Quarterly Letter — Q2 2020
We might be the only people in the world that think Rocky II is the second-best film in the Rocky franchise (which, of course, also includes the Creed films). Sure, the film follows the same basic plot structure as the original, with the only difference being Rocky has a little bit more money and fame and a new wife and kid.
But for us, it is all about the 15th round of the boxing match. It is the most epic scene of all the films.
Apollo Creed dominates Rocky for the first fourteen rounds. A battered, bruised, and all but beaten Rocky then switches back to his natural southpaw style after fighting right-handed throughout the match to protect his detached retina injury from the first fight in the original film. He comes storming back, has just enough energy to put the beat down on Creed, but – amazingly – both fighters end up getting knocked out. Then the dramatic, slow-motion ten count that takes a minute of film time. Then Rocky’s dogged determination to get up first to win. Finally, the incredible flurry of Bill Conti’s “Gonna Fly Now” music orchestration with the visual of everyone rushing the ring to congratulate Rocky as the victor. That dramatic scene makes some grown men cry. It is pure cinematic brilliance.
Today we feel a bit like Rocky before the 15th round. In this case, our Apollo Creed is a recently announced, potentially harmful regulatory development relating to ACN Inc., the investment compliance essential service business we own. This development may materially affect the future valuation of ACN, and, as a result, we are temporarily suspending our new capital raise and returning accepted capital until we learn more. We will go into more detail below in the ACN section of this letter. Battered, bruised, but definitely not beaten, we will get up first and win the match.
On a much more positive note, we did complete a dual-signed letter of intent with the fantastic, well-run non-emergency medical transportation company located in Fremont, Ohio, that we mentioned last quarter. After a hardcore due diligence phase (another activity that is akin to a brutal boxing match!), we closed the deal on July 31st. We funded this acquisition with our own internal capital. Again, more details below.
During this still-unusual time, we attempt to remain rational (and not worry about being brilliant, ala Charlie Munger) as we make investment decisions, take care of the business of business, and focus on what is both important AND knowable. We remain energized by our private company investment opportunity set as all of the “pre-pandemic” reasons outlined in our Q4 2019 letter 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 valuation opportunity we mentioned last quarter proved fleeting, but some potential opportunities remain.
We continue to believe the pandemic will end, normal life will gradually resume, and the broad economy will recover. In the interim, the path forward is clear: use this downturn to acquire attractively priced, well-run small private and public essential service companies.
PRIVATE COMPANY INVESTMENT PIPELINE UPDATE
Since the “lockdown” lifted, our prospective deal pipeline activity has picked up nicely. Clearly, the recent experience has rattled some private business owners who were contemplating selling their businesses before the pandemic. And it has also disturbed those who were not thinking about it a mere three months ago. No surprise, valuations “feel” like they are moving lower based on deal scuttlebutt. The table below, updated through the first quarter of this year, shows valuations were already coming down before the full economic damage toll from the pandemic and associated lockdowns.
To that end, we have made meaningful progress on three of the four prospective private company deals we mentioned in our letter last quarter (the fourth went AWOL), most notably, “MEDTRAN,” highlighted below.
MEDTRAN UPDATE
Despite the setback in our ACN business, we are very excited by our acquisition of a well-regarded Northwest Ohio non-emergency medical transportation company. We were able to negotiate a purchase price that will give us around a 33% free cash flow yield on the outlay to buy the business as is and a modest working capital investment. Officially called NBH Medical Transport Service LLC (MTS for short going forward forever!), it competes in the marketplace as Hart’s Ambulette. We are obviously in the early stages of getting our arms around the new company, its fantastic employees, and its operations. What we can say is that the key to any transportation service business is adequate route density in a company’s local markets, and this company has it in spades.
Note this: the attractive free cash flow yield does not include cost optimization or the potential growth kicker from expansion into adjacent regional markets. Dillon Thompson, our point man responsible for aggressively optimizing and growing ACN over the last three years and leading our due diligence efforts on this deal, is excited to get to work doing the same here.
It is important to point out, our work on this deal over the past few months yielded two pleasant surprises. The first is the fantastic relationship we have developed with the previous owner, a man with an extraordinary entrepreneurial passion for service excellence. His openness about his business, his willingness to help us learn about the industry, and his commitment towards a smooth ownership transition are noteworthy and hard to find in the sometimes hostile and combative trenches of deal due diligence and completions. The second surprise is learning about the incredible importance of this business in the community it serves. Serving and helping physically disabled customers get to the essential places they need to go genuinely adds more than just economic value.
THE REST
While Dillon gears up for our MTS opportunity, he continues to keep our potential private deal pipeline full and find great opportunities that we are aggressively pursuing, including the following in order of attractiveness:
“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 the company’s growth through an incentivized compensation plan. Stay tuned.
“BANKCOUR” – A Midwest bank courier service provider with customized/customer-specific solutions and a very high customer retention rate; the current ownership group and management team want to stay for, at least, five years after a sale. We are currently negotiating a purchase price for the business, but the current spread is wide.
In addition to those three, we are also reviewing a handful of other attractive new opportunities that have recently come on our radar screen. One early standout is a Northeast Ohio auto service center in business for over 35 years at a great location and housed in a fantastic, meticulously maintained facility.
