Quarterly Letter - Q3 2023
Dear Owner Partner -
I used to be a film fanatic.
I would watch hundreds of films a year and travel far and wide to film festivals nationwide. That all changed around eight or so years ago for reasons I will not go into here (but if you ask me offline, I will tell you!). These days, I only watch a handful of films per year. From my perch, the best films (like music) are mostly non-commercial, off-the-beaten-path, auteur-driven stuff not put out by the major film studios and production companies.
No surprise, these films are rarely the most commercially successful.
A great example of a recent film that fits the profile is Tár, released in October of 2022. This fantastic film is a subtly crazy, psychological drama written and directed by the tremendous Todd Field, starring Cate Blanchett as Lydia Tár, a controversial world-renowned conductor dealing with some misconduct accusations. While scoring a 92 on Metacritic and on the "best films" list for 2022 of many important critics, the film only grossed $7 million in the U.S. and Canada (and $29 million worldwide).
Being a business analyst and someone who is not an artist but loves art, I love that filmmaking represents an interesting intersection of art and commerce. Despite being an artistic success, Field's total cash-on-cash return on investment was 16% on the film's $25 million budget before any income from streaming services offset by marketing costs…So, he and the studio that distributed the film may have had a very modest positive economic return on the endeavor.
Of course, the biggest-grossing films - Star Wars, Titanic, Avatar, and the clutter of superhero films - all achieve excellent economic returns on their investments. However, while finding high-quality film industry data is challenging, around 80% of films created lose money, and most of the rest have very modest returns.
Now, at this point, I am sure you are wondering (like me!), what is the best-returning film of all time? I will be shocked if you can guess it.
Paranormal Activity, the 2007 horror film directed by Oren Peli, is, by far, the winner with a massively staggering 1,300,000% cash-on-cash return on its $15,000 budget! While I have been lucky enough to have a few "multi-bagger" investments in my career, I have never had anything close to that incredible return (yet!).
At North Beach, we do everything focused on cash-on-cash returns on our invested capital. By putting out our capital to 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 time, we aim to get high returns on our capital outlay. So far, we have done a decent job overall (see our Holding Company Update comments below). But sometimes, we make mistakes and do not achieve adequate returns on our capital (see our Brahler's Cleaning & Restoration comments below). It is inevitable we will make more mistakes in the future.
We work to optimize our returns and minimize our mistakes by understanding 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 cash returns in good times and bad. 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.
We don't attempt to worry about things out of our control, like when an economic recession will start, how large government deficits will impact the economy or the effects of Middle East geopolitical volatility. The future outcomes of those things are important but unknowable. We are not macroeconomic pundits or geopolitical strategists. For us, spending time on these pursuits is a waste. It is more beneficial to try and understand what is happening now in the areas we can control.
There is no fundamental difference in our attempt to achieve optimal cash-on-cash returns between owning an exceptional private operating company, making necessary capital expenditures for one of our private operating companies, and owning the common stock of an exceptional public company. In all cases, we protect, enhance, and deploy our hard-earned and sacred permanent capital in a durable, concentrated, and differentiated collection of superior service companies with an eye on good cash returns. 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 third 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 1% decline in equity book value per unit during the quarter compares favorably to the S&P 500 Index's 3% quarterly decline. Additionally, our annualized 6% decline in invested capital during the quarter does not compare favorably to our 20% objective and the S&P 500 Index aggregate return on invested capital of 10%.
Once again, the primary driver of the insufficient result was the weak operating performance of our private companies. 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.
More importantly, since inception (January 1st, 2021), our equity book value per unit grew 68% (21% compounded annual growth). This long-term performance compares favorably to the S&P 500 Index's 19% total growth (7% 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 albeit small performance contribution, given its small relative size to our overall asset base.
Alternatively, a more straightforward way (using cash-on-cash results!) to characterize our performance since inception: your holding company received cash dividends from the private operating and public companies, equating to 76% 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.
