Quarterly Letter — Q3 2020
Dear Friends —
We lost some great musicians this so far year. Reggae and ska godfather Frederick “Toots” Hibbert (Toots & the Maytals), Kraftwerk founder Florian Schneider, and Dave Greenfield, keyboardist for the U.K. punk band The Stranglers, are some personal favorites. Say nothing about losing legends like Little Richard, Bill Withers, Kenny Rogers, Charlie Daniels, and Neil Peart.
But maybe losing Eddie Van Halen had the most impact.
Widely recognized as one of the greatest rock guitarists of all-time, his rise to fame during the early ’80s coincided with the MTV music video generation’s rise and inspired many kids to learn to shred on the electric guitar. EVH’s solo on the instrumental song “Eruption” from Van Halen’s 1978 Van Halen album is considered one of the best electric guitar solos. For the uninitiated, you can check out an extended live version of EVH brilliantly playing it here. His claim to fame is an unorthodox but highly effective “tapping” technique he adopted and took to the next level in the song. The idea came to him after being in the right place at the right time: watching Jimmy Page of supergroup Led Zeppelin use a more basic version of the technique live at the Los Angeles Forum in the early 1970s. Rock-n-roll fans have been grateful ever since.
EVH being in the right place at the right time reminds us of another great Charlie Munger quote (BTW, our quarterly letters would not be complete without summoning Munger at least once!):
“Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past.”
Taking those wise words to heart during the second half of this weird year, we follow through by acting promptly in scale when the odds are in our favor. First, we bought a non-emergency medical transportation service company (NBH Medical Transport Service LLC d/b/a Hart’s Ambulette) in August. Now we are excited to announce that we executed dual-signed Letters of Intent (LOI) to purchase not one but two(!) more outstanding service companies in October, both to close by the end of the year (more details below).
Underlying Munger’s messaging is definitively knowing what we can control and not worrying about what we cannot.
On the latter, we know we cannot control, nor can we become paralyzed or overreact to things like the economy, the impact of the COVID-19 pandemic, or the presidential election. The future outcome of those things is important but unknowable. We are not macroeconomists, epidemiologists, or political strategists. We don’t focus on predicting the direction of interest rates, disease kill-rates, or who will win the presidential election.
We are business analysts and stay within our tight circle of competence. We focus on finding outstanding essential service private and public companies at sensible prices - not mediocre companies at bargain prices. We work hard to understand them deeply from the bottom up and allocate capital accordingly.
The one thing we can control is the price we pay for companies. A sensible price incorporates a wide margin of safety for unexpected problems. It protects against a permanent capital loss. We believe we have paid sensible prices for the two companies we bought to date for RPM Capital. Similarly, we believe we negotiated sensible prices for the two companies under LOI.
We continue to believe the pandemic will end, everyday life will gradually resume, and the broad economy will improve. More importantly, our private company investment opportunity set remains attractive (not so much on the public company landscape). Our path forward endures: acquire attractively priced, well-run small private and public essential service companies.
PRIVATE COMPANY INVESTMENT UPDATE
The song from the last quarter remains the same. Our prospective deal pipeline activity has picked up nicely since the lockdown lifted. The COVID-19 pandemic and the continued fear of its unending spread are rattling business owners contemplating selling their businesses. Add in fear of potentially higher capital gains tax rates in 2021 after the election. It may come as no surprise that valuations “feel” like they continue to move a bit lower based on our deal community scuttlebutt. The table below – representing multiples of free cash flow paid for the acquisition of small companies valued at less than $50 mln – supports that position:
ACN SOLUTIONS INC. (ACN) UPDATE
ACN, the investment compliance essential service business we own, had another great quarter. The unstoppable Spencer Wirick continues to navigate the ship in the right direction, which is healthy revenue and free cash flow growth. Amazingly, this accomplishment comes on top of his responsibilities of running our public investment process as well.
At the same time, we wait for the outcome of the Securities and Exchange Commission’s proposal to change the Form 13F investment manager reporting threshold requirement (from those overseeing $100 million in U.S. equities to $3.5 billion). For more information on the impact of this change to one of our largest service lines of business, please see our Q2 quarterly letter. We are incrementally more optimistic after discussing the change with several legal experts who all seem to believe the SEC does not have the legal authority to change the threshold.
That said, we are preparing for the worst (decreasing marketing spend and growth capital expenditures) but hoping for the best. Regardless of the outcome, ACN will be a viable business that adds enormous value to its investment compliance reporting market niche.
