Quarterly Letter - Q2 2023
Dear Owner Partner -
The recent episodes of crazy hazy smoke invading Northern Ohio (and many other regions across the U.S.) from the Canadian wildfires remind me of a freaky fishing trip I took in 2018.
That trip was part of my annual 40-year tradition of traveling to the greater expanses of the northern Canadian wilderness. After a 24-hour drive northwest of Cleveland, this beautiful middle-of-a-nowhere of evergreen trees and lakes is accessible only via a fifty-mile flight from civilization on an old de Havilland Otter pontoon plane. Once dropped off at camp, for a week, I am totally cut off from the modern world - no cell phones, no internet, no nothing; just me (and a small group of seasoned fishermen), the wilderness, and some of the best walleye and northern pike fishing imaginable. As an outdoorsman and a fisherman, I call it fish heaven.
Except when something terrible happens.
I have encountered sketchy situations and always had a plan to handle them. Bad weather? Bundle up. Thick swarms of black flies and mosquitos? Bug spray and mosquito nets. Bears? Wave your hands in the air, yell loudly at them, and they will go away (at least black bears do!). Low on beer? Well, that IS the end of the world; however, just deal with it as best you can by rationing.
But nothing focuses the mind more than the fear of an out-of-control forest fire blazing somewhere unknown nearby. You can see and smell the smoke in the air. Given the wind pattern, you can figure out the general direction it is coming from. But you don't know how close or fast it is moving - and that is where the fear comes from.
We read somewhere that fear is an emotional response caused by a threat - real or imaginary. This perceived threat triggers a change in brain and organ function, as well as in behavior. Fear can make you do goofy things at times. When the fear of the forest fire set in, I experienced these responses firsthand.
While the threat of fire remained for the rest of the trip, the fear (and goofy behavior) was only temporary. How did I (and the rest of the group) banish fear? Taking action, getting prepared, and creating a contingency plan for the worst outcome was how: scouted out an alternative campsite on an island in the middle of the lake, kept a spare boat loaded with essentials ready to go, and kept watch on the western front where the smoke was coming from.
This episode is analogous to making investment decisions and operating companies during uncertain times.
The "forest fire" threat is inevitable. Today, the economy is probably (of course, I have no idea) at the tail end of a business cycle expansion. The U.S. economy has not experienced a prolonged recession in quite some time. At some point, this expansion will end, and recession will hit. I am old enough (and scarred enough!) to remember what those look and feel like. It may be more challenging for our private and public companies to make money and grow.
But, like a forest fire, that stuff is out of our control. We worry about what we can control, like taking action and creating a contingency plan.
Most importantly, by design and long before the fire starts, the type of companies we choose to own are more insulated from the economic cycle's ups and downs than the average company. We own companies that provide essential services to their customers, such as regulatory financial compliance, wheelchair transportation, landfill services, and drug distribution. If the economy slows down, these services still need to be performed. These services also provide strong recurring revenue from their respective customers. That is, for some reason (e.g., we do a good job, contractual, cost, etc.), our customers return to our companies repeatedly for service.
We also strive to keep a strong balance sheet with low debt (relative to equity and cash flow) and a lot of reserve cash. This practice will allow us to invest in additional services, employees, customer relationships, and advertising at lower costs while other companies may have to scale back. Of course, we can also look to buy new companies at bargain prices, as we did in the depths of the pandemic recession. Similarly, our effort and investments during challenging times can create better companies and more substantial competitive advantages and economic characteristics for us in the future.
We always work to understand what is in and out of our control. We are business analysts and operators and stay within our tight circle of competence. We focus on finding and owning outstanding small private and public service companies at sensible prices, not mediocre ones at bargain prices. We work hard to understand them deeply from the bottom up and allocate our capital accordingly to maximize potential returns in good times and when the fires start. We then strive to operate our owned private companies well and be an excellent partner to our owned public companies. All the while, we are looking to build an incredible culture free of fear during the fires.
We don't attempt to worry about things out of our control, like when an economic recession will start, how artificial intelligence will influence the world in the future, or the effects of extreme weather and climate change. The future outcomes of those things are important but unknowable. We are not macroeconomic pundits, technologists, or meteorologists. We don't focus on predicting when we will be in a recession. We don't worry about artificial intelligence taking over humankind. We don't pretend to know how climate change will alter the physical world. Spending time on these pursuits is a waste. It is more beneficial for us to try and understand what is happening now in the areas we can control.
Our path forward endures: 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 will likely be materially higher many years from now.
HOLDING COMPANY UPDATE
Our second quarter financial performance was unsatisfactory on the two most important metrics we track.
