Quarterly Letter — Q2 2021

Dear Friends —

Formula One (F1) is the most thrilling class of international auto racing IMHO. I am a big fan - I have spent countless Sunday mornings (most races are in Europe) watching Grands Prix action. As a former very amateur racecar driver (assuming taking a weekend high-performance driving class at Mid-Ohio Sports Car Course and some time trials at Nelson Ledges Road Course many years ago counts!), I am blown away by and find beauty in an aggressive racing line for a corner apex, proper turn braking to hit the right exit point location, efficient pitstop utilization timing, calculated fuel consumption planning, the right tire selection for track conditions, dialed-in suspension tuning for optimal handling, and everything else that professional F1 driving requires.

Nothing in the world combines the mastery of both mechanical technology and human skill more than F1 racing. It truly takes the right combination of car and driver to win individual races and the annual championships. The F1 season (2021) covers 23 races, and there is both a driver championship and a "constructor" (the entity that designs the chassis and engine) championship each year. To win championships, drivers and constructors (together, an F1 team) need to get on podiums regularly. Both the car and the driver need to perform consistently well throughout the season. Rarely do you have a great driver win in a not great (i.e., fast) racecar; conversely, it takes a great driver to fully realize the potential of a great car.

Along the same lines, rarely do you win in investing when you do not have both a great company (the racecar) and a great manager (the driver) running it.

As part of our investment process at North Beach, we dig deep to ensure the business model of any company we buy (private or public) has specific enduring attributes that can make it outstanding. For example, a reputation for excellence, high recurring or repeat revenue, low-quality competition, low customer concentration, high customer process integration, and a low-cost proposition for customers are all components we look for in great companies. When those attributes are combined with unique intangible assets, cost advantages vs. competition, high service switching costs, network effects, or efficient scale advantages, a company can indeed have a durable competitive edge. (For a more detailed discussion on these business model attributes and competitive advantages, please see Spencer Wirick's fantastic "Wonderful Company" blog series here). Finding the right business attributes and competitive advantages is similar to a racecar that combines the proper chassis and engine to make it go as fast as possible.

Similarly, we make sure the management teams that run our companies can deliver long-term free cash flow growth results. Capital allocation prowess is paramount. Our private company managers (i.e., the operating company Presidents) must either take the free cash flow that hits the bottom line and reinvest it with high returns back into the business or send it up to our holding company for broader allocation. Our public company managers have more options. They can reinvest capital back into the business (similar to our private company Presidents). They can buy other companies or buy back company shares in the open market (which, by definition, increases our ownership stake in the company). They can pay down any outstanding debt or pay a dividend. Either way, managers that deliver consistently high returns on invested capital should also have sustainable free cash flow growth. This concept is akin to drivers winning Grand Prix podiums regularly.

As a North Beach "team owner," I love the car and driver combinations that are on the track today racing for the long-term championship. We continue to look for more car and driver combinations to add to our holding company collection. We want to purchase great companies with incredible business models selling at reasonable prices. Our private company investment opportunity set remains deep with $10 trillion worth of small companies ( <$5 million market valuation) set to transfer over the next fifteen years as baby boomers seek exit plans. Furthermore, there is a persistent valuation opportunity with private companies compared to other investment options on a free cash flow yield basis (the way we value everything we look at). The public company opportunities are fewer and far between.

PRIVATE COMPANY INVESTMENT UPDATE

Our overall private company results during the quarter were pedestrian in what matters: achieving full free cash potential and growth at all of our operating companies. While there were idiosyncratic issues at two (Brahler's and S&S) of our four companies, one big prevailing issue remains the inability to find qualified employees to hire. I mentioned this last quarter, but so far, this has not improved. The companies have not been able to tap into the meaningful growth initiatives because they do not have the underlying employee base to support the additional work. Additionally, they had to pay current employees overtime wages which cut into profitability during the quarter. Given the June end of the extra $300 per week unemployment incentives the Biden administration signed in March, I am optimistic that the situation should improve.

Nevertheless, the company Presidents did an excellent job managing their respective issues. They kept the racecar on track by executing service excellence, maintaining high levels of customer satisfaction, adhering to growth budgets the best they could, and keeping employees safe and engaged.

ACN Solutions

I probably sound like a broken record. Once again, Spencer Wirick, ACN's President (and also our Director of Public Investments), delivered another solid quarter of revenue growth, EDGAR filings, and, most importantly, free cash flow sent up to our holding company. Spencer continues to keep controllable expenses in line with his budget and made significant progress on redesigning the "front-end" of our website (BTW - it needs it and should be ready to go live this quarter!). He believes that it should better capture new EDGAR filing business through enhanced search engine optimization once it goes live. Also, Spencer continues to lead the migration of clients to our online subscription platform. The goal, of course, is for more revenue growth with a decline in cost per filing and more free cash flow.

Brahler's Cleaning & Restoration

Since the company's purchase at the beginning of February, I have come to love inclement weather that can cause severe insurance losses (e.g., torrential rain that causes basement flooding!). Unfortunately, the first six months of the year produced the lowest number of storm events in, at least, the last twenty years. According to the National Oceanic & Atmospheric Administration's National Center for Environmental Information, Stark County, Ohio, only registered three "events" - one winter weather event and two high wind events. Needless to say, quarterly revenue growth for our quality disaster mitigation and restoration company was challenged. However, just halfway through July is a different story - we are on track to have the best month in the last five years.

Brahler's President, Joy Plumley, once again proved to be a fantastic leader and operator by offsetting soft revenue in the restoration division with a great quarter of revenue growth from the cleaning (mostly carpet) and remodeling segments. However, profitability was lower than expected due to higher overtime costs (more employees needed!) and a lower gross margin in the remodeling division.

