Quarterly Letter — Q1 2021
Dear Friends —
The 1995 film “Heat,” directed by the great auteur Michael Mann, is my pick for the greatest film ever.
If you have not seen it, stop what you are doing immediately, watch it, and prepare to have your mind blown. I have seen it dozens of times at this point and take something new away each time. For the uninitiated, Robert De Niro stars as Neil McCauly, a rational, high-level thief conducting heists around L.A. while chased by Vincent Hannah, a seasoned police detective played by Al Pacino. The film has everything you want in it, namely, thoughtful treatment of the subject matter, emotional power, and a crisp, tightly wound cinematic style.
Referencing a film that celebrates professional thieves who take down big-time scores - including a pretty epic bank robbery - may not be the best idea for an investment company. Still, the investment process lessons in the film are manifold and essential. I highlight three here.
The first comes right at the beginning of the film. McCauly’s close-knit crew uses an outsider, Waingro, to help pull off a $1.6 million robbery of an offshore drug dealer’s bearer bonds in an armored truck. Without providing any spoilers, the heist is successful, but Waingro becomes a liability. He is not disciplined, nor does he share the same values as the rest of the crew.
As contemporary thinker Naval Ravikant is fond of pointing out: All returns in life come from compound interest in long-term games, and you play long-term games with long-term people. You have to make sure your team, spouse, friends, etc., are composed of people you trust, and they have integrity and share the same value system. Our small team at RPM Capital and our owner-partners in North Beach Holdings are long-term people playing a long-term investment game. There are no Waingros among us.
As an experienced thief, the motto McCauly lives by is one of the best (and repeated) lines of dialogue from the film: “Don’t let yourself get attached to anything you are not willing to walk out on in 30 seconds flat if you feel the heat around the corner.” As the second lesson from the film, the discipline associated with that statement is tough to live by, but we take it to heart in our investment process.
Whether it is a public company or private company decision-making, we try not to get emotional. We have walked away from being very close to purchasing private companies because something in our due diligence process did not meet our high expectations. After spending countless hours examining a company, it is difficult to walk away, but it is ultimately the right decision on a gut check. Similarly, when a public stock appreciates in value and massively exceeds our calculated intrinsic value and looks to continue to move higher due to the momentum, it can be a hard decision to trim or sell the position. Rightly or wrongly, we do it anyway. That is the discipline of our investment process.
Finally, there are countless examples of McCauly and his crew thinking about and mitigating the risk of the scores they take down. Understanding the potential downside and protecting against risk is a fundamental concept we imbed in our investment process. Requiring an extreme “margin of safety” (the difference between a company’s market price and our estimate of its intrinsic value) serves our core purpose by reducing the risk of a permanent loss of our owner partners’ capital.
At the beginning of the pandemic, we said it would end, everyday life would gradually resume, and the broad economy would recover. During the very unusual time over the last year, we are proud of our rational decision-making and successful execution of our investment process. We put our capital to work by purchasing three outstanding private companies and a collection of public companies, all at what we believe to be very reasonable prices. We took care of the business of business and focused on what was both important AND knowable. Our approach will not change going forward.
We remain energized by our private company investment opportunity set as all of the “pre-pandemic” reasons outlined in our previous letters endure. Those include: (1) the $10 trillion worth of small companies ( <$5 million market valuation) set to transfer over the next fifteen years as baby boomers seek exit plans; and (2) the persistent valuation opportunity compared to other investment options on a free cash flow yield basis. On the other hand, the public company opportunities remain challenging due to excessive valuation levels. Still, we continue to hunt for “scores” that fit our disciplined investment criteria.
PRIVATE COMPANY INVESTMENT UPDATE
Richard Feynman, a Nobel Prize-winning theoretical physicist and one of our favorite thinkers (his book “Surely You’re Joking, Mr. Feynman!” is required reading around here), once said:
“You are under no obligation to remain the same person you were a year ago, a month ago, or even a day ago. You are here to create yourself, continuously.”
Of course, we try to be perpetual learning machines and improve 1% per day by working, reading, and thinking deeply about anything that sparks our intellectual curiosity. Our collective effort helped transform the opportunity set for North Beach Holdings into something different, more meaningful, and improved over the last year. One year ago, we owned one private company - ACN Solutions; today, we own four thanks to the herculean efforts of our Director of Private Investments, Dillon Thompson. Led by four fantastic leaders, our growth opportunities across those four companies now put us on what we believe to be a sustainable long-term growth trajectory.
During the quarter, each operating company leader did a remarkable job “controlling the controllables” for their respective companies: executing service excellence, maintaining high levels of customer satisfaction, adhering to growth budgets, and keeping employees safe and engaged. One big “uncontrollable” is proving to be a growth headwind: finding new high-quality employees. In three of our four private companies, we are actively seeking new employees to increase growth. We are currently making do with the incredible employees we have, i.e., increasing productivity where we can, but look forward to the end of some of the fiscal stimulus’s perverse incentives.
