Quarterly Letter — Q1 2020
Dear Friends —
First and foremost - we wish you and your loved one’s health and safety during this most unusual period. These are difficult times, but we have confidence we will get through them together and emerge stronger. Our hearts go out to the brave medical professionals and first responders on the front line of this COVID-19 pandemic war as well as the entrepreneurs and small business owners who are suffering financially and emotionally.
Our investment career started in 1996. We have seen a lot since then including the global markets crash of 1997, the Russian debt crisis in 1998, the dot-com technology crash in 2000, the 9/11 attacks in 2001, and the global financial crisis in 2008-2009. As avid students of market history, we have read about the impact on stocks from the Great Depression, the October “Black Monday” crash of 1987, the “junk bond” crisis of 1989, the real estate and savings & loan bank crisis in 1990, and Iraq invading Kuwait in 1990. In our opinion, the economic fallout from the COVID-19 pandemic crisis is right up there with the worst of them.
No surprise, virology and epidemiology are way out of our circle of competence, as are pretty much all -ologies. We will not attempt to divine when “the curve” will flatten, what the kill rate of this thing is going to be, or what the R-naught will ultimately be. Nor will we get caught up in misguided hysteria that abounds today. We are trying to do what our investment hero, Charlie Munger, prescribes: “While a lot of other people are trying to be brilliant, we're just trying to be rational.” To us, staying rational means focusing on what we think will be true in the future: the pandemic will end, shelter-in-place will end, the quarantines will end, normal life will gradually resume, and the economy will recover.
Financial markets and investment securities are, by their nature, forward looking – price weakness usually precedes economic weakness and stronger prices will appear before and, in anticipation of, business normalcy returning. Like each of those major crises in the past, now, too, is an incredible opportunity for substantial future investment returns. We believe both our private and public company investment opportunity set is more attractive today than ever before even considering the near-term economic challenges. We are eager to use this downturn to acquire attractively priced, well-run small private and public essential service companies.
PRIVATE COMPANY INVESTMENT PIPELINE UPDATE
Over the last two years we talked directly to over one hundred small business owners about buying their businesses. The vast majority were what we called “distressed” sellers. No, they were not bankrupt or going in that direction. Quite the opposite. These folks owned very financially viable businesses. However, they were baby boomers selling their companies due to forced retirement (by their spouse who wanted them to relax or move to Florida or both!) or health reasons and did not have a succession plan in place. Their children did not want their business and/or there was not an employee or group of employees that had the financial wherewithal to buy the company. Furthermore, as much as the idea of retirement and selling their prized business pained them, there was one thing that offset that pain: avoiding the distress of not going through another financially and emotionally debilitating recession like 2008-2009.
And here we are about to enter another recession.
Knowing this seller demographic, we believe we can be a financially agile solution to their uneasiness about the recessionary future. We hope to capitalize on it soon. Social distancing and mandated quarantines make networking, company visits, and, ultimately, deal making slower than usual. Like everyone else, we are adapting.
The persistent valuation opportunity in small private business compared to other investment opportunities available today is alive and well. As an example, companies worth less than $5 million can be bought with free cash flow yields (the cash left over after a company pays for its operating expenses and capital expenditures divided by the company’s market valuation) between 23-50% according to the International Business Broker Association/M&A Source/Pepperdine Private Capital Markets Market Pulse Q4 2019 Survey:
This compares to the S&P 500 Index (a collection of the largest 500 publicly traded companies in the U.S.) current free cash flow yield (after the recent market meltdown) of only 5.7% according to Bloomberg and the 10-year U.S. Treasury yield (a form of free cash flow) of only 0.7%!
“CLEANCO” KILLED
If you recall from last quarter’s letter, we mentioned we were negotiating a LOI with a well-run commercial carpet cleaning company. Long story short, when you get down to the “knife fight” of deal negotiations, you are lucky to see your opponent’s true colors early so that you can pivot and react accordingly. Only in this case, the true colors were bizarre hostile legal threats and due diligence terms that were, frankly, unorthodox and unwieldly. We chose to be disciplined and walked away despite the hard work and energy our team put into attempting to complete this deal. We learned a lot from the setback and will improve our process going forward.