Hart's Ambulette

Kristy Summers, Hart's President, delivered key company objectives for the quarter - revenue growth and expense control. This resulted in a better operating margin and free cash growth sent to North Beach despite higher vehicle maintenance costs for new tires and brakes on a significant portion of our fleet.

Total ambulette trips were up 23% compared to last quarter, including logging our best day ever in terms of the number of daily trips during the quarter. Growth was a function of three things. First, the normal seasonality (better weather!) of the business came through. Second, Kristy's execution of her marketing plan was put into place at the beginning of the year. As part of the plan, the city of Sandusky was identified as a target growth market, and trips originating there grew 56% quarter over quarter. Finally, Kristy was able to increase the utilization of our vans, which ultimately results in higher free cash flow per total hours driven.

On the expense side, Kristy kept fuel costs in check as a percentage of revenue by renegotiating better rates on our fleet fuel credit cards and incorporating GasBuddy (an app that identifies the lowest gas station fuel prices by location) into our operations. Additionally, she was able to implement a much-needed preventative maintenance program. She is now focused on completing one final key objective - improving accounts receivable.

One challenge during the quarter was our inability to purchase new vans. Given the supply-side problems auto manufacturers are experiencing, new vans are impossible to find, and the used market is non-existent. Nevertheless, we believe we can achieve a very high return on invested capital in new vans if only we can find them!

S&S Filter

The company added six new customers during the quarter, and revenue growth was solid and ahead of our expectations. Our current employees have been working non-stop, and we are endlessly grateful for their commitment to S&S. Once again, S&S's President, Dan DeBellis, did an excellent job of maintaining a high level of service and safety while managing through continued working capital challenges (which were mentioned last quarter). Free cash flow growth remains elusive, but we have an aggressive plan to improve working capital during the second half of this year. Although our internal process and procedure improvements have been somewhat slow out of the gate since the company's purchase in January, we are now moving even more aggressively to enhance productivity tools and improve the technology stack.

PUBLIC COMPANY INVESTMENT UPDATE

While we made great decisions on the companies we chose to invest in during a target-rich environment last year, we made a mistake not allocating more capital to our public portfolio at the time. Since our initial allocation of public company capital at the end of Q3 2020, our return on capital deployed is over 81% compared to the S&P 500 Index's return of 32% through the end of June. Year-to-date and Q2 2021 returns were 43% and 10%, respectively, compared to 15% and 9% for the S&P 500 Index.

That said, this is an exceptional nine-month period of outperformance that we, frankly, do not expect to continue to such a degree. But, again, we can't say this enough - we remain relatively unexcited with our aggregate public company investment opportunity set because market valuations are too high.

We remain focused on building a collection of public essential service 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 and the price paid for our shares skewed materially in our favor.

We are currently building two new positions in microcap-sized companies for our collection. The first is a respiratory medical equipment provider led by a very seasoned management team that owns over 15% of the shares outstanding. In addition, the trailing 5-year compound annual revenue growth rate is close to 30% and is expected to stay above 20% for the foreseeable future. It is rare to find an excellent growth company like this offered to us with a free cash flow yield north of 10%, but leave it to Spencer to uncover this potential diamond in the rough! We expect this company to be a meaningful long-term position in our collection in the future.

The second company is more opportunistic and not expected to be a core position over the long term. Also, in the healthcare sector, this company has legacy hospital communication software and service offerings but is also developing a new "Software-As-A-Service" cloud-based offering. Competition is fierce, and the success of the new service is not guaranteed.  According to Spencer's work, assuming a slow decline of the legacy business and the abundance of cash on the balance sheet, today's market valuation implies we are getting a "free option" on the new business offering. We believe there is an attractive asymmetrical risk opportunity - low downside vs. a potentially meaningful upside proposition if the new offering is moderately successful.

Other than our positions in Berkshire Hathaway Inc., Criteo S.A., Graham Holdings Company, and Support.com Inc, we will continue to refrain from publicly identifying the ten other companies in our collection because we are still building our positions. In most cases, these are illiquid, "trade-by-appointment" situations in very small public companies. 

 …

Here is a controversial statement for all the F1 enthusiasts: Ayrton Senna was and still is the best F1 driver ever, and no one was or will better, not Schumacher, Prost, Clark, or Hamilton. Senna won three world championships before a fatal crash took his life all too early.

Consider his first lap at the 1993 European Grand Prix held at Donington Park. It is perhaps the most incredible lap in F1 racing history where Senna starts from the fourth position on the grid, drops to fifth place after a bad start, but then unbelievably passes four cars to take the lead well before the lap was even over. And this was all done in torrential rain! See the brilliance here.

It was the third race of the 1993 season. Senna was in a relatively new and still unfamiliar race car (his team, Marlboro McLaren, switched to Ford V8 engines at the beginning of the 1993 season after Honda decided to discontinue its race engine pursuits). But on that magical day at Donington, Senna had a plan and executed it brilliantly amid adversity like any other race day. Despite his anger at starting in the fourth position and the unrelenting rain, Senna and his pit crew had a specific race plan that helped produce a winning outcome that day.

 We are channeling our inner Senna these days.

Like Senna, we have a new racecar in our holding company. Our start on the grid is, frankly, not where we want to be compared to the operating companies' combined free cash flow potential, given the short-term challenges we face with some of our private companies. We are working hard to get there soon.

 The core focus of creating a best-in-class investment holding company is the true racing line Dillon, Spencer, and I are focused on 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 that we will use 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 North Beach Holdings.

Best regards,

Russell P. Moenich

President/Chief Investment Officer