IDEA TRACKER UPDATE, PART 2: SOFTBANK

SoftbankA great capital allocator and sum of the parts

The long thesis here is basically that Softbank is run by an excellent capital allocator and is trading at a deep discount to its sum-of-the-parts or break-up value. I largely agree, however I want to have greater clarity on how Mr. Son is going to unlock shareholder value over the near-term. Any eminent catalysts over the next 2-3 years would be great for closing the holdco discount gap and consequently increasing the IRR on this investment. But I also wouldn’t worry too much if the stock stays flat in a trading range for a little while. Given Son’s exceptional track record, (I believe Softbank has been able to compound intrinsic value per share at 20%+ since it went public) I think it’s a very high probability that Softbank will continue to compound intrinsic value per share at superior rate of return for a very long time. If we analyze all of Softbank’s major investments since inception, the compounded rate of return has been roughly in the mid 40’s%, driven largely by the investment in Alibaba; Son invested $20MM in Alibaba when the business will still being run out of Jack Ma’s apartment. Talk about a visionary. Even if we exclude Alibaba from the return figures, I believe his track record is still in the low 20’s%. I think how Son runs Softbank is actually quite similar to how Buffet grew Berkshire – intelligently investing all the cash flow from existing cash cow businesses into opportunistic, very long-term investments. I guess for Buffett it was more like investing the low-cost float received upfront from his insurance businesses. For Son his Japanese telecom business is basically the cash cow. I really like how Son is building Softbank’s ecosystem to prosper in the “mobile revolution”. He’s investing in the infrastructure (Sprint), the content via mobile games (Gungho, Supercell), and in the services (Alibaba).

Aside from the typical complex holdco discount, I believe that investors’ worries over the outlook for Sprint and the negative short-term sentiment for Alibaba is why Softbank’s shares are still trading at such a large discount to intrinsic value. But for the enterprising, opportunistic value investor that’s willing to dig through all the moving parts, I believe Softbank is quite cheap.

Domestic Telecom Business: The Japanese wireless industry is basically a 3-player market and although Softbank continues gain incremental market share, it remains third behind its competitors DOCOMO and KDDI. Apparently Son was able to convince Steve Jobs to give him exclusivity in bundling the original iPhone models with wireless plans when they were first released. Along with his foresight in betting on the iPhone, Softbank was able to undercut industry pricing by a large margin which led to huge market share gains. Some analysts were expecting Apple’s iPhone’s handset margins to come down as competitors would eventually catch up and pressure pricing in an increasingly commoditized product; if this were to occur then the telcos would be able to pass on some of these device cost savings to consumers. Despite the increasing competition, the iPhone product lifecycle doesn’t seem to be ending anytime soon and pricing hasn’t been pressured at all. I’m not sure if Apple’s ecosystem will allow them to earn above-average profits for the long-term but what I do know is that Softbank’s customers continue to buy lots of expensive iPhones among all the alternatives. So overall the business remains healthy today. They’re currently #1 in terms of networks speeds and they’ve recently completed a major CapEx upgrade cycle to 4G, so I expect their free cash flow to materially ramp-up over the next several years. Moreover, the industry players have each recently shown signs of ending aggressive promotional pricing, which should further support healthy long-term ARPU growth, or at the very least support stable pricing. I value their wireless business in-line with comps at 6x EBITDA.

Sprint: Sprint definitely has its problems. The US wireless industry remains an extremely competitive 4-player market as T-Mobile and Sprint continue to invest large amounts of capital on upgrading their networks and hurting the overall industry profitability with their deep pricing cuts. I’m not an expert on the US wireless industry so I don’t think I have a huge edge here. Some analysts even believe that Sprint’s equity could be worth $0. Fair enough. Let’s assume Sprint’s equity is worth 0. Worst case scenario, Softbank would inject a little bit more equity capital in a cash-hemorrhaging Sprint. Even under this scenario, my break-up analysis suggests that Softbank’s shares are still worth nearly 15,000 YEN 2 years from now. So whether or not Sprint is successful in reaching minimum efficient scale doesn’t make or break the thesis.

Alibaba: I believe Alibaba’s value is worth much more than the current market cap of Softbank today. I value this business at 25x 2017E EBITDA of $12B, or $300B. As they continue to scale their marketplaces, their operating margins should continue to ramp-up, along with an increasing incremental return on capital. With such a large fixed-cost base, I don’t see how their incremental margins on transaction growth won’t hold up despite the monetization concerns. I also think the fake product concern is short-term in nature. On top, they have a huge payments processing arm in AliPay, an infrastructure-as-a-service (IAAS) business that sells excess cloud capacity, and a logistics joint-venture; this is a monster of a business and likely one of the highest-quality in the world. These guys were basically a start-up that drove eBay’s business out of China. Their end market growth runway is huge, they’re in a net-cash position, and for a monopolistic, asset-light, toll-booth business on China’s growing e-commerce market, I think $120 per share is reasonable. Since Mr. Son is also the largest shareholder of Softbank, I doubt that he would want to incur a large tax hit should he decide to monetize the Alibaba stake with the huge tax basis. I assume, like Yahoo!, that their stake will eventually be spun-off in a tax-efficient transaction, so I apply no after-tax value. I also think the domestic regulatory or currency risk is quite limited. Longer-term I think as the market better appreciates Alibaba’s value it will be a driving force in lifting Softbank’s shares.

softbank nav

If Softbank shares can close 90% of the holdco discount in 2 years, the IRR on this investment will be ~38%. Like most other major non-US currencies, the Yen has been getting annihilated. In terms of structuring this position, I think I’m going to fully hedge out the Yen, and I might even short the proportional Sprint stub. Based on the proportional values of each piece, you can create your own stub if you like.

Idea Tracker Update, Part 1: EBAY

I’ve been looking for some garbage to short in this market. I think it’s been increasingly difficult to find attractive long opportunities in larger companies that meet my hurdle rate. The only real opportunities I see right now are special situations where the underlying company is undergoing some type of corporate event and coincidentally these are in industries I think I understand best. I don’t think the market is overly expensive nor cheap by the way. Over the next little while I’m going to post a mini marathon set of posts that will update some of the ideas recently mentioned on this blog.

First up is eBay.

 

eBay – Revisiting the spin-off thesis

The stock has done quite well over the short-term since Steven recommended it. I original liked the idea as well, but now that I have a much higher hurdle rate, it simply doesn’t meet my return requirements unless I structure a long position in combination with more leveraged instruments such as derivatives which I’m unwilling to do at these trading levels.

The original thesis was focussed on the pending spin-off of the PayPal unit from the Marketplaces unit which would unlock substantial shareholder value mainly through improved capital allocation, better corporate governance, operational focus, cost rationalization and in general just getting rid of a rather idiotic CEO. I think the CFO needs to go as well.

I think the opportunity still exists partly because of everyone’s frustrations with the mediocre operating performance and the subpar capital allocation.  But I also think investors are increasingly fixated on faster-growth opportunities in the general tech space. Ebay is sort of becoming a “dinosaur” compared to some of the more newly emerging, sexy, rapidly growing technology-based industries such as enterprise SaaS and social media. Moreover, from an event-driven angle there was also little guidance given from management (at the time of the spin-off announcement) for how each business would get capitalized, the complexity of where to allocate the corporate overhead, D&A, etc and the typical failure of most market participants in properly valuing 2 divergent earnings streams.