NBH MEDICAL TRANSPORT SERVICE LLC DBA HART’S AMBULETTE (MTS) UPDATE
MTS’s fleet of modern wheelchair-lift-equipped vans, licensed by the Ohio Department of Public Safety Division of Emergency Medical Services and driven by a collection of certified, kind, and compassionate drivers, transport physically disabled wheelchair users safely and comfortably wherever they want to go. The essential and recurring nature of the service’s revenue base (e.g., many dialysis-related trips), its lack of economic cyclicality, and the demographic tailwind combine to make for a high-growth essential service company. And let’s not forget serving and helping physically disabled customers get to the vital places they need to go genuinely adds more than just economic value.
Dillon Thompson, our point man responsible for aggressively optimizing and growing ACN over the last three years before Spencer’s leadership, is doing the same on this investment. Working closely with Kristy and Lynette, our two fantastic day-to-day company managers, he has moved very fast and is ahead of schedule since we took over the company on August 1st. He created a new all-digital operations module that replaces a burdensome, slow, and unreliable paper-based system for the ultra-important functions of driver dispatch, insurance reimbursement, billing, and payroll calculation.
The benefits of the new module are manifold. First, it removes a ton of time, effort, and cost from Kristy and Lynette’s workflow and allows them to focus on higher-value tasks. Unlike the paper-based system, the new module offers another boost: it collects key data to measure capacity utilization (loaded van hours driven per 8-hour day), asset efficiency (loaded miles driven per total van hours driven), and operational efficiency (free cash flow per loaded mile driven).
Maximizing and growing these three metrics will power the business’s economic engine: free cash flow per unit of capacity (defined as total daily hours driven in an 8-hour day) as shown above.
“THE TWO MORE OUTSTANDING SERVICE COMPANIES”
Energized by our two new opportunities, which we expect to have an aggregate free cash flow yield north of 25%, our team is deep into due diligence work. Please note, we are under non-disclosure agreements with both companies (codenamed “INDVAC” and “RESTCO”) and cannot say too much today. We will have a lot to say about these wonderful service companies and their employees next quarter after the deals close. In the meantime, here are quick synopses:
INDVAC – A Northeast Ohio industrial vacuum and water blasting service provider to recurring waste byproduct manufacturers such as municipal water & wastewater plants and steel fabrication & production. The company does not have a clearly defined 2nd layer of management. However, we have identified a young, talented operating executive capable of managing the company day-to-day and eager to participate in its growth through an incentivized compensation plan.
RESTCO – A 45-year old family-operated cleaning, restoration, and remodeling company located in the greater Akron-Canton Ohio area. They provide quality disaster cleaning and repair, including 24-hour emergency service and fire, water, wind, vandalism, and other damage repair services. They also provide commercial and residential carpet, furniture, and air duct cleaning services. The owners have cultivated a next-generation executive leadership team eager to take the company to the next level through an incentivized compensation plan.
Both companies’ owners exude integrity, trust, and a deep desire to see their company and employees continue successfully in the future. You may recall our checklist for attractive companies includes a reputation for excellence, and we believe it starts at the top with ownership. Both companies also cover the rest of the checklist: essential service, high recurring/repeat revenue, deep customer integration, low-cost service proposition, low customer concentration, and acyclicality.
PUBLIC COMPANY INVESTMENT UPDATE
We remain unenthused with our aggregate public company investment opportunity set. Needless to say why, but we will: aggregate market valuations remain elevated compared to levels we deem attractive. According to Bloomberg, the chart below shows the S&P 500 Index (a collection of the largest 500 public traded companies in the U.S.) free cash flow yield since 1990; as of September 30th, 2020, it is only 4.7%. As referenced above, this reading compares to our targeted small private company free cash flow yields of 25% or more.
Nonetheless, Spencer continues to follow our core principles diligently to dig deep into public markets to find potential out-of-favor essential service investment opportunities. And he has found a few that have become small positions in our holding company collection. We will refrain from identifying those today because we are still building these illiquid/”trade by appointment” nano-cap and micro-cap companies’ investment positions.
In all cases, these companies have (1) broad insider ownership so that we partner with management teams aligned with us on a long-term basis; (2) impeccable balance sheets (i.e., more cash than debt) to weather anything wicked that comes this economic way; and (3) long-term revenue growth runways to ensure these companies will be more significant in 5 years. We believe the trade-off between these public companies’ durable competitive advantages (“moats”) and the price we paid for our shares on a sustainable free cash flow basis is massively skewed in our favor.
Our team is excited to move forward with ACN, MTS, our two new private companies under LOI, and our public company collection. We will also restart our outside capital raise this quarter, including an ACN valuation contingency plan that will depend on the SEC’s 13F reporting threshold final rule publication.
The core focus of creating a best-in-class investment holding company through the long-term ownership of small private and public essential service companies is “Job #1” every day/all day for Dillon, Spencer, and I. Doing so will push 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. Committed to having material skin in the game, we want to compound capital for decades to come and execute our plan.
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
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.