Quarterly Letter — Q4 2021
Dear Friends —
I am very rarely the smartest person in the room.
And I am okay with that.
However, I have a different goal. I want to be the one in the room who learns the most!
Considering these days, I spend most of my time in rooms with my former Mensa International member wife, my 23-year-old genetics PhD-to-be son, my best friend Lino, who happens to be the most intelligent investor I know (and I know a lot!), my wicked-smart partners - Dillon Thompson and Spencer Wirick, or my incredible network of colleagues and advisors. I have learned and will continue to learn from all of them.
That said, I learned a lot in 2021, the first full calendar year of activity for North Beach. But, maybe the most important lesson I learned is the importance of getting the culture right in our entire organization.
Charlie Munger, always the smartest person in the room and Warren Buffett's right-hand man at Berkshire Hathaway, said:
"The three best operating companies I'm aware of are Costco, Kiewit, and Glenair. There is nothing remarkable about the product or field for any of these three. But there is something remarkable about the cultures of all three."
You can infer from his comment that a focus on culture is a good starting point to figure out why companies are exceptional and have long-term competitive advantages. Getting culture right starts with having the right people in the right seats on the bus and getting the wrong people off the bus. Only then can the bus go forward in the right direction. When the culture is good, we do not have any problems.
However, at each of our operating companies, we have had, at times, the wrong people in critical positions on the bus or the right people in the wrong seats, and financial results have suffered. Once the wrong folks got off the bus or the right folks moved into the right seats, both the culture and the financial results improved materially.
Once you have the right people in the right seats and the bus is moving in the right direction, you still need to continuously improve culture until the levels of trust, security, caring, fairness, and reciprocation are self-evident by all employees. The culture must be so good that an employee does not want to leave. In reality, you never know you are there, but you know when you are not there. One example that shows us we are not there yet at one of our operating companies is how we suffered due to the "The Great Resignation," a phenomenon where American workers are voluntarily leaving their jobs in record numbers. We are actively making personnel changes and adding a lot of effort to that operating company to get the culture right. We believe better financial results will follow.
Last year was a great reminder that the “business of business” is a knife fight. We had big plans for growth at our operating companies and were prepared to invest into the year. Unfortunately, our growth plans were not fully realized. We could not hire additional incremental employees or purchase necessary equipment due to well-publicized employee and supply-chain challenges. Now, these are things that were not in our control. However, we did execute on the things that were in our control. One thing was improving our human resources assets and skillset (e.g., we elevated the great Nikki Salas to an HR leadership role at the holding company, giving her oversight power over all of the operating companies). Another was finding expert supply-chain solution partners instead of doing it on our own (e.g., sourcing filter media from a new provider at S&S and working with Mobility Works for sourcing non-emergency medical transport vans for Harts Ambulette).
We also had plans to add one additional operating company in 2021, but that did not happen either. This should not be viewed as a negative. Our expert Director of Private Investments, Dillon Thompson, filled our pipeline with some fantastic opportunities last year. Under his leadership, we remained disciplined on the price we offered when the opportunities presented themselves and did not get a completed deal. We have stayed very patient and continue to pursue several high-quality private essential service companies that meet our requirements.
In all cases, we spend time focusing on the things we can control and not stuff out of our control like macroeconomics, the impact of the COVID-19 pandemic, or political bullshitnonsense. The future outcomes of those things are important but unknowable. We are not macroeconomists, epidemiologists, or political strategists. We don't focus on predicting the direction of inflation or interest rates, disease kill rates, or what the tax rates will be in the future. Those pursuits are a waste of time.
It is more beneficial to try and understand what is happening now in the areas we can control. 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.
Our path forward endures: acquire attractively priced, well-run small private and public essential service companies that can deliver free cash flow growth for a long, long time. There is no fundamental difference between catching an exceptional private operating company and catching the common stock of an exceptional public company. We protect, enhance, and deploy our hard-earned and sacred permanent capital in a durable, concentrated, and differentiated collection of superior companies. These companies are run by able and honorable entrepreneurs that possess important and unique long-term competitive advantages so that free cash flow earnings are very likely to be materially higher many years from now.
PRIVATE COMPANY INVESTMENT UPDATE
Our collection of private companies had a strong finish to 2021. Aggregate revenue grew year-over-year, our operating profit margins improved, and we now have the employees we need to deliver outstanding service and realize our growth potential. Most importantly, our plan to get traction and grow free cash flow is in place and now working. Part of our growth plan is meaningfully raising prices for our services at each company in line with or more than our cost inflation in 2022.
ACN Solutions
It is the same story each quarter: Spencer Wirick, ACN's President (and our Director of Public Investments), executed another solid quarter of revenue growth, EDGAR filings, and, most importantly, free cash flow sent up to our holding company. In addition, the updated website has improved ACN's search engine optimization, and the goal to push more clients to our online service and improve profitability continues unabated.