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
Pay out a liquidating cash distribution
As a result of our quarterly review, we remain incrementally more positive on small public company investments and will add more capital to this bucket when available. Rest assured, the best use of capital remains investing in our existing and new operating companies, which we continue to evaluate (see below for more detail).
THE SALE OF BRAHLER'S CLEANING & RESTORATION
In a bit of "last in/first out" deal-making, Brahler's Cleaning & Restoration was the last company we purchased back in 2021, and now it is the first company our holding company has sold. The sale's rationale was three-fold:
The company's sought-after disaster mitigation recurring revenue from insurance agents and adjusters proved difficult to perpetuate without intense marketing spend and effort;
We aim for a 20% continuing cash return on our investment capital, and, despite our best efforts, we could not consistently get the company to deliver an adequate return;
As described in more detail below in the New Private Company Pipeline, we are working on a big (for us) potential acquisition that, fingers crossed, will close by the end of the year; the capital and our team's time freed up from the Brahler's sale can be better utilized toward this new opportunity.
We completed the sale late last quarter for a modest gain compared to our cost. The buyer is a local holding company with a plan to grow the company using their specialized digital marketing skills. We thank the Brahler's employees for their incredible work during our ownership and wish the company and its new owners well into the future.
PRIVATE OPERATING COMPANY UPDATE
Guided by North Beach Chief Executive Officer Mike Foran and Chief of Staff Nikki Salas, our 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. Our remaining private operating companies had a fair quarter regarding 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, growing revenue and free cash flow. And the news just keeps improving: in addition to the previously updated N-PX filing requirement, the U.S. Securities and Exchange Commission recently updated the filing requirements for Schedules 13G and 13D and added a new required filing for those investment managers that sell common stocks short. Both of these initiatives substantially add to our potential revenue growth. ACN's President Spencer Wirick's plan for the future is twofold: (1) prepare for the new filing service offerings and (2) increase digital marketing efforts.
Hart's Ambulette
With revenue and free cash flow growing in the third quarter compared to last year's third quarter, Kristy Summers, Hart's President, plans on continuing the momentum by a continued focus on marketing in our current service geographies and beyond. That said, we are not satisfied with our cash-on-cash return on our overall investment here and have put a robust plan in place to get to where we need to be. And, of course, Kristy is up for the challenge!
BioVac Industrial Service
This year is turning out to be a roller coaster ride: a crappy first quarter, a blowout second quarter, and an uninspiring third quarter. While revenue was more or less solid across our three segments (landfill, water plant, and industrial), our operating expenses ran above budget due to one-time cost hits and planned marketing investments to continue building our brand in the landfill service industry. Led by President James Baird, those marketing investments are starting to yield fruit: our Q4 and 2024 revenue pipeline looks better than it has in a long time.
New Private Company Pipeline
Today, the "Power Ranking" of the top three opportunities in our pipeline are as follows:
Landfill and Renewable Natural Gas Plant Service Provider - We are pleased to achieve a dually-signed "Letter of Intent" to purchase a leading landfill compliance service company. We are now deep into due diligence with a target to close by the end of the year. We have expertise in and are very bullish on this industry, given our experience with BioVac (one of their primary end-markets is servicing the biogas filters landfill operators use to recover renewable natural gas).
Given the size of this transaction (i.e., significant for us), we are creating an "equity-lead" independent sponsor investment vehicle into which we will contribute our 100% ownership of BioVac, raise direct equity capital from new investment partners, and utilize some form of debt. When everything is said and done (again, fingers crossed!), we will control and own 25% of the combined company alongside the current owner, who is "rolling" a portion of his current equity (good for 12.5% ownership) into the new company; our new investment partners will own the rest.
If you or someone you love are interested in learning more about this investment opportunity, please let us know, and we would be happy to send you our Investment Opportunity Guide under a non-disclosure agreement and answer any questions you may have.
Information Technology Managed Service Provider
Control Room Visualization Solution Provider
Unsurprisingly, all the companies mentioned above adhere to our checklist: they provide essential niche services, have high recurring revenue, and are divorced from the ups and downs of the economy.
While we 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.
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.
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).
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.