THE TOP FOUR OPPORTUNITIES
Dillon Thompson, our brainiac investment analyst, has done a great job finding four new great opportunities that we are aggressively pursuing. They are listed below in order of attraction based on business model fundamentals and our investment checklist (by the way, we use codenames because we are under non-disclosure agreements for all). Please note, one of the key components on our checklist is having an adequate 2nd layer of management in place after an owner-operator retires. If it is not there – and we cannot find a skilled manager in our network readily available to run the company – we generally kill the deal. We do not hold ourselves out as day-to-day company operators. That is out of our circle of competence. We add value by working closely with the management team and advising on financial control, operational excellence, and capital allocation.
“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.
“MEDTRAN” – A well-regarded Northwest Ohio non-emergency medical transportation company with adequate route density in their local markets and the possibility of expansion into adjacent regional markets. The owner-operator of the business believes a key employee can become the general manager in the near future.
“INDVAC” – A Northeast Ohio industrial vacuum and water blasting service provider to recurring waste byproduct manufacturers such as steel fabrication & production and municipal water and wastewater plants. While we love this business, there does not appear to be an adequate 2nd layer of management in place; however, one of the two owner-operators is considering staying on for an extended period after a sale.
“POTICO2” – A very well-run, Columbus, Ohio portable toilet rental company with a high repeat customer base balanced between event-based and construction end-market exposure. Besides the potential risks to the business in a post-COVID-19 pandemic world (which, of course, can be mitigated by paying the right price!), we believe there are two key employees that can run the business day-to-day.
ACN UPDATE
You may recall from last quarter’s letter our rationale for why ACN is the quintessential essential service company. Well, you can add that it is pandemic-resistant to the list! All ACN employees work from home and have been utilizing cloud computing and communications technology for years. While we do not foresee any interruption to ACN’s business model, operations, or financials due to the COVID-19 pandemic, we continue to monitor developments in a global business environment that changes daily.
Twelve-month trailing revenue as of March 31, 2020 grew 19% on a year over year basis while operating income grew 50% year over year. Since our ownership started in 2018, ACN’s strong growth has benefited from operational efficiency and working capital improvements for the last 18 months. Some of these improvements have a “one-time” positive impact on growth and are not expected to continue in the future. Free cash flow grew just over 40% in 2019. As we mentioned last quarter, we are investing in more talent, technology, and advertising and marketing in 2020 as a part of our capital allocation plan. We believe this will help continue to grow revenue in the future. All in, we feel confident using our experience in improving ACN’s financial control, operational excellence, and capital allocation over the course of our ownership to improve the companies we acquire in the future.
PUBLIC COMPANY INVESTMENT PIPELINE
The stock market sell-off in response to the COVID-19 pandemic has improved public company valuations compared to last quarter. However, those valuations did not come close to those seen in the 2008-2011 period. In the chart below, the free cash flow yield of the S&P 500 Index (a collection of the 500 largest companies in the United States; shown in orange) went from around 4.0% at the end of 2019 to 5.7% on March 31st during the recent sell-off (the yield of the 10-year U.S. Treasury Bond is also shown in blue):
Just as we do not hold ourselves out as virologists or epidemiologist, macroeconomics is outside of our circle of competence. The questions of how deep the recession goes and how long it lasts are important questions. However, they are, unfortunately, unknowable by anyone, even the loudest and smartest-sounding financial media pundits. We will not wade into that guessing game. Our working expectation is the damage done from government-mandated shelter-in-place orders, quarantines, and social distancing policies may continue to rear its ugly head in the short-term and public company valuations may also improve as economic reality sets in.
We will stay within our tight circle of competence as business analysts focused on finding outstanding essential services businesses at sensible prices - not mediocre businesses at bargain prices - and deeply understanding them from the bottom up and allocating capital accordingly. That said, here at RPM, we view the shelter-in-place order as a gift of time from the government which we are using to continue to dig deep in order to find potential out-of-favor essential service investment opportunities.
Specifically, we want the trade-off between a public company’s business model with very durable competitive advantages (“moats”) and the price we pay on a sustainable free cash flow basis for the company massively skewed in our favor. Of course, these companies must also have: (1) large insider ownership so that the management teams we partner with are aligned with us on a long-term basis; (2) impeccable balance sheets in order to weather anything wicked (like pandemics and forced economic shutdowns!) that comes this economic way; and (3) and long-term revenue growth runways to ensure these companies will be bigger in 5 years.