The thesis for the marketplaces segment is based primarily on financial engineering and returning capital to shareholders via leveraged share buybacks. I had modelled ~$4.1B in EBITDA for marketplaces by 2017, which is actually on the back of low single-digits top-line growth and ~300 bps in EBIT margin compression. I’m actually quite bearish relative to consensus on the long-term prospects of the marketplaces business given what I think is a few emerging structural challenges that this business will face in a changing e-commerce competitive landscape. I think the two large concerns I have is the slowing organic growth and the additional marketing and R&D spend that I think will need to be incurred in order to even sustain positive long-term revenue growth rates. The recent security failure might have also turned off a lot of users and damaged brand equity for the long-term; I know I would be pissed if my account and password got hacked. 1) In the recent full conference call, management projected 0%-5% fx neutral top line growth for marketplaces which I think is pretty ridiculous in light of the fact that US and global e-commerce is still growing at around high-single to low double-digits. This tells me that management have mismanaged the business to such an extent that they’re now losing massive market share. Given the international exposure, I think there’s even a possibility for reported revenue growth to go negative, especially if the US dollar continues to surge against major international markets. Given the operating leverage and rather concentrated US cost base of this segment, the downside won’t look pretty. For a typical dominant network, winner-take-all marketplaces business model that should be taking incremental market share this is just a very worrisome possibility. But honestly, after going over some of management’s bullish forecasts in previous analyst days (that have badly missed or have been revised down), 0%-5% could potentially be very realistic. On the margin side I think larger incremental spending will be required since this business increasingly looks outdated (doesn’t seem to be attracting millennials) and irrelevant.

So I feel like there’s quite a bit of execution risk going forward to revitalize this business and better compete against Amazon. I think going forward the only real value proposition for this platform will be for existing “power sellers” that have a long merchant track record and have less of an incentive to move their business. The major business lesson here: Despite having a business with superior economics on the surface: an asset-light, cash-generative toll-booth business (with ~40% operating margins) vs. Amazon’s fulfilment model (with ~1% operating margins), a dominant network effect doesn’t automatically off-set an inferior service. In Tony Hsieh’s book, Delivering Happiness, he talks about the great lengths Zappos went to continually improve their customer service even if it sacrificed near-term profitability; this included things like free shipping for customers, free returns, and an exceptionally trained, passionate customer service team. Zappos was eventually acquired by Amazon and I feel like even in this new information age economy, the level of customer service remains a critical factor to the success of these e-commerce service platforms.

I assume the new marketplaces management will increase the pace of buybacks and leverage up to 2.5x net debt to EBITDA by 2017. Working from EBITDA to FCF per share, I modeled out nearly $2B in fully-capex’d FCF by 2017. If marketplace can raise debt over the next 3 years at an average after-tax cost of 3.5%-4%, leverage up to 2.5x by 2017, and assuming they pay full repatriation taxes on existing foreign cash, I think they can repurchase ~22% of the total current float over the next 3 years. They should be over a comfortable interest coverage ratio of over 5x as well. Originally I expected closer to 30% of the float to be repurchased but since they’ve announced that they’re capitalizing PayPal with $5B in cash, I think this is less likely. Given the number of large actavist funds in this name (Jana, Third Point, Glenview, Icahn), and the leveraged share buybacks that have already taken place over the past year (~$4.6B in share buybacks) I’m rather confident that they will shrink the equity accretively in this low rate environment – I just don’t know to what degree (2.5x is what I’m assuming or 4x that some have suggested). For a still rather high-margin, cash generative business with a network effect moat, (although structurally challenged I believe) I value marketplaces at a range of multiples of 14x-16x (or a ~6%-7% fcf yield) my estimate for $2 per share by 2017. On these numbers, marketplaces is basically worth $28-$32 per share 3 years from now. Unlike most of the Street that values marketplaces on an EBITDA multiple, I believe we have to take into account a more efficient capital structure that involves leveraged share buybacks.

However, if top-line growth rates dip to negative territory and FCF growth decelerates even faster, the entire leveraged buyback thesis falls apart. On the upside case, it’s very possible that Alibaba will eventually acquire eBay and fix its problems. I think Jack Ma has real ambitions to expand outside of China. I would just assign a 0 value on the GSI segment (which is now getting sold) since it’s immaterial and was a horrible acquisition. On a side note, Donahoe has repeatedly said that it was a great acquisition – I wonder why the sudden change of heart?

 

For the PayPal unit, here’s an excerpt from my last letter to my investors:

“… Although we acknowledge that Apple Pay can potentially become a major contender in the payments industry, we remain skeptical of a wide spread merchant and consumer adoption of Near Field Communication (NFC) technologies, along with the issues of convenience and security being adequately addressed. Apple Pay is currently only in ~220,000 merchants in the US, which is ~2% of the total addressable market. Furthermore, we believe that their competitive focus will remain in the offline, mobile Point-of-Sales (PoS) space which is currently a miniscule part of PayPal’s existing business. In fact many market players, including PayPal, have failed to gain much market traction in the mobile offline payments industry over the past several years. This is partly due to the high barriers of entry including scale and security requirements, but more challengingly the need to get the different parties with differing economic incentives in the payments ecosystem including customers, merchants, financial regulators, banks, and the payment networks to facilitate wider spread adoption of PoS mobile payments.  If Apple Pay can indeed generate considerable traction and wider spread adoption of PoS mobile payments[1], we actually believe that this will ironically be a net positive for an independent PayPal; it can it open up a large offline payments opportunity as a free option, currently not being priced into shares, in our view. As per the unit economics, Apple Pay currently takes $0.15 for an average $100 PoS transaction versus PayPal’s ~$1 – a stark differential. Although PayPal may have to sacrifice some existing unit economics in order to create substantial value in PoS mobile payments, we believe given PayPal’s strong brand equity and franchise value, PayPal can eventually generate sufficient scale to participate in this opportunity.

 

PayPal’s ~$216 billion in Total Payments Volume (TPV) is currently ~20% of the $1 trillion online commerce total volume – second to only AliPay – and only ~2% of $10 trillion in the total commerce opportunity. The online eCommerce market is a long-term secular growth market and should continue to grow faster than brick-and-mortar TPV. We believe that post-spin, independent PayPal will have ample strategic options to aggressively pursue the total eCommerce opportunity – both online and offline. PayPal can position itself as either platform agnostic like it has for the most part historically, or it could potentially form strategic partnerships with either Apple, Google, Facebook, Samsung or even Amazon, among other large market players once it is separate from core eBay. We believe there was likely internal conflict and misaligned incentives between past PayPal executives and the C-suite, leading to poor strategic decisions for PayPal’s positioning in the marketplace. An independent PayPal will likely become a more nimble, focussed, disruptive “Silicon Valley-like” entity, with future business performance properly aligned between management and employees. The bottom line is that we believe spinning-off PayPal is the right strategic decision and will better position PayPal to tackle a rapidly changing global payments competitive landscape.”