We did not grow 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 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 3% decline in equity book value per unit during the quarter compares unfavorably to the S&P 500 Index's 9% quarterly return. Additionally, our annualized -15% return on invested capital during the first quarter does not compare favorably to our 20% objective and the S&P 500 Index aggregate return on invested capital of 10%.
The primary driver of the insufficient result was a much worse-than-expected quarterly operating performance from Brahler's Cleaning & Restoration (see the Private Operating Company Update section below for further detail). Please note a weak quarter from any of our operating companies affects the overall holding company in two ways. First, operating income from the owned private companies is considered NBH revenue, so NBH's operating results go down when it goes down. Additionally, when an operating company loses money in a quarter, the private operating company's carrying value on our balance sheet is reduced, i.e., an unrealized loss for the quarter (see 2022's fourth quarter letter for a more detailed discussion on this topic).
Similar to our counsel on focusing on the long-term performance of our public company collection, we don't pay much attention to our performance over short periods. Given how our "mark-to-market" valuation accounting policy and procedure works, our overall performance can and will be volatile. Nevertheless, we fully believe we will add material value and outperform over long periods.
Our equity book value per unit has had 71% total growth (24% compounded annual growth) since inception (January 1st, 2021). This long-term performance compares favorably to the S&P 500 Index's 23% total growth (9% 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 positive but small performance contribution, given its small relative size to our overall asset base.
Alternatively, a more straightforward way (using cash flow results!) to characterize our performance since inception: your holding company received cash dividends from the private operating and public companies, equating to 59% of our aggregate purchase cost of those companies
Finally, the above 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 comprised 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. Therefore, we continue to believe we will be the better option over the long term.
There are three additional holding company-level comments this quarter:
"Trade-offs" - As part of a regular review cadence of our investment process, we assess our capital allocation options, i.e., what we can do with our excess cash. Our ten possibilities include:
Existing operating company internal reinvestment
Existing public company reinvestment
Existing operating company external investment ("add-on" acquisition)
New operating company investment
New public company investment
New risk-free short-term Treasury bill investment
NBH Owner Partner unit buyback
New outside investment manager vehicle investment
Hold cash
Payout NBH cash distribution
We plot our ten potential capital allocation options on a "quality" vs. "value " trade-off matrix similar to the one below:
As a result of our review, we are incrementally more positive on small public company investments and will add more capital to this bucket. Rest assured, the best use of capital remains investing in our existing operating companies, when available, and in new operating companies, which we continue to evaluate (see below for more detail).
2. "And then we all switch places when I ring the bell" - While maybe not the most appropriate song lyric to use, we do have a "new style" to our organizational duties:
Dillon Thompson will shift most of his time, effort, and energy to improving private operating company operations and financial oversight of NBH (i.e., Chief Financial Officer duties); the rest of his time will be on developing and analyzing our new private company acquisition pipeline.
Mike Foran, our Chief Executive Officer, will split his time between private operating company operations and developing and analyzing our new private company acquisition pipeline.
This move is a big-time win-win change: the actions better align Dillon's and Mike's skillsets with their respective passions, and NBH wins by being in a better position to grow our equity book value per unit.
3. "Bank error in your favor/collect more equity book value per unit!" - Last quarter, we reported that NBH equity book value per unit declined 20%. This report was incorrect, and the correct value was an 8% decline. We discovered an error in our calculation during a routine review.
PRIVATE OPERATING COMPANY UPDATE
Guided by North Beach Chief Executive Officer Mike Foran and Chief of Staff Nikki Salas, our outstanding employees once again delivered excellent customer service throughout the quarter. We are grateful for their dedication and amazed at their daily ability to do what they do day in and day out. Three of our four private operating companies had a good quarter in terms of profitability and free cash flow. More importantly, business momentum and culture are improving overall. At the same time, we navigate a tricky macroeconomic environment (e.g., inflation and slowing pockets of business activity here and there).
ACN Solutions
ACN delivered another record quarter, solidly growing revenue and free cash flow. The company also adequately defended against one of its most significant threats since the U.S. Security & Exchange Commission's 13F filing scare: a key consulting firm client was recently acquired by another client. Spencer Wirick, ACN's President, beautifully managed through the tricky situation by further entrenching the at-risk client base. His maneuvering resulted in revenue and free cash flow that outpaced his year-to-date budget. His near-term focus is on incorporating and investing in additional frictionless compliance filing services supplemented with digital marketing efforts.