Spencer Wirick, our new investment analyst hired on at the beginning of the year, has done a stellar job of getting up to speed on our investment process as well as adding massive value by finding interesting public essential service companies for us to dig into. In addition to Nielsen Holdings, Issuer Direct Corporation, and Psychemedics Corporation, which we profiled last quarter, the following are two examples of companies that fit our criteria well and are currently “on sale” today.
MiX Telematics Ltd (MIXT)
Founded in 1996, headquartered in South Africa, and with substantial business in the U.S., the company is a leading global provider of fleet and mobile asset management solutions delivered in a “software-as-a-service” subscription revenue model or SaaS. They have multi-year contracts with their customers and garner a +90% subscription renewal rate. Their solutions are delivered to over 812,000 vehicles and provide measurable return on investment by enabling their customers to manage, optimize, and protect their investments in commercial fleets, mobile assets, or personal vehicles. They generate actionable intelligence and data that enables a wide range of customers, from large enterprise fleets to small fleet operators and consumers, to reduce fuel and other operating costs, improve efficiency, enhance regulatory compliance, promote driver safety, manage risk, and mitigate theft. The company’s management team is led by founder and CEO Stefan Joselowitz and owns over 23% of the shares outstanding. Capital allocation has been brilliant since inception. The balance sheet is clean and has no net debt.
The company is “on sale” today because of its exposure to the energy industry, which represents around a quarter of revenue. The industry has been under pressure due to the global slowdown associated with the COVID-19 pandemic as well as the recent dramatic fall in oil prices due to the implosion of the OPEC oligopoly. We believe this will be temporary in nature and will not matter to the long-term investment thesis for this company. That thesis, by the way, is grounded in the large addressable market (around $87 billion) in the premium fleet space. Current industry penetration is only 19% of the 206 million potential vehicles out there today.
With a market cap of $200 million, this under-the-radar company is offered to us at around $8.50 per share compared to our scorched-earth, conservative intrinsic value calculation of $13.50 per share.
Discovery Inc. (DISCK)
The company is the owner of the most popular non-fiction media content in the world today including Discovery, TLC, HGTV, Food Network, and Animal Planet. By virtue of being a vertically integrated content company that owns both domestic and international channel content and produces most of the nonfiction (or reality) programming that airs on its channels, it is highly profitable compared to more fiction-oriented media companies that have to pay outrageous costs for content (think Netflix, HBO, Amazon, Apple, etc.). As an example, given its reach, the company’s content has demonstrated widespread appeal that translates across both borders and languages. The company capitalizes on this appeal by editing and updating its content to provide localized versions that can be distributed to its subscribers in more than 200 countries in 45 languages. More than 50% of the programming on international networks is originally produced for U.S. networks, providing a significant source of margin leverage. Beyond using the content on its own channels worldwide, Discovery can license the same shows to SVOD (subscription video on demand) providers globally, as the company owns the digital rights to its content. The management team and other company insiders, including cable and media investment legend John Malone and former Advance/Newhouse chairman, Robert Miron, own over 10% of the shares outstanding and even larger blocks of voting control.
The company is “on sale” today primarily for two reasons we think. The first is a persistent worry about consumers cutting the cable TV cord and the company losing advertising revenue as a result. We believe the company is somewhat insulated from this trend compared to other domestic programmers because of its significant international asset base, where cord-cutting is less prevalent, as well as their own direct to consumer programming initiatives. By the way, they are the most-watched media company for women in the U.S. and the largest producer of live sports outside the U.S. The second is the near-term worry from the impact of the COVID-19 pandemic. Advertisers are cutting back on spending in this environment in order to cut costs and preserve cash. In addition, the company owns the broadcasting rights to the 2020 Olympics outside the U.S., which has been postponed until next year but is fully insured and will not be a negative hit to the income statement.
The company is offered to us at around $18 per share compared to our scorched-earth, conservative intrinsic value calculation of $30 for the Class C shares
…
As a reminder, the self-sustaining flywheel of our investment strategy is simple: own enduringly profitable companies that generate free cash flow in order to own more and more enduringly profitable companies that generate more and more free cash flow. We want to compound capital for decades to come. We will be committed with material skin in the game, and we are excited to execute on our plan.
As always, thank you for your continued interest in RPM Capital.
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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