Quarterly Letter — Q4 2020
Dear Friends —
On January 8th this year at the legendary California surfing spot Mavericks, 51-year-old big wave legend Pete “The Condor” Mel surfed the most incredible wave ever. You can check on the gnarly footage here.
For the uninitiated, Mavericks is one of the three premier big wave surfing spots globally (the other two are Jaws in Hawaii’s North Shore and Nazaré Portugal). Located in northern California outside Pillar Point Harbor, just north of Half Moon Bay, this spot routinely fires in the winter, and waves can top out at over 60 feet, which it did on that beautiful day for Mel.
As a lousy surfer during my youth relegated to the “ferocious” winter northeast swell of the “Cleveland Pipeline” at Edgewater Beach or, at best, weekend trips to OBX, I can still appreciate the stoke in Mel’s ride. The maximum point of risk - and reward - is when he gets to his feet at 0:09 and then drops past the “shelf” and commits fully into the “bowl” of the wave (a “full send” as the kids say). Any big wave surfer will tell you that moment is always a very heavy situation, but it is what they live for. Fear gets ignored as adrenaline and skill take over. Mel makes it look super easy as he gets through the crease in the bowl at 0:14 and stands tall in the pit of the wave. Then he completely relaxes and enjoys that special moment.
Since then, the surfing community has gone bonkers with adulation for Mel (e.g., the comment at 0:53). All agree there isn’t a comparable wave to this one. Sure, some have surfed larger and more ferocious waves. However, Mel’s combination of wave judgment, riding skill, immense power, and perfection stands unique and above every other wave ridden in history.
Like Mel, our holding company, North Beach Holdings LLC, is attempting to ride some pretty big waves as well.
The largest intergenerational transfer of private companies in history – worth an estimated $10 trillion according to the U.S. Small Business Administration – will happen over the next 15 years.
Many private companies are valued at less than $5 million, and their baby boomer owners are “distressed” sellers. No, they are not bankrupt or going in that direction. It is quite the opposite. These folks own very financially viable businesses. However, they need to sell due to forced retirement (by their spouse who wants them to relax or move to Florida or both!) or health reasons and do not have a succession plan in place. Their children do not want their business, and/or there is no employee or group of employees with the financial wherewithal to buy the company. Sophisticated professional buyers (e.g., private equity firms) are mostly interested in private companies valued at $5 million or more. There are not enough qualified individual buyers for companies valued at less than $5 million. We want to ride this long-term selling wave by buying small essential service businesses that fit our investment criteria.
Another wave we want to continue to ride is the relative value opportunity in micro-cap public companies compared to large-cap public companies. The orange line in the chart below simply shows the price ratio between the Wilshire U.S. Micro-Cap Index (a collection of the smallest public companies in the U.S.) and the Wilshire U.S. Large-Cap Index (a group of the 750 largest companies in the U.S.):
When the line is moving up, micro-caps are outperforming/large-caps are underperforming, and vice versa. The ratio exhibits a “reversion to the mean” tendency and has shown three distinct phases: (1) after peaking in July 1983, micro-caps underperformed large-caps until February 1999 during the Dotcom Internet Bubble; (2) micro-caps then outperformed large-caps through March of 2006; (3) since then, micro-caps have underperformed until the fall of last year. We believe there is a good chance we entered a new phase, and micro-caps will continue to outperform large-caps in the future.
The most powerful wave we want to ride is what Albert Einstein reputedly called “the 8th wonder of the world” = the power of compounding wealth. Our investment hero, Charlie Munger, has said, “the elementary mathematics of compound interest is one of the most important models there is on earth.” However, the human brain has a hard time comprehending compound growth, also known as exponential growth. A simple exercise: if you invest $1 at 10% for five years, you will end up with $1.61. If you invest $1 at 10% for ten times as long (50 years), you do not end up with $16; you end up with $117.40!
As part of our investment process, we want to continually reinvest as much of the free cash flow we receive from our investment holdings as possible to compound our investment capital for decades to come.
We know we cannot control or get caught up and bothered with things like the economy, the impact of the COVID-19 pandemic, or politics. 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 the fallout from political contests. 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 deeply understand them from the bottom up and allocate capital accordingly.