 

In sum, I think an independent PayPal makes a lot of sense. In order to attract some of the brightest talent needed in Silicon Valley today, I think an independent stock currency is required for stock-based compensation. Base Case: PayPal earns nearly $3B in operating income by 2017. I assume a bit of margin compression (~200 bps) if they go after the offline payments opportunity and continue to deploy large amounts of R&D spending. So net-net the lower incremental margins from the offline opportunity should outweigh their existing scale benefits. I also think there’s a bit of risk from PayPal’s projected ~20% top-line growth rate – if we assume eBay’s top-line is slowing down to LSD-MSD, then by default PayPal’s related transactions on the eBay platform (around one third of PayPal’s business) should be slowing down dramatically as well.

On a 25x-30x net operating profit after-tax (NOPAT) multiple, PayPal is basically worth $50-$60 per share 3 years from now, or nearly double eBay’s value. I’m not quite sure what management plans to do with the $6.3B in incremental fcf that they’ll generate over the interim years so I very conservatively assume that it just builds up on their balance sheet. There’s definitely a bit of upside if the actavists push new PayPal management for better capital allocation as well. PayPal will be capitalized with no debt and $5B in cash to help fund the credit part of their business but I think realistically they’ll just need half of that amount. PayPal’s $9B in excess cash by 2017 will be basically worth ~$7.5 per share.

So let’s add all the pieces up to arrive at intrinsic value: 1) eBay marketplaces: $28-$32, 2) PayPal: $50-$60, 3) PayPal’s excess cash: $7.5, and 4) a 9x multiple on corporate overhead’s negative after-tax income: ($13.5). If we add it all up the stock is worth $72 – $86 by 2017. If we take the mid-point of the intrinsic value range and if the post-spin catalysts materialize as expected, the stock should generate a near 18% 2-year IRR under my base case from today’s $57 price tag. Unfortunately this is way below my hurdle rate, so I’m officially closing this position for the blog. How I’m going to play this situation out is to observe the stock up to the spin-off event and see if I can get more clarity on post-spin capital allocation and if there’s any post-spin forced selling. I’m not long now, but at least I’ve done the necessary work should Mr. Market present an opportunity. I’m also much more interested in the PayPal piece. For bigger funds that have a lower hurdle rate, the opportunity might be worth it if you’re confident that capital will be adequately allocated in both pieces and if you think marketplaces isn’t in a long-term structural decline.

One last note on management that I want to get out of my system. These guys (management) are honestly amateurs when it comes to capital allocation and corporate governance. If I were to grade them alongside the management teams that run my portfolio companies on a relative scale from 1-10, these guys would be sitting on a negative digit. I have absolutely zero confidence in existing management to execute on what is necessary to build long-term shareholder value. I recall reading a transcript with the CFO basically saying in like a proud way that the ~$15B of cash that they’re holding on their balance sheet is generating a lot of interest income. Well, no shit. If you give me $15B I can sit on my ass and buy long-term US treasuries too! These guys seriously need to go. The high executive turnover, constant flip-flopping on major strategic issues and operational missteps is suffice evidence. Next time don’t hire a management consultant to run a once leading, global technology company.

[1] NFC only works on the newest iPhone 6 models, which is ~70 million users as of the end of 2014; Apple has large existing installed base of ~500 million iPhones

The Security I Like Best: Interactive Brokers

“I always have been attracted to the low cost operator in any business and, when you can find a combination of (i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation.” – Warren Buffett

 

Interactive Brokers (IBKR) currently offers a rare opportunity to invest in an extremely high-quality, fast-growing compounder operating within the large, secular growing electronic online brokerage industry. IBKR is a fully-automated electronic online discount broker and market-maker that was founded by billionaire Thomas Peterffy in 1977. The thesis is pretty simple: 1) The e-broker business is massively under-earning WRT its true earnings power and 2) due to IBKR’s extremely deep and durable moat which allows the e-broker to operate with the lowest-cost structure in a largely commoditized industry, the business (with considerable operating leverage) should be able to grow after-tax earnings at 30%-35% per annum over the next 3-5 years or more.

If that isn’t enough for you, then we also have several free “call options” that I have not fully priced into my base case valuation.

1) Tremendous earnings accretion from having a steadily growing margin lending business being leveraged to rising interest rates,

2) Under-appreciated enormous untapped pricing power in the brokerage business, and

3) At this stage of the cycle, the business is a great hedge against rising market volatility based on the rather subdued daily average revenue trades (DARTs) per average account metric

 

Pricing is by far the most important driver within the global electronic brokerage industry, and IBKR is by far the price leader in margin lending and commission rates since the business operates at an enviable position at the low-end of the industry cost-curve.

Figure 1: Comparing IB’s margin and commission rates with its largest US competitors

Figure 1: Comparing IB’s margin and commission rates with its largest US competitors

IBKR’s deep moat is sustainable not because its intellectual property can’t be replicated[1], (although it will be an extremely difficult and time-consuming process) but because its main competitors largely operate with a different ethos. In the US market, Schwab, TD Ameritrade and E-Trade primarily target the mass online retail market and employ a more asset-intensive distribution and sales model by deploying physical branches and large sales forces; their services are tailored to less financially sophisticated, lower-value accounts. In order for IBKR’s competitors to profitably price their services even remotely close to IBKR’s levels, they would have to cut an enormous amount of fat in their cost structure. Think about all the branches[2] that will need to be closed down, the firing of thousands of employees, the difficulties in hiring a ton of smart developers and technical staff (that are currently in short supply) in order to automate a large portion of their operations that will take a very long time, and the courage needed from senior management to drastically change a long traditional corporate culture that is focussed on sales, marketing and distribution to a technologically-driven culture. Let’s just say the execution risk and opportunity cost will be enormous. It has literally taken IBKR decades to develop their full suite of technologies[3] that continue to improve year after year, similar to how Google has consistently perfected their search engine algorithm. In fact, I believe even Google would have a better chance of replicating IBKR’s technology than IBKR’s main competitors.

 

In terms of prime brokerage competitors such as Morgan Stanley and Goldman Sachs that focus on the institutional market, they offer inferior trading execution and uncompetitive commission rates relative to IB, and also operate at a large cost disadvantage by employing expensive labour all the way from the front-to-back office. So it’s no surprise that IBKR’s operating and pre-tax margins are roughly double the US industry average, and with reasonable top-line growth should approach or exceed 70% over the next 2-3 years.

 

“I think in 10 years we could be the biggest broker in the world, and I am not kidding, because our technology is way ahead.” Thomas Peterffy, Chairman and CEO – from IB’s Q3 2014 earnings conference call.

 

IBKR has an extremely long runway of secular growth in end markets powered by an increasing geographic mix-shift to the under-penetrated, higher-growth Asian market and a rapidly growing attractive core customer profile that consists of emerging hedge funds, independent financial advisors, proprietary trading groups, and introducing brokers among other institutional clients. Just in the US alone, IBKR’s market share is a miniscule 1% in terms of customer accounts and total online brokerage assets. WRT customer economics, IBKR has the lowest customer acquisition costs in the industry; for perspective, Schwab and TD Ameritrade each spend ~$250MM on marketing and advertising annually (~5% and ~8% of their total revenues, respectively), and E-trade financial spends ~$120MM (~6%-7% of revenues). IBKR has a near fully-automated customer registration process and spends almost nothing on marketing and sales yet the business is growing high-value customer accounts and customer equity 3x-4x faster than its closest competitors. Why? Because the most efficient operator – not the most well-known franchise or sales organization – will be the long-term winner in this industry. A referred customer incurs no marketing spend and is typically a stickier and more valuable customer over the long-term, and roughly 1 in 4 of IBKR’s new accounts are generated through customer referrals.