ACN Solutions
Like clockwork, Spencer Wirick, ACN’s President (and our Director of Public Investments), led another solid quarter of revenue and, more importantly, free cash flow growth. Two of our three main service lines (Form 13F and Schedule 13G/D) grew revenue quarter over quarter and year over year; our notoriously volatile Form 13H service line was down. Spencer continues to keep controllable expenses in line with his budget. Notably, he welcomed two new filing employees to our team. This move will free him up to focus more on strategic initiatives like ACN’s new marketing plan for 2021. Spencer designed it to increase new client interactions and push more filings to our online subscription platform. When successful, revenue grows, cost per filing declines, and free cash flow goes up.
Brahler’s Cleaning & Restoration
After closing the transaction on February 1st, we worked quickly and closely with the fantastic BCR team to upgrade operations, the information technology platform, and financial reporting processes. After getting to know the company and its President, Joy Plumley, better since closing, we believe we purchased a company with an even higher growth potential than initially realized. Joy’s incredible focus on growth, cost containment, and outstanding client service drove solid results in the quarter - led by the Cleaning and Contents divisions - and we are confident she will continue to do so in the future.
Hart’s Ambulette
In her first full quarter as President, Kristy Summers hit the ground running and delivered excellent results in a challenging quarter for the company. While the first quarter is seasonally weak, this quarter was weaker than expected due to two major external issues. First - the effects of the COVID pandemic forced many nursing home facilities and doctor offices we serve to “re-lock-down” in January before the vaccines were widely available and distributed. The second issue was the weather - there were more “snow days” than average in January and February, which impeded and delayed service. Once again, our dialysis service business continued uninterrupted and provided a stable revenue base.
Kristy added five new medical facilities, a local manufacturing factory, and many new private pay clients to our long-term, recurring revenue service roster. She did a fantastic job on the cost-containment front, reducing overhead spending and, more importantly, our service vehicle repair and maintenance expense. She did this by utilizing two of our drivers who have experience repairing heavy equipment to perform our preventive maintenance program and “easier” repairs at a lower cost than our regular repair shop.
S&S Filter
Dan DeBellis deserves the most-improved President award for the quarter! We closed the purchase in January, and Dan - completely new to the business - lasered the municipal waterworks plant “bid” season by winning key new business for the company, expertly navigated some working capital challenges that were not his doing, and quickly developed a great working relationship with the hard-working employee team. Like Brahler’s, we believe the growth potential for this business is even better than initially thought. During the quarter, we identified an attractive essential service “add-on” company for SSF and submitted a Letter of Intent to purchase. As of this writing, the current owner is still contemplating our offer.
PUBLIC COMPANY INVESTMENT UPDATE
Since our initial allocation of public company capital in October of 2020, our return on capital deployed is over 65% compared to the S&P 500 Index’s return of 19% through the end of April. Despite our early success, we remain relatively unexcited with our aggregate public company investment opportunity set compared to private company opportunities. Needless to say why, but we will once again: aggregate market valuations are too high.
We remain focused on building a collection of companies with (1) broad insider ownership where management teams are aligned with investors on a 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 (economic “moats”) and the price paid for our shares skewed materially in our favor.
We are currently building a position in a new company for our collection. While we usually prefer micro-cap companies (<$300 million in market capitalization), Spencer identified a large-cap drug distribution company that was attractive on the above-outlined investment criteria. This very high-quality company operated by a competent management team in an oligopolistic industry has produced a long history of excellent returns on capital. In this case, we are happy to purchase shares, delivering a free cash flow yield north of 10%.
Other than our full positions in Berkshire Hathaway Inc. and Graham Holdings Company, we will continue to refrain from publicly identifying the ten other companies in our collection today because we are still building our positions. In most cases, these are illiquid, “trade-by-appointment” situations in very small public companies.
…
Back to “Heat.” The classic (and best) scene from the film is the sitdown with McCauly and Hannah having coffee in a restaurant (which is, in fact, the first time Robert De Niro and Al Pacino appear together in one scene in a film! Check it out here). The two experts in their respective crafts (robber and cop) discuss their existential struggles in life, culminating in the following dialogue:
MCCAULY: That’s the discipline.
HANNA: What you’re left with is pretty empty.
MCCAULY: Yeah? Then maybe you and me, we should both go do something else, pal.
HANNA: I don’t know how to do anything else.
MCCAULY: Neither do I.
HANNA: And I don’t much want to.
MCCAULY: Neither do I.
I think of myself professionally as a business analyst and capital allocator. Like McCauly and Hanna, I don’t know how to do anything else. And I don’t want to. The core focus of creating a best-in-class investment holding company is “Job #1” for Dillon, Spencer, and me every day/all day. Doing so will push hard on our investment strategy’s self-sustaining flywheel, which is simply owning enduringly profitable companies that generate free cash flow to own more and more enduringly profitable companies that generate more and more free cash flow.
As always, thank you for your continued interest in RPM Capital and our holding company, North Beach Holdings.
Best regards,
Russell P. Moenich
President/Chief Investment Officer