If we focus on what matters and what we can control, like riding the three waves mentioned above, in the future, we will have a good chance of favorable investment growth over the long-term. All three waves start by understanding that the only thing we can control is the price we pay for the companies we buy. 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 companies we bought to date (including the two private companies we purchased last month).
We continue to believe the pandemic will end, normal everyday life will gradually resume, and the broad economy will continue to improve. More importantly, our investment opportunity set remains attractive as we ride the waves. Our path forward remains the same: acquire attractively priced, well-run small private and public essential service companies and rationally compound capital for decades to come.
PRIVATE COMPANY INVESTMENT UPDATE
We are excited to announce that we successfully closed the two deals we mentioned last quarter. We established a great relationship with both sets of owners right from the beginning and worked extremely hard to complete these deals at the original price offered in the letters of intent. Though the deal process took slightly longer than anticipated, the negotiations and due diligence investigations were thorough, and the final purchase price did not deviate from initial expectations. 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.
Admittedly, our potential private deal pipeline has not grown much since last quarter. The reason is mostly because we were very busy conducting deal due diligence on our two new companies (BTW - never again will we try to close two deals at once!). It is not a reflection of the current small business deal environment. Now that those deals are closed, rest assured, Dillon Thompson, our head of private investments, will look to add to our private deal pipeline along with his work integrating and optimizing operations for all of our private companies.
Speaking of Dillon: those of you who have met him know what an impressive young man he is - an unstoppable, highly intelligent dynamo. But this quarter, he took it next level like Pete Mel. Not only did he work incredibly hard leading our due diligence efforts to get both deals closed, but he also welcomed his first child (baby Noah!) at the end of October. He then passed the notoriously challenging Level II Chartered Financial Analyst exam in December. Truly extraordinary!
NBH Industrial Service LLC d.b.a S&S Filter
One of the two new companies in our collection and our largest acquisition to date, S&S Filter, is headquartered in Austintown, Ohio. The company operates various vacuum and water blasting equipment used to aid water filtration plants by removing and replacing filter media such as sand and gravel. The company also aids heavy manufacturing companies in keeping their facilities clean of dirt, grime, oil, paint, and other contaminants that slowly build up in their facilities.
We were lucky to find Dan Debellis to serve as President of S&S and run its day-to-day operations. He is a young, talented operating executive and eager to participate in its growth through an incentivized compensation plan focused on free cash flow growth. Dan was deeply involved in our due diligence work before closing the deal, and he has already hit the ground running since day one. His engineering background and leadership experience are noteworthy and invaluable as he leads the company’s ten hardworking, skilled, and dedicated employees.
NBH Cleaning & Restoration Service LLC d.b.a Brahler’s Cleaning & Restoration
Brahler’s is the second recent addition to the collection. It is a 45-year-old family-operated cleaning, restoration, and remodeling company located in Massillon, Ohio. The company provides quality disaster mitigation and repair, including 24-hour emergency service and fire, water, wind, vandalism, and other damage repair services. They also offer commercial and residential carpet, furniture, and air duct cleaning services.
The company is blessed by a next-generation executive leadership team eager to take the company to the next level with a thoughtful growth plan. This team is led by Joy Plumley, one of the finest young business executives we have encountered. Her unique combination of leadership skills, enthusiasm, addiction to growth, and kindness is hard to beat. She, too, is eager to participate in its growth through an incentivized compensation plan focused on free cash flow growth.
NBH Medical Transport Service LLC d.b.a Hart’s Ambulette
Since our purchase of Hart’s at the end of July last year, we moved quickly to optimize and improve operations by doing three important things.
The first was building and installing a new all-digital operations module that tracks driver dispatch, insurance reimbursement, billing, and payroll to replace a burdensome, slow, and unreliable paper-based system. The new system allows us 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) to maximize and grow the company’s economic engine (free cash flow per unit of capacity defined as total daily hours driven in an 8-hour day). The new module’s early benefits are starting to come through.
The second important thing we did last year was create and execute a marketing plan for the company. The prior owner did not market the business on purpose. He was content with the company’s size and operational complexity. We are not. We believe we have a fantastic growth opportunity in the region we serve and look to spend marketing dollars to capitalize. This spend will include a new logo, website, social media initiatives, and marketing personnel investment.