ACN UPDATE
While ACN is surviving the pandemic headwinds with flying colors and no negative financial or operational impact, a recent proposed change to the Form 13F investment manager reporting threshold requirement (from those overseeing $100 million in U.S. equities to $3.5 billion) by the Securities and Exchange Commission (SEC) would be a financial body blow. Our Form 13F service is our largest service segment, and we are the largest 13F solution provider in the world today. Today, there are over 5,000 firms that file a quarterly Form 13F on the SEC’s electronic platform; the proposal as written would reduce the count to only 550 firms. The SEC’s argument is based mostly on reducing the compliance cost burden for smaller 13F filers (if you are interested in reading the proposal, here it is). The final rule will come sometime after mid-September, after a 60-day public comment period. Don’t worry, we will be submitting a public comment letter aimed directly at the SEC’s outrageously incorrect estimate of the compliance cost burden as well as the loss of public market transparency.
Admittedly, the SEC’s change was a “left-tail” risk we were aware of but did not see coming. Early on, before we took majority ownership of the company, we reviewed the 1975 statute passed by Congress and took comfort in the language addressing the market value threshold: “at least $100,000,000 or SUCH LESSER AMOUNT.” It should be no surprise to any reader that government law is not in our circle of competence, so we are unclear how the SEC gets authority to change the law without an act of Congress. Clearly, they feel empowered to do so in some way.
Based on years of observing SEC rules and regulations coming and going, we know there are three outcomes: (1) no change to the existing rule, (2) the final rule gets written just as the proposed rule, and (3) the final rule varies from the proposed rule based on public comment input. We put a 5% probability on the first and best outcome, 30% on the second (i.e., worst-case scenario), and 65% on the third. From our perspective, the lower the investment manager reporting threshold, the better.
In the meantime, ACN continues to grow year over year but has reined in extensive marketing and capital expenditure projects related to our 13F business segment. ACN remains a fantastic essential service business, while its brand, customer relationships, and knowledge base are very strong in the investment compliance marketplace. The team, now led by our new young gun Spencer Wirick, is actively reviewing growth opportunities in our other business lines outside of 13F and optimizing our cost structure for any future scenario. Once again – battered, bruised, but definitely not beaten, we will get up first and win the match.
PUBLIC COMPANY INVESTMENT PIPELINE
As we eluded to last quarter, we were and continue to be “meh” about public company valuations. At the nadir on March 23rd, aggregate valuations did not come close to the wreckage of the 2008-2009 time period. Ever since then, valuations improved. As business analysts focused on finding outstanding businesses at sensible prices - not mediocre companies at bargain prices - and deeply understanding them from the bottom up and allocating capital accordingly, we remain busy looking for meaningful dislocations.
During the equity market’s drawdown and subsequent recovery, we made a pleasant observation (though not supported by rigorous research only “back of the envelope-type of analysis”!). Our focused investment universe – enduringly profitable, essential service companies with fantastic balance sheets (i.e., no net debt) and incentivized owner-operators (i.e., high insider ownership) – outperformed the broader equity market. We guess that this outperformance is mostly due to the balance sheet strength during the short-term credit and liquidity crisis that raged throughout capital markets. On a negative note, most of these management teams did not make good use of the economic dislocation by buying back stock at more reasonable prices and increasing targeted hiring and marketing when the getting was good.
Points International Ltd. (PCOM)
Spencer, splitting time and seemingly unlimited energy between running ACN and our investment process, continues to add enormous value by bringing new investable ideas to the table for review, including this one. Points is the global leader in providing loyalty e-commerce and technology solutions to the loyalty industry. Through approximately 75 commercial agreements with leading loyalty brands, Points connects loyalty programs, 3rd party brands, and end consumers across a global transaction platform named the “Loyalty Commerce Platform.” Points provides solutions to make their partner’s loyalty programs more engaging to over a billion loyalty program accounts while driving revenue and increased profitability to the programs. The company recognizes revenue in the following three segments: Loyalty Currency Retailing, Platform Partners, Points Travel. Management owns approximately 7% of the shares outstanding. The balance sheet is incredibly conservative, with no net debt.
The company is “on-sale” today due to the COVID-19 pandemic’s impact on the global travel community. However, the essential business model and a brilliant management team have allowed Points to achieve approximately break-even adjusted EBITDA for the second quarter, which is very promising. As both the airline and hospitality industries continue their rebound from the global pandemic, we expect Points’ partners will rely on them to drive high margin revenue and increase member engagement. Increasing company dependence on loyalty programs to drive profitability will be a critical factor driving the intrinsic value of Points International moving forward.
With a market cap of $123 million, this incredible micro-cap company is offered to us at around $9.50 a share compared to our scorched-earth, conservative intrinsic value calculation of $14 per share representing a 30%+ margin of safety.
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To reiterate one more time: this was a mixed quarter for the team here. The ACN regulatory development and potential impact is a bummer but offset by our substantial progress getting MTS across the finish line. We remain excited despite the delay in our capital raise. And we are excited to move forward with our core focus on creating a best-in-class investment holding company through the long-term ownership of small private and public essential service companies.
As a reminder, the self-sustaining flywheel of our investment strategy is simple: own 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 on 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.
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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.
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