 

To size up IBKR’s growth prospects in greater detail, we have to account for the discount brokerage industry growing faster than traditional higher-cost brokerage, the trend of emerging small institutional investors such as financial advisors and hedge funds migrating to higher-value proposition brokerage services, and in general above-average growth in global wealth creation in excess of long-term global GDP rates (especially in Asia where 60% of IBKR’s business is now coming from at current run-rates). Finally IBKR’s wide moat will allow them to continue to take market share for a very long time. All-in-all it is no surprise that IBKR is growing customer accounts and equity at near 20% with little marketing spend, compared to mid-single digits growth for the rest of the industry. Due to these industry dynamics and IBKR’s sustainable moat, above-average earnings growth should easily be sustainable in the double-digits or more and be measured in decades – not years – out.

 

IBKR has an extremely scalable business model due to the breadth and depth of its automation of many functions all the way to customer acquisition to client risk controls which should lead to improving returns on equity for the brokerage business as it continues to grow at a rapid clip over time. IBKR’s growth in DARTs, margin lending, customer accounts and equity comes with very low marginal costs because of the business’ automated trading infrastructure.

ibkr roe

I believe backing out 75% of excess capital in my ROE estimate for the brokerage business is reasonable.  Remember, this is basically idle capital that is in excess of regulatory requirements, and based on the size of rather large client account blow-ups over the past few years, I believe this is a conservative assumption in light of IBKR’s superior risk management controls. I’m not saying that larger client account losses are not possible, but the $2.5 billion in excess capital set aside creates a fortress balance sheet which has no debt.  Furthermore, all margin loans within IBKR’s margin lending business are basically recourse debt, so IBKR can go after customer assets[4] if they’ve suffered large losses on margin.

 

Unlike other large online retail-focussed brokerages that sacrifice client order execution for better brokerage economics, IBKR does not sell its customer order flow to the highest bidder, which has spurred considerable controversy in the industry. The founder, Mr. Peterffy, has been an outspoken proponent against high frequency trading (HFT) and its negative implications for the industry. I’m also comforted by the fact that Mr. Peterffy was an industry pioneer in electronic trading, and has structured IB in a way that puts its customers’ interests first. He’s also quite shareholder friendly, with a record of returning excess capital from the market-making segment in the form of special dividends. Although I typically almost always prefer share buybacks over dividends as a superior tax-efficient method of shareholder return, I understand Mr. Peterffy’s interest of increasing the public float over time. With an ~75% stake in the total capitalization of IB and founding the business itself, Mr. Peterffy is an archetypical “owner-operator” – a special class of management that I typically favour partnering with given their propensity to act in the long-term interests of all shareholders. The only concern I have is the current pricing of commission and margin rates. I actually believe IBKR’s rates are priced excessively low, well below rates that they can charge where the incremental value created will vastly outweigh any marginal decline on total DARTs, margin lending, or customer equity growth. With such a large gap between the operating costs of IBKR’s model vs. competitors (with pricing ranging from 10%-20% the industry average levels), and vastly superior pricing execution[5], the vast majority of clients would not even consider switching brokers and trading volumes and total margin loans should be marginally affected due to the vastly uncompetitive alternatives. Even a reasonable 50%-100% increase in average commissions and margin lending rates will flow straight to the bottom line, which should create nearly the same amount of incremental shareholder value. That’s why I believe IBKR has tremendous untapped pricing power. Although I assume it’s not in the cards for Mr. Peterffy to raise prices since he is overly focussed, in my view, on volume growth, (a negative given that he could literally raise prices tomorrow to maximize the value of the business), a sale of the entire business to a strategic buyer should reflect this untapped pricing power. Due to easily realizable synergies and a takeover valuation reflecting higher rational economic pricing, we could easily arrive at a present value of $75-$100 per share on the back of IBKR’s unique franchise under this upside case. And I assume Mr. Peterffy is not stupid enough to not recognize the enormous untapped pricing power in his business. In fact I believe this scenario will increasingly become more probable over time as he ages and looks for an exit.

 

What is Mr. Market Missing?

Complex accounting and holding structure, obscuring the true profitability of the e-broker business and making the headline earnings multiple misleading. The business is also very under the radar, and almost never gets mentioned in industry reports. Due to the stock’s small public float (~14.5% of all shares outstanding worth ~$1.9 billion) and IBKR’s lack of business with the Street, sell-side research coverage is extremely limited with around 2 boutique broker-dealers actively covering the name (I don’t think they’re doing a good job, by the way). The market also typically doesn’t do a good job valuing 2 divergent cash flow streams (the market-maker vs. the e-broker).

 

So why now? Aside from the huge margin of safety at today’s stock price, I believe we are at or near an inflection point where outsized share appreciation will be driven by 1) increasing investor awareness of IBKR’s electronic brokerage growth story along with the market-maker business becoming irrelevant and/or 2) We should be near or at the sweet spot of the interest-rate cycle where the market will begin to appropriately price in earnings accretion from higher rates. The market is certainly already partially pricing in higher rates for Schwab, TD Ameritrade, and E-Trade Financial.

 

On the cost front, despite the sizable volume growth in brokerage cleared trades, the exchanges have been pressured on transaction fees due to heavy pricing competition from dark pools, leading to a large decline in IBKR’s variable execution and clearing fees.[6] Long-term fixed costs should be roughly 50% of total non-interest expenses, providing plenty of operating leverage. After netting out the market-making business’ ~$1 billion in equity conservatively at 1x tangible book value, we are effectively paying slightly less than 18x my estimate of 2015E after-tax earnings for the phenomenal, high-growth brokerage business. My conservative implied valuation of this business is 30x my estimate of 2015 earnings. Because of the business’ largely untapped pricing power and the depressed current interest-rate environment, even if growth rates temporarily slow down, the smoking gun is that the brokerage business is massively under-earning which de-risks my thesis to a large extent. In fact, aside from spiralling deflation, I can’t think of anything else that can tank my thesis.

 

The stock is conservatively worth $45 today, and $50 per share by 2015YE on the back of a multiple re-rating, providing more than 50% upside 1-year from now: Although this is my short-term forecast, I’m much more excited about the high likelihood that the growth in intrinsic value per share will exceed the share price growth for many years to come, implying a potentially very long-term holding period. Another way to think of valuation is that if we assume a 30%-35% annually compounded growth in the brokerage business’ intrinsic value over the next 3-5 years, an 18x multiple throughout the holding period is very reasonable for a business with such an attractive long-term, predictable earnings growth profile and very high returns on equity.

 

Interactive Brokers is the Security I Like Best: It is what Buffett would call an “inevitable[7]”, a high-quality, long-term compounder where I can reasonably predict its earnings power 10-20 years from now.