Finally, promoting Kristy Summers to President of the company in December is the most important thing we’ve done so far. We are fortunate and excited to have someone like her now in place. She loves the service we offer, our employees, and our customers. She goes over and above to solve service problems. She relishes the challenges of delivering that service as efficiently as possible to maximize free cash flow. Like our other private company Presidents, Kristy has an incentive compensation plan in place to reward her for achieving those objectives.
Last quarter’s financial results were mixed, and we believe we can do better by improving things we control. Despite the effects of the COVID-19 pandemic on nursing homes, we grew revenue quarter over quarter (but not compared to the same quarter last year) due to our early marketing efforts offsetting lower dialysis and overall customer count due to COVID-related deaths. We did not do an adequate job of non-marketing expense control, and, as a result, free cash flow growth was lower than expected.
Looking forward to 2021, we are optimistic about the financial fundamentals. We believe the COVID-19 revenue headwind will be short-lived due to the early vaccine rollout targeting nursing homes and other high-risk age demographics. Also, we are confident Kristy will get expenses under control and grow free cash flow. After all, she is very incentivized to do so through her compensation package!
ACN Solutions LLC
ACN delivered another solid quarter and year of revenue growth overall and in each of our three main service lines (Form 13F, Form 13H, and Schedule 13G/D). However, revenue growth for the year was lower than we expected due to the decision to turn off our marketing spend in the second half in response to the Securities & Exchange Commission’s (SEC) 13F regulatory threat (more on that below). Spencer Wirick, ACN’s President (and our head of public company investing), did an extraordinary job managing controllable expenses and reducing days sales outstanding in delivering significant operating cash flow growth for the year. Free cash flow growth was slightly lower than the results in recent years due to focused discretionary investment in our online filing platform.
As we look forward to the year ahead, we expect more of the same: solid revenue and free cash flow growth. We are excited to restart our marketing efforts and continue investing in more talent and our online filing platform to support our growth trajectory.
Finally, we are happy to get the SEC’s potential 13F regulatory proposal threat behind us. In November, then SEC Chairman Jay Clayton conceded the proposal’s defeat during Senate hearing testimony, acknowledging the massive outpouring of arguments against changing the reporting threshold (for more background on the proposal, please see our two previous quarterly letters). In the future, we believe changing Form 13F’s regulatory requirements will be very low on the new SEC Chairman’s to-do list.
PUBLIC COMPANY INVESTMENT UPDATE
Compared to the investment opportunity in private companies, we remain relatively unexcited 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.
That said, in addition to his ACN leadership duties, Spencer has done an excellent job of digging deep well off the beaten path to find the 11 public companies currently in our collection. Most of these companies are micro-caps (<$300 million in market value), and in all cases, these companies have (1) broad insider ownership so that the management teams are aligned with investors on a long-term basis; (2) impeccable balance sheets to weather anything wicked that comes this economical way; and (3) long-term revenue growth runways to provide these companies with substantial opportunities to be more significant in 5 years. Most importantly, we believe the trade-off between these public companies’ durable competitive advantages (economic “moats”) and the price we paid for our shares on a sustainable free cash flow basis is skewed materially in our favor.
Since our initial deployment of public company capital at the end of Q3 of 2020 through January 31st, our return on capital deployed is over 35% compared to the S&P 500 Index’s return of 10%. Clearly, our positions are benefiting from the tailwind associated with the second wave mentioned above. However, there were also many idiosyncratic developments at several companies we own. These include favorable business developments at many of our companies, a one-time special dividend issuance at one company, and an uplisting from the OTC market to the NASDAQ market announcement for another. We will continue to refrain from publicly identifying those companies today because we are still building these illiquid, “trade-by- appointment” investment positions.
Back to Spencer – we are not sure where he finds the time to do it all so well (running ACN, overseeing the public investment process, grad school, etc.). Long-time readers know he is an avid long-distance runner and competes at the collegiate level while attending grad school. He recently set two “PRs” (personal records) in his 1-mile and 5K times, and those times are mind-bogglingly fast!
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Finally, we were excited to welcome our first outside owners, who graciously invested their family’s permanent capital in North Beach. We are honored and humbled to have them as partners and will work hard to earn excellent returns and compound our collective wealth over the long-term.
As always, our team is excited to move forward with our private and public company collection. The core focus of creating a best-in-class investment holding company is “Job #1” every day/all day for Dillon, Spencer, and I. Doing so will push hard on our investment strategy’s self-sustaining flywheel (shown above), 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.
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