Brahler's Cleaning & Restoration
The company had a horrible quarter resulting in financial performance that was crushed by a lack of disaster mitigation work. Unfortunately, this lack of lead generation - a la recurring revenue - cannot be easily pinpointed to one fixable source and remains an ongoing risk. In the meantime, we are actively right-sizing the business's cost base.
Hart's Ambulette
While quarterly revenue and trip count were solid, profitability and free cash flow growth suffered due to several one-time large-scale fleet repair and maintenance costs. However, Kristy Summers, Hart's tenacious President, solved two key issues plaguing the business for several quarters: (1) implemented a more efficient use of its enterprise resource planning system for scheduling and invoicing; (2) and improved working capital by solving many lingering accounts receivable issues. In addition, after successfully growing into the Sandusky region, Kristy is now looking to plant our flag in new geographies. Stay tuned!
BioVac Industrial Service (formerly known as S&S Filter)
And we're back!
After a weak first quarter of the year, new President James Baird has hit the ground running and delivered a fantastic quarter of revenue and free cash flow growth. Now back in form, the company, under James's guidance, is prioritizing a more diverse and balanced service revenue pipeline (think less water plant and more industrial service work) and restructuring the team in a way that can soon capitalize on operating leverage at double its current revenue run rate or more. We look forward to the second half of the year when James' full vision for BioVac will materialize and are excited for subsequent opportunities to reinvest additional capital.
New Private Company Pipeline
As mentioned, Mike is now leading the charge on business development and our new private company pipeline. With Dillon's help, he has hit the ground running and continues our momentum on finding extraordinary, enduringly profitable, niche service companies for us to potentially purchase.
Today the top three "Power Ranking" in his pipeline are as follows:
1. A landfill compliance service company; this is an industry we are bullish on and have some expertise in, given our experience with Biovac (one of their primary end-markets is servicing the biogas filters landfill operators use to recover renewable natural gas). We have submitted an "Indication of Interest" and now working on negotiating a dual-signed "Letter of Intent." Stay tuned.
2. A seed performance testing analytical laboratory company
3. A geological and emissions testing and compliance company
Unsurprisingly, 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.
You may recall we were keen on an emergency backup power system fuel management company and an environmental water service company last quarter. Both opportunities were killed due to sharp differences in valuation with the seller during the past quarter.
PUBLIC COMPANY INVESTMENT UPDATE
The long-term return on the capital deployed into our public company collection compares favorably to standard general index benchmarks
Though our aggregate public company collection is up in market value over the trailing twelve months, we don't pay much attention to our performance over short periods. We don't because we fully believe we will add material value to our holding company over the long term by owning public companies with the same sought-after private company attributes mentioned above, along with:
Strong free cash flow generation;
High and stable returns on invested capital;
Long-term revenue growth runways;
Impeccable balance sheets for maximum financial flexibility;
Broad insider ownership where the management teams we partner with are aligned with us on a very long-term basis;
Most importantly, the trade-off between durable competitive advantages and the price we paid for our ownership is skewed materially in our favor (see "Quality" vs. "Value" matrix mentioned above).
While today's valuation level is still nowhere near the attractive valuation levels between 2008-2011 or even the depths of the pandemic sell-off in March 2020, as mentioned above, we are incrementally more positive on our small public company investment opportunity set (but not large public companies, e.g., most companies that comprise the S&P 500 Index).
That said, during the second quarter, we started building a new core company position for our collection in the commercial credit and supply-chain information industry. Given the inflationary environment in 2022, the corresponding tightening of interest rates by central banks, and the number of businesses with limited ability to cover their interest expenses with earnings and cash flow, we expect the number of corporate bankruptcies will, at worst, return to long-term average levels which will support the need for this company's counter-cyclical credit rating solutions.
In April, we also sold our full position in Patriot Transportation Holdings Inc., a liquid (think gasoline and clean drinking water) and dry bulk trucking company located in Florida. While checking our necessary business model boxes, we identified two unneeded real estate assets (old terminals) on the balance sheet that were carried at costs way below market prices. Management wisely sold the parcels and issued two substantial special dividends. Overall, we enjoyed an almost 80% return on our investment since the fourth quarter of 2020.
Other than our positions in AmerisourceBergen Corp, Berkshire Hathaway Inc., Criteo S.A., Graham Holdings Company, and Vornado Realty Trust, we will refrain from publicly identifying the other eight companies in our collection since we may add to our positions at any time. These are all illiquid, "trade-by-appointment" situations in very small public companies.
…
Despite our triumphs and challenges this quarter, we plan to keep working on: (1) improving our investment and operating processes; (2) improving our culture; and (3) 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
Investment Analyst & 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 undertake 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.