Brahler's Cleaning & Restoration
The fourth quarter was not kind to Brahler's. As the weak spot in our collection, revenue did not grow, and free cash flow was non-existent. In addition, the company's bread and butter disaster mitigation and cleaning businesses were both weaker than expected. Compounding the weakness was the inability to produce full staff levels due to COVID-related staffing headwinds, which caused overtime costs to skyrocket. Additionally, earlier this month, the company's President, Joy Plumley, decided to part ways. We wish her well in her future endeavors. Fortunately, our executive bench there is deep: the talented Dave Alexander - hired as the Director of Operations earlier this year - has been named the new President, and Stacy Ignacio, an internal operations specialist, has been promoted to Production Manager. The team is working hard to get the company back on track.
Hart's Ambulette
Once again, Kristy Summers, Hart's President, grew revenue and customer trip count during the quarter despite the holiday schedule and the "omicron" pandemic headwind that resulted in temporary nursing home closures and medical appointment cancellations. The best news was adding a new van to our fleet. Now, if we can only get two more! Kristy's marketing efforts are also paying off - she added another new nursing home facility to our customer list. Expenses were unusually high (again) due to the theft of multiple van catalytic converters; there is now a pro-active plan to not let that happen again. The streak of quarterly free cash flow growth continues.
S&S Filter
Dan Debellis, S&S's President, absolutely crushed it in the fourth quarter: massive revenue growth, profitable operations, very strong free cash flow growth, and a future business activity pipeline that is the strongest in its history. All his hard work navigating the business around a litany of challenges mentioned in previous quarterly letters has finally paid off: getting the right people in the right seats on the bus, adding several new customers, and improving internal operating systems. As a result, the company, the collection’s largest, is poised for stellar growth in the year ahead.
New Company Pipeline
When Dillon Thompson is not working expertly to improve our operating companies' operational profitability, he is working hard to find new enduringly profitable service companies for us to acquire. His pipeline is always teeming with interesting opportunities - today is no different. It is focused on the managed information technology and mobile drug testing service spaces and a few add-on opportunities for our existing operating companies. While still too early to get more specific here, we remain excited to meet and learn from these incredibly talented entrepreneurs. They built unique businesses and are now looking for the proper transition plans and homes for their companies. We hope to help them.
PUBLIC COMPANY INVESTMENT UPDATE
We are building a collection of publicly-held essential service companies with (1) broad insider ownership where the management teams we partner with are aligned with us on a very long-term basis; (2) impeccable balance sheets for maximum financial flexibility; (3) high and stable returns on invested capital; (4) long-term revenue growth runways; and (5) most importantly, the trade-off between durable competitive advantages and the price paid for our shares skewed materially in our favor.
Since our initial allocation of public company capital at the end of Q3 2020, our return on capital deployed is 78% compared to the S&P 500 Index's return of 44% through the end of 2021. In addition, our 1-year and Q4 2021 returns were 41% and -2%, respectively, compared to 29% and 11% for the S&P 500 Index.
For the most part, since inception, our public company management team partners have carried themselves admirably and allocated capital intelligently. Most teams are reinvesting capital at high rates of return. A few actively buy back company shares at desirable discounts to intrinsic value. In one instance, we received more than our total cost basis in two special dividends after the management team wisely sold non-operating real estate assets at great prices.
There have been two disappointments. The first is a decision by a management team to sell our company at a price well below our calculated intrinsic value (but well above our cost basis, providing us with net gains to be redeployed elsewhere). The second disappointment is a management team materially selling their personal holdings in the company at a price that is also below our conservative calculation of intrinsic value. Selling can be okay at times, but, in this case, it comes after the management team repriced some executive compensation options very much in their favor and not in our favor. This is not how we want our partners to behave. Consistent with our investment philosophies discussed in prior letters, we have since sold our share of the company, even though it was at a loss.
Spencer did add one new name to our public company collection at the beginning of last quarter. This company, run by a great under-the-radar management team with a long history of excellent capital allocation, has a unique collection of financial technology and communications assets. While not overly inexpensive on a free cash flow yield, this is more of a "sum-of-the-parts is much greater than the whole" investment opportunity. Spencer's conservative estimates of the total value of each part are worth more than twice the current market value of the whole company. Even better, the management team has demonstrated the ability to recognize the value in the past by either selling assets outright or spinning assets off to shareholders.
Other than our positions in AmerisourceBergen Corp, Berkshire Hathaway Inc., Criteo S.A., and Graham Holdings Company, we will continue to refrain from publicly identifying the other ten companies in our collection since we are still building our positions. In most cases, these are illiquid, "trade-by-appointment" situations in very small public companies.
As a reminder, we remain relatively unexcited with the aggregate public company investment opportunity set because market valuations are too high. Our sentiment from last quarter bears repeating here. We don't have to buy the whole market (i.e., index investing) and are not forced to put capital to work at any time. There is no master strategic plan or need to proceed in some ordained or conventional fashion. By remaining flexible and keeping our investment options open, we decide what makes long-term investment sense given a practical and tight circle of competence.
…
By focusing on creating a best-in-class investment holding company, Dillon, Spencer, and I 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. For us, this is what we can control all day, every day. We finished 2021 as a stronger organization after learning a lot and focusing on what we can control. We are set up for a great year in 2022.
As always, thank you for your continued interest in North Beach Holdings.
Best regards,
Russell P. Moenich
President/Chief Investment Officer