’s earnings adjusted for interest expense divided by the total value of equity and debt capital used in the business). It should be noted that our overall equity value grew slightly during the quarter, but the number of units grew somewhat faster after the first quarter distribution and subsequent reinvestment beginning in the second quarter. As a frame of reference, NBH’s -1% contraction in equity book value per unit during the quarter and 6% growth year-to-date could be compared to the S&P 500 Index’s -16% and -20% contraction in value during the first quarter and year-to-date, respectively. Similarly, our annualized 8% return on invested capital during the quarter does not compare favorably to the S&P 500 Index aggregate return on invested capital of 10%.
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. 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 believe we will be a better option over the long term.
PRIVATE OPERATING COMPANY UPDATE
Our collection of private operating companies had a more subdued (which means disappointing!) quarter in terms of profitability and free cash flow compared to previous quarters. Some of this resulted from things in our control (reinvestment) and other things out of our control (cost inflation). Nonetheless, our outstanding employees continued to deliver excellent service to our customers. We are grateful for their dedication and amazed at their daily ability to do what they do.
The collection as a whole - now under Mike’s guidance - is better poised for free cash flow growth as our market opportunities continue to grow, we achieve a solid return on our invested capital, and we double down on our cost control efforts.
Allow me to riff on some of the topics mentioned above:
Inflation - Our response to inflation is to do what we can control: never stop trying to be the best. As the best service provider of an essential service in a local market, we should continue to procure pricing power that can offset cost inflation. We are more or less seeing that in our operating companies.
For example, this year, ACN’s and S&S’s customer base completely ignored price increases.
We have not been as successful at Hart’s Ambulette, the best non-emergency medical transportation provider in the local rural market we serve. Fuel costs are a significant input and negatively dig into our profit margins. Outside of our Medicaid customers (which have a fixed state government reimbursement component unadjusted for cost inflation and a big part of our revenue base), we have been able to raise prices a bit to non-Medicaid payors (think nursing homes and individuals) but not enough to offset the increase in costs so far.
At Brahler’s Cleaning & Restoration, half of the business (disaster mitigation) is driven by property insurance reimbursement, which is excellent in this case. The property insurance industry (unlike governments) does an outstanding job overall to continually earn a profit and is quick to respond in inflationary environments. Unfortunately, the other half of the business - cleaning - does not have great pricing power even though we have a powerful brand in our local market.
Cost Control - The team and I recently read an incredible book with a silly title: Double Your Profits in 6 Months or Less(DYP) by Bob Fifer. Made famous by the incredible investment firm and long-term Berkshire Hathaway investment partner in Kraft Heinz, 3G Capital, this book is a practical how-to guide for attacking and reducing costs throughout an organization. We are now running “DYP” reviews at every operating company. The early results are promising, but we have a ways to go. Nevertheless, it is impressive how some attention and questions can reduce cost structure.
Reinvestment - Here is an excellent Warren Buffett quote from the Berkshire Hathaway 1994 Annual Meeting:
“There’s a huge difference in the business that grows and requires a lot of capital to do so, and the business that grows, and doesn’t require capital. And I would say that, generally, financial analysts do not give adequate weight to the difference in those. In fact, it’s amazing how little attention is paid to that. Believe me, if you’re investing, you should pay a lot of attention to it...Some of our best businesses that we own outright don’t grow. But they throw off lots of money, which we can use to buy something else. And therefore, our capital is growing, without physical growth being in the business. And we are much better off being in that kind of situation than being in some business that, itself, is growing, but that takes up all the money in order to grow, and doesn’t produce at high returns as we go along. A lot of managements don’t understand that very well, actually.”
In aggregate, our operating company collection throws off more cash flow than we can use for reinvestment internally. We ultimately will use that growing pile of cash to add new operating and public companies to our collection. However, from time to time, we identify ways to reinvest in our operating companies to tap new growth opportunities and make them more profitable.
At ACN and S&S Filter, we have identified big growth areas to invest in.
At ACN, we are investing in our filing agent platform in preparation for upcoming regulatory changes to the Form 13F filing requirements. This investment should help us increase our already top market share position and market penetration.
At S&S Filter, we have identified a massive opportunity in the biogas industry. As a result, we are materially increasing our employee base to capitalize. Of course, this will pressure profitability in the short term, but the long-term payoff should be significant.
At Hart’s Ambulette, we are investing in routing software that should improve our asset utilization and profitability.
More riffing: here are quick comments on each operating company:
ACN Solutions - Similar to “Forty Second” Boyd’s undefeated record in the sky, Spencer “Big Time Free Cash Flow Growth” Wirick continues to deliver free cash flow growth every quarter.
Brahler’s Cleaning & Restoration - Massive kudos to Stacy Ignacio, Brahler’s newly appointed President. She has the company’s culture in the best place it has been since we bought the company. We fully believe her work will lead to better financial results. Her work on improving gross margins is starting to pay off, and now she will turn her attention to improving operating margins to get the company right-sized and free cash flowing.
Hart’s Ambulette - In the face of nasty fuel cost headwinds, Kristy Summers, Hart’s President, continues focusing on long-term growth by signing up new transportation broker partners, pivoting away from unprofitable trips, and implementing the new routing software.
S&S Filter - After getting traction in hiring and growing the team, Dan Debellis, S&S’s President, is focused on the above-mentioned massive opportunity in the biogas service space.
New Private Company Pipeline
When Dillon Thompson is not bringing more awesome kids into this world (his second son, Milo, was born in June!) and working expertly to improve our operating companies’ operational profitability, he is working hard to find new, enduringly profitable, service companies for us to acquire. Today, his pipeline focuses on managed information technology, litigation support, and mobile drug testing service spaces. While we are currently negotiating two letters of intent with sellers, it is still too early to get more specific here. Nevertheless, we remain excited to learn from these incredibly talented entrepreneurs. They built unique businesses and are now looking for the 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 relative to standard benchmarks:
However, we are reminded of Warren Buffett’s golden investment guidance: “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.” We have not done an excellent job of following those rules in the short term. However, as a reminder, we don’t pay much attention to our performance or market indices over shorter periods. We fully believe we will add material value and outperform over long periods by owning public companies in our collection, which have 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 paid for our shares skewed materially in our favor.
Our largest public position in the collection coming into the second quarter, Points.com Inc. (previously undisclosed), was acquired by a private company in the global travel loyalty industry in an all-cash transaction that closed June 30th for a reasonable price and positively contributed to our outperformance in all periods. Kudos again to Spencer, also serving as our Director of Public Company Research, for hitting another home run (the total return for our ownership over 1.75 years was well over 150%). The only downside is this may force us to deploy a considerable amount of cash into public companies that may not have the same potential for capital appreciation. Spencer’s job is never done!
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 are still building our positions. In most cases, these are illiquid, “trade-by-appointment” situations in very small public companies.
We continue to remain relatively unexcited with the aggregate public company investment opportunity set because the broad public company market valuations are 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 2021. Today’s valuation level, however, is still nowhere near the outstanding valuation levels between 2008-2011:
Call us weird, but we get really excited when public 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 be ready to add new companies to our collection that make long-term investment sense given a practical and tight circle of competence.
…
Choosing how you spend your time and who you do it with are incredibly important decisions, e.g., your spouse and your career. I love working on growing the equity book value per share of North Beach all day, every day. I am blessed with incredible partners who are focused on creating a best-in-class investment holding company for you, our owner partners. 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 how we will “do something” in the spirit of John Boyd.
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.