 

-Richard

 

Disclaimer: I hold shares of IBKR and may buy or sell shares at any time without notice.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer’s securities.

1) All content of this blog, including correspondence between the author and readers, represents only the authors’ personal opinions and is neither investment advice nor a recommendation to buy or sell a security. No information presented on this blog is designed to be timely and accurate and should be used only for informational purposes.

2) The authors are likely to transact on securities mentioned on this blog without notice to the reader. Disclosure of the authors’ holdings of any securities mentioned will be done on a best effort basis.

3) The reader agrees not to invest based on information presented on this blog and should conduct his or her own due diligence with respect to the securities mentioned before initiating a position.

 

Here’s my shameless promotion: I’ve used IBKR’s trading platforms for the past 4 years now and absolutely love it, and so does everyone else I know that uses it. I highly recommend it to anyone.

 

 

 

[1] Feel free to ask any competent computer engineer how difficult and time-consuming it would be to develop all the algorithms and test and fix all the bugs that will be required to scale and automate all the processes involved in providing customers with the best execution across all significant worldwide exchanges and products

[2] Schwab, TD Ameritrade, and E-Trade have over 300, 100, and 30 branches, respectively

[3] I believe the most important pieces are their fully-automated IB smart routing and risk management algorithms

[4] Based on the size of future potential losses, I believe most would come from institutional customers, which are more likely to have valuable assets that IBKR can go after vs. retail investors

[5] Largely due to IB’s SmartRouting technology

[6] My research suggests that pricing may be starting to firm up again from the exchanges, especially in their cash equities business. I’ve conservatively assumed growth largely in-line with volumes.

[7] A business which will be much more valuable 10-20 years from now

The Americans are Coming

CSU’s shareholder base

Latest Holders
Holder Common Stock Equivalent Held % Of CSO Market Value (CAD in mm) Change in Shares
Fidelity Investments                                                 2,734,037                                               12.902                                              1,151.0
OCP CSI Investment Holdings Inc.                                                 2,069,623                                                 9.766                                                 871.3
Mawer Investment Management Limited                                                 1,982,531                                                 9.355                                                 834.6
Leonard, Mark (Founder, Chairman and President)                                                 1,433,482                                                 6.764                                                 603.5                                             431,259
Pyramis Global Advisors, LLC                                                    811,300                                                 3.828                                                 341.6                                              (1,900)
Neuberger Berman LLC                                                    663,242                                                   3.13                                                 279.2                                            (33,500)
Ruane, Cunniff & Goldfarb Inc.                                                    257,168                                                 1.214                                                 108.3                                                    368
Salna, Dexter (President of Constellation Homebuilders Operating Group)                                                    236,097                                                 1.114                                                   99.4                                                    155
Aune, Jon Brian (Former Director and Member of Audit Committee)                                                    208,328                                                 0.983                                                   87.7
Leith Wheeler Investment Counsel Ltd.                                                    207,150                                                 0.978                                                   87.2
Akre Capital Management, LLC                                                    166,518                                                 0.786                                                   70.1                                               29,518
Canada Pension Plan Investment Board                                                    161,000                                                   0.76                                                   67.8
Symons, Barry (Chief Executive Officer of Jonas Operating Group)                                                    160,098                                                 0.755                                                   67.4                                                      13
Canadian Imperial Bank of Commerce, Private and Investment Banking Arm                                                    150,646                                                 0.711                                                   63.4
BlackRock, Inc. (NYSE:BLK)                                                    148,134                                                 0.699                                                   62.4                                              (1,213)
Anzarouth, Bernard (Vice President of Mergers & Acquisitions)                                                    146,234                                                   0.69                                                   61.6                                                      28
The Vanguard Group, Inc.                                                    124,005                                                 0.585                                                   52.2                                                 2,148
BMO Investments Inc.                                                    120,650                                                 0.569                                                   50.8                                               32,877
Norges Bank Investment Management                                                    114,890                                                 0.542                                                   48.4
IG Investment Management, Ltd.                                                    104,931                                                 0.495                                                   44.2
Bender CA, Jeff (Director and Chief Executive Officer of Harris Operating Group)                                                    103,883                                                   0.49                                                   43.7
Industrial Alliance Investment Management Inc.                                                    102,275                                                 0.483                                                   43.1
TD Asset Management, Inc.                                                      97,004                                                 0.458                                                   40.8
William Blair Investment Management                                                      94,219                                                 0.445                                                   39.7                                               94,219
Miller, Mark Robert (Chief Operating Officer, Director and Chief Executive Officer of Volaris Operating Group)                                                      85,755                                                 0.405                                                   36.1
Metlife Advisers, LLC                                                      83,220                                                 0.393                                                   35.0
Calamos Asset Management Inc. (NasdaqGS:CLMS)                                                      83,200                                                 0.393                                                   35.0                                            (30,500)
Manulife Asset Management Limited                                                      81,923                                                 0.387                                                   34.5                                                    728
Montrusco Bolton Investments Inc.                                                      80,330                                                 0.379                                                   33.8
EdgePoint Investment Group Inc.                                                      79,883                                                 0.377                                                   33.6

Constellation Software – Reverse Engineering a Past Thesis

One of my core beliefs in becoming a better investor is a willingness to learn from past mistakes, whether they are from someone else’s or my own.

Roughly 2 years ago when I was still in school, I wrote-up Constellation Software, which I believe to be one of the best managed businesses in Canada and on the planet (sorry Valeant fan boys). The track record certainly speaks for itself. (Please see the appendix at the end of this write-up.) I recently noticed that the company had a rights offering and were raising capital with debentures. According to my Capital IQ, Mark Leonard recently purchased ~430,000 shares last month, raising his total stake in the company to nearly 7% which is valued at almost $600MM. If my CapIQ is right, he is currently the third largest shareholder. I can’t confirm the purchase 100% as I can’t find the associated public filing. But that’s still a lot of stock and an extremely bullish signal from an extremely astute capital allocator that models his company under the Berkshire model.

Below is my write-up and a blast from the past.

Exchange: TSX   |   Ticker: CSU.TO   |   Stock Price: $123.40   |    Market Cap: $2,615MM   |   EV: $2,618MM

Introducing Constellation Software – Canada’s Outsider 

Company Overview

Constellation Software Inc. is a global provider of mission critical enterprise software solutions serving a broad range of distinct vertical markets. The company’s strategy is to acquire and manage vertical market software businesses that serve clients in over 40 different verticals ranging from public transit in the public sector to golf clubs in the private sector.

Constellation is simply an exceptional business that is trading at a reasonable price. Not only does the business possess excellent economics, it is headed by one of the best corporate management teams in the country in terms of allocating capital. A suburb track record of intelligent capital allocation decisions and a history of strengthening acquired businesses organically have yielded average returns on invested capital of 20% for the past decade and strong maintenance revenue growth in excess of 20% for the past several years[1]. Given the large market opportunity, the high predictability of future earnings and management’s proven track record of executing value accretive acquisitions, Constellation is well positioned to compound its intrinsic value at an above average rate of return for many years to come.

Industry Analysis/Competitive Analysis

Constellation’s clients are small to medium-sized enterprises that generally have less than 1000 employees. These vertical software markets are highly fragmented with many small competitors that lack the capital resources and long-term orientation necessary to provide their customers with an adequate suite of software solutions tailored to meet their specific needs; product development lead times in the VMS (vertical market software) space can last up to 7 years, creating a barrier to entry for potential new entrants.  Relative to the rest of the software industry, these are niche markets and almost every vertical market imaginable requires mission critical software in order to run their daily business operations.

Constellation’s strategy is to acquire the number 1 or 2 market leader in selected vertical markets for attractive prices and then to grow these acquired companies through organic initiatives and/or “tuck-in” acquisitions – whichever strategy yields a higher return on invested capital. These acquisitions usually come with management teams in place that are extremely knowledgeable about their specific vertical niche, and understand the specific needs of their clients well. With support from senior management in the form of capital and other resources, the ultimate goal is to strengthen these vertical businesses through scale and expansion into adjacent markets. Tuck-in acquisitions make a lot of sense in a very fragmented industry and the decentralized management structure of Constellation allows the VMS management teams with deep industry expertise to successfully pursue tuck-in acquisitions to grow their operating businesses at an accelerated pace with scale.

This industry structure is very favourable for Constellation’s strategy. Larger software vendors have a limited presence in vertical markets given the small size of these markets and the mismatch between their relatively expensive enterprise resource planning solutions versus the specific needs of customers in small vertical markets. And as mentioned above, smaller competitors are usually in a weak market position given the large initial investment outlays required for successful long-term penetration. Although Constellation possesses almost every quality imaginable that makes it a fantastic business, it can be summed up by three main points below.

  • High Switching Costs for Customer

One of the keys to Constellation Software’s competitive advantage is its focus on providing proprietary software solutions that are mission critical to its customers. Because of the nature of these products, customers have high switching costs yielding attractive economics to the vendor and result in a very stick relationship with the customer; the time, training and financial resources required to be spent on IT staff and departments in order to have them switch over to another software provider is considerable. Moreover, the mission critical nature of these software solutions exacerbates this opportunity cost since the specific software is needed for the smooth functioning of daily business operations and without this type of software in place, these businesses would simply not be able to conduct normal operations. New software packages introduced by competitors would likely not be cost effective for customers, unless they provided a substantial boost to the productivity or efficiency to the business that would offset the high opportunity cost by a large margin.  And given Constellation’s product policy of providing clients with free software upgrades for life and a strong commitment towards post-installation maintenance services, this is unlikely to happen. Arguably, public organizations are even less likely to consider competitor software replacements, given that they do not have to compete in the marketplace and thus are more lenient towards the higher overall costs of sticking with their current provider vs. possible costs savings from switching to another vendor; approximately 74% of Constellation’s 2011 EBITDA was from the public sector. Finally, the company also dominates the competition by being the market leader or #2 player in each vertical market, thus providing them with scale advantages for R&D and a broader product suite over smaller competitors. These factors make it extremely difficult for competitors to steal market share away from Constellation.

  • High predictability of future revenue streams

As mentioned, Constellation’s client base consists of thousands of small to mid-sized businesses, providing the company with a diversified stream of revenues through the large number of customers in more than 40 different markets; this also means that the bargaining power of customers is very low. Historically, customer retention has been extremely high with customer attrition rates of ~4% which is much better than the average software company and implies that the average customer stays with Constellation for 25 years. Ultimately, customers pick Constellation as their software vendor given the company’s deep understanding of their specific needs and a confidence in Constellation having the financial resources to strongly commit to support and maintenance services through offering a “software for life” policy; this is essentially a commitment in providing free software upgrades. As a result, maintenance contracts are typically renewed on an annual basis by customers, which provide Constellation with a high quality, recurring revenue stream. These maintenance and professional fees are a majority of Constellation’s revenue streams (~80%), and are very high-margin and stable in nature. Historically these revenue streams have also been a very stable proportion of Constellation’s revenues, and should remain that way in the future given the large demand for these services.

  • Untapped Pricing Power

Constellation has a very long runway for growth given the large market opportunity in many vertical markets that are currently underpenetrated by the company. In the North America alone there are over 500 viable “tuck-in” acquisition candidates in different verticals for the company to consider in order accelerate market share growth; there is also a similar opportunity in the rest of the world. Moreover, there is a large opportunity available to expand into new vertical markets where large platform acquisitions are possible.

Strong pricing power is possible based upon the points made above about the company having a very captive customer base and the high barriers to entry that exists for new entrants. In addition, Constellation’s software solutions are also a very small part of customers’ overall costs (~1% of customers’ revenues). Over the long-term, the company’s pricing power should remain intact given the necessity for their products and services, the weak bargaining power of customers and the low cost of these services relative to the customer’s overall cost structure.

Management Assessment

Constellation’s success has largely been derived from exceptional capital allocation decisions made by the senior management team; they have had a suburb record of growing the company by strategically consolidating niche vertical markets at a high rate of return. As mentioned, the company has many operating subsidiaries in different verticals, and operating managers in these subsidiaries recommend acquisitions or reinvestment opportunities to the senior management based upon a return on investment threshold. Within this capital allocation framework, capital is either returned to the main corporate holding company if there is a lack of attractive investment opportunities or is allocated to operating subsidiaries with attractive opportunities; this rigid framework ensures that capital is always allocated to the highest return on investment opportunities.[2]

Another aspect of Constellation’s success is its decentralized management structure which creates an optimal incentive system for managers in VMS operating subsidiaries to focus on value creation. A decentralized management structure allows the operating managers to focus on what they do best, and not have their performance constrained by overreaching bureaucracy. Many of these operating managers decide to retain their position heading their respective operating subsidiaries after being acquired by Constellation, thus preserving the deep industry knowledge and customer relationships critical to the success of the overall company.

In terms of compensation policy, the majority of performance-based bonuses are linked to ROIC and net revenue growth, and at the operating level, is based entirely on that operating subsidiary’s performance; this is a fair compensation scheme that does not reward or punish an operating manger’s performance based on the performance of another subsidiary. The management team is very disciplined in setting a minimum after-tax IRR as a hurdle rate for all new projects and major platform acquisitions to ensure that there are adequate returns on capital deployed. Management at all levels of the organization are compensated based on two main criteria: profitability and growth. Also there is a strict requirement to invest 75% of an officer’s after-tax incentive bonus into shares of the company which are held for a lock-up period for several years. In addition, a hurdle rate of 5% is used for a minimum rate of return or no performance bonus is paid out, which is usually absent in other corporate compensation schemes. Overall, employees and management are compensated to think like “owner-operators” and the executive management team and board of directors collectively own 42% of fully diluted shares outstanding as of the latest proxy, which is considerable and helps align their interests with shareholders.

The President Mark Lenard was a venture capitalist for 11 years giving him a solid background in capital allocation and experience in the operating side as well; this is rare to have in a President as many corporate executives lack the capital allocation skills in order to maximize shareholder value. Although there is little information available regarding his past track record as a venture capitalist, as illustrated below in the APPENDIX, he headed Constellation as the company continues to grow at an impressive rate with high returns on invested capital. He also writes candidly to shareholders about the economic realities of the business in his letters and does not promote the business aggressively to potential shareholders.
 * Note from the Present: In fact when I first emailed Mark asking for a meeting and my interest in investing in the company he told me that the current margin of safety in the shares wasn’t large enough * – Now how many CEO’s running public companies even know the 3 most important words in investing and speak this candidly to potentially interested investors????  Mark Leonard is one of the most impressive CEOs that I have gotten to know. Unfortunately Mark is a phenomenal value investor and I placed nearly 100% of my trust and analysis on his advice to not invest at the time. Perhaps he was like me and being overly conservative on the intrinsic value of the business, but he certainly knows more about the business than I do, so of course I listened to him. *

The company recently put itself up for strategic review in March 2011 and in light of the situation, management looked after minority shareholder’s interests. At the time, shares were trading for less than$70 and several minority shareholders voiced out their concerns about selling the company at an undervalued price level. It is interesting to note that the PE firms Birch Hill Equity Partners and OMERS Private Equity in aggregate controlled half of the board seats at that time, with similar ownership in the company’s stock. The likely reason for the strategic review came from pressure from the PE firms looking for a liquidity exit for their massive stake. Management could have easily succumbed to the pressure of the larger PE stakeholders and sell the company at a clear discount to intrinsic value, but decided not to, demonstrating an interest in looking out for minority shareholders.

Valuation

Given the high growth rate of the business, the key question becomes, is it sustainable for the next 5-10 years? I believe it is given management’s successful track record, the long-term stable cash flows of the business and the large market opportunity that remains ahead; albeit it will be at a slightly slower pace given the increased difficulties of sustaining the high growth rate as the company size increases. EBITDA margins should also be increasing based on scale and further synergies from acquisitions, although at a slower pace than before.

In addition, the business should be able to grow through the business cycle as 1) takeover targets are likely to sell at more attractive valuations during recessionary environments[3], and 2) VMS businesses and public organizations are not significantly impacted by lower business spending given the mission critical nature of the service and the stability of maintenance revenues.  Looking back to the period of the last great recession of 2008/2009, the business comfortably grew revenues and EBITDA at greater than 30% levels due to the large amount of growth attributed to acquisitions that helped offset the slight slowdown in private sector organic net revenue growth.

On an owner’s earnings multiple, Constellation currently trades at ~18x my estimate for 2013 owner earnings and ~11x my estimate for 2013 EBITDA which unfortunately doesn’t provide a large enough margin of safety at the current price level. I have a 1-year target intrinsic value range of $132.56-$150.69 based on a blended multiple valuation of 13x 2013 EBITDA and 20x 2013 Owner Earnings. I have also run a conservative DCF that results in an implied valuation of 13.33x 2013 EBITDA and 22x 2013 Owner’s Earnings. My estimate for 2013 EBITDA margins is 22.2%.

The company deserves to trade at a premium multiple to the broader market

Firstly, adjusting for amortization expenses make sense given the high likelihood that the economic value of the intangible assets of the business have actually been growing instead of declining over time; these intangible assets came purely from acquisitions made by the company. Since the company has been able to grow their maintenance revenues organically, even during the great recession, the value of these intangibles have likely increased rather than decreased. Economic goodwill should also be increasing over time as accounting goodwill is not representative of the economic realities of the business.

Secondly, the company’s true earnings power has also not been realized yet. Near term earnings and EBITDA margins are likely below normalized levels given the amount of time it takes for synergies to have a sizable effect on business performance. For example, margins are likely to improve from the PTS acquisition done in 2009; right now, PTS is at a 19% EBITDA margin; Company-wide EBITDA margins have been expanding over the past several years from 14.2% in 2005 to nearly 22% as of 2011.

Thirdly, the company can grow its revenues organically with little to no incremental capital and with extremely high returns on net unlevered tangible assets deployed. VMS businesses such as Constellation tend to operate with negative working capital as a result of the collection of maintenance payments and other revenues in advance of the performance of these services.

Lastly, I believe my valuation is slightly conservative despite using premium multiples. I’ve assigned a normalized tax rate of 35% despite the fact that around 20% of the business is outside North America and subject to lower tax rates; also there should be continued tax deductions from goodwill created by future acquisitions. I have also used positive working capital assumptions for the business to maintain itself into the future, taking into account a trend towards higher hardware based sales.

In summary, I recommend purchasing shares near $100[4]. At that price you can obtain an extremely high IRR business at 65 cents on the dollar with intrinsic value growing comfortably between 12-15% longer-term. You would also be buying into a company with great economics, probably one of the best capital allocation teams in the country, ample growth opportunities well into the future, and at a nice discount to intrinsic value which is growing at double digits year after year. Under these circumstances, it is very difficult to envision a scenario that would lead to a permanent impairment of capital.

Why is the business undervalued?

-Complex structure such as a colgomorate with many small VMS businesses operating in 40 different verticals

-Still relatively underfollowed by large institutional investors and long-term potential overlooked by sell-side

-Long term growth potential still underappreciated by the market

-little float in shares traded

Risks:

-Higher buyout valuations are necessary for larger platform acquisitions due to a more limited set of decent larger companies and more competition from PE and other firms; however, many VMS markets are still highly fragmented and there is still much more room for growth before considering larger buyout candidates; average consideration for a tuck-in acquisition is around a few million dollars at the moment

-As the company continues its high growth the corporate structure will grow increasingly complex for senior management to deal with as they have to keep track of the performance and investment opportunities for the many operating subsidiaries and also have to keep an eye out for potential platform acquisitions; Although they have been able to successfully execute this “many verticals” strategy from one vertical market to now over 40

Appendix:

csu record

[1] maintenance revenue growth is a reliable proxy for the growth of the company’s intrinsic value given that Constellation can grow its business with little to no incremental capital

[2] An example is that they acquired Public Transit Solutions (PTS) from Continental AG in 2009 for a mere $3MM in cash; Since the acquisition, PTS has contributed $33MM in operating cash flow.

[3] Although this was not exactly the case during the recent great recession, as many VMS businesses were quite resilient

[4] Implies valuation multiples of 8.88x 2013 EBITDA and 14.6x 2013 Owner Earnings

Summary:

Obviously you can tell from my valuation work that I didn’t invest in the company at the time. WHAT A HUGE MISTAKE! 

Hindsight is always 20/20, and I always view investing through the lens of a “probabilistic world”, but I’m pretty certain looking back now that my valuation was overly conservative. If we do the math the 2-year IRR of this investment would have been ~87%. Even if we assume constellation is 50% overvalued today (highly unlikely and laughable), this was a terrible mistake of omission. In fact it might even be a great buy today.

The Lesson: simply be willing to pay up for exceptional businesses run by exceptional management – the Outsiders 

I think what happened here is that I underestimated the upside because I wasn’t willing to put that “premium” on the stock for an exceptional CEO and an exceptional business. The trick here is that, there simply aren’t that many “Outsider” CEOs in the first place, so when I did my typical analysis of this company, I did a bad job of assessing the long runway of this business and the future cash flows. This was probably a lapse in my judgement since I take the view that the vast majority of good to great businesses are typically richly priced and trade close to full value (a cheery consensus with not a lot of uncertainty), and I lumped Constellation into this “category”. As a value investor I try to not be overly optimistic in projecting business performance, as I believe it’s in human nature to be optimistic with projections. In short, I didn’t think hard enough about the margin of safety and realistic upside scenarios for this particular case. This is why valuation is much more of an art than science as there are always many moving parts to consider and not just simply slapping a multiple on a business without much thought. In fact the most important piece of valuing a company is understanding the nature of the business, not adjusting figures in the 20th tab in an excel model. There may be only a handful of these types of publicly-traded companies operating in the world today, so if you’re confident that an extremely high-quality business is going to compound intrinsic value at 35%+ for many years to come, don’t just slap on a 20x multiple like I did. I think 30x+ made much more sense. With this type of business run by a great capital allocator, I should have been much more confident about predicting the future cash flows of the business. Let’s just say the “tail risk” for the bull case was much more fat than anticipated. Enterprise software is also an extremely scalable business model. Constellation is a compounding machine, and I don’t think these past 2 years have changed this fact. Another thing, although probably a bit more minor, was taking into account the incremental value from recent acquisitions. Constellation is an extremely acquisitive company that closes small deals every few weeks (reminds me of Malone rolling up rural cable systems during the TCI days) so the GAAP reported numbers are always messy. But if you believe the management team are extremely savvy and disciplined in capital allocation (it’s all about the target return on capital), then you can be confident that these acquisitions will be extremely accretive. I certainly would rather own this business over Valeant, but that’s just me and my circle of competence.

Buffett has always said that his biggest mistakes were errors of omission rather than commission. I think this is a great example of myself making that mistake.

1) All content of this blog, including correspondence between the author and readers, represents only the authors’ personal opinions and is neither investment advice nor a recommendation to buy or sell a security. No information presented on this blog is designed to be timely and accurate and should be used only for informational purposes.

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AUTOCANADA – IT’S TIME TO BACK UP THE TRUCK, LITERALLY

Share Price: $39.22 CAD | Market Capitalization: $961,269 CAD | Adjusted Enterprise Value: $1,072,499 CAD | Idea Type: Growth at a VERY reasonable price

Note: As I was writing this up the stock has gone up nearly 30% since the panic low last Friday. I believe the shares still remain very undervalued and provide a highly asymmetric risk/reward scenario. All calculations are based on a $39.20 share price.

”Be fearful when others are greedy and greedy when others are fearful” – Warren Buffett

Synopsis and Elevator Pitch:
AutoCanada is what Peter Lynch would call a “fallen angel” and one of the fattest pitches I see today in my small-cap Canadian stock universe. I had bids set last Friday as the shares plunged to around $32 that unfortunately were not filled; that was a very costly mistake, as the shares have surged up nearly 30% since then! AutoCanada was a high-flying Canadian stock market darling that experienced an atmospheric rise last summer on the back of a string of accretive acquisitions and strong growth in Canadian retail vehicle sales. The main headline risk now is that the precipitous fall of oil prices will have a negative effect on the Alberta economy and consequently falling employment in that region. In fact if we compare AutoCanada’s share price history over the past several months you’ll notice that it’s largely been trading in sync with WTI. Although I believe a slowdown in the Alberta economy is very likely, I believe investor fears over AutoCanada’s exposure are way overblown. Mr. Market’s overreaction and manic depressive behaviour has rewarded us with a current share price which provides a tremendous opportunity for investors to buy shares in an extremely well-run auto retail growth business at a large discount to intrinsic value. Even in the unlikely event that nationwide new vehicle sales decline double-digits and AutoCanada closes no further accretive deals in 2015 (very unrealistic, nearly impossible based on a confluence of factors that I will explain) – shares are still worth between $47 to $51, providing 19% to 30% upside one year from today. In my more realistic but still rather conservative base case scenario, the shares are worth $61 to $65, providing 1-year upside of 56% to 65% upside.

 

Quick Company Summary:
AutoCanada is a high-growth story and the only publicly-traded Canadian franchised auto dealership group. The business was taken public in 2006 with the thesis of tapping into the public markets to consolidate the fragmented Canadian automotive retail industry. Since the company’s IPO, AutoCanada has acquired or opened 34 additional dealerships and expanded its lineup of partner OEM brands to 19. Last year alone the company acquired/opened 16 dealerships as growth accelerated. The founder and new chairman, Patrick Priestner, was a university dropout who started his career in the industry as top salesman selling Chrysler branded cars at the age of 17 in Alberta.

Thesis – The Devil is in the Details:
1) Despite AutoCanada’s relatively large dealership exposure to the vulnerable Alberta economy, I estimate that only 33% of AutoCanada’s current 48 dealerships are truly “at-risk” to Alberta’s slowing oil sands’ economy and consequently weaker employment. Furthermore, if we further digest the news of large CapEx budget cuts announced by the E&P companies in Alberta’s high cost oil sands, then we can reasonably assume that fleet sales (corporate sales) should be disproportionately negatively affected in a business slowdown relative to retail sales. Fleet sales are very low margin (typically less than 1% gross margins) and thus should have a miniscule effect on consolidated gross profits even if we assume large volume decreases in this category. Due to this favourable business mix-shift in the event of rapidly falling new corporate vehicle demand, I argue that the situation is less dire than what is perceived by the market.

2) I believe the bears (or panic sellers?) in general under-appreciate the resiliency of the franchised multi-dealership business model and especially AutoCanada’s track record of achieving best-in-class operational efficiency in their parts & services (P&S) segment. This segment is basically the bread-and-butter of every franchised car dealership should perform strongly even in an economic downturn.

3) Despite AutoCanada’s heavy Western Canadian exposure, the business is quickly diversifying in terms of acquiring new OEM partner brand dealerships outside of Alberta. The size of these acquisitions have been growing larger as the business scales its dealership base which should help mitigate the risk of declining profits in the event of any serious downturn in the Alberta economy.

4) I believe the market is pricing in the absolute worst case scenario where AutoCanada will do no more acquisitions or open up anymore dealerships (highly unrealistic) over the next several years. With a highly fragmented Canadian auto industry (~3,500 dealerships nationwide), acquisition targets remain plentiful and this predictable growth cannot be ignored. In short, management’s proven strategy of high-quality growth by acquisition remains intact, and should provide a long runway of multi-year growth compounding at high rates of return well into the end of this decade.

Debunking the Bear Case:
1) What’s really at risk?

Alberta, like many Canadian provinces, is quite big, and although is very reliant on the oil industry, there are more moving parts to consider. In fact, slightly more than a quarter of AutoCanada’s Alberta-based dealerships are located in Grand Prairie, which is an area that is more exposed to natural gas, forestry and the US housing industry than to oil. The rest of the company’s 22 Alberta dealerships are located in Calgary, Edmonton, Sherwood Park and Ponoka. Due to their employment demographics, these dealerships should be considered more exposed to a slowing local oil sands economy.

at risk dealerships

It’s all about the gross profit, not the sales.

I believe the slowdown in total new vehicle sales should disproportionately affect fleet sales (corporate sales) more than retail sales. As mentioned, fleet sales gross margins are very low and are typically less than one tenth of new retail vehicle gross margins. We can assume that the E&P companies will be cutting back on purchasing light pick-up trucks on the back of falling oil prices and budget cuts. In fact, if we look at the most recently reported quarterly results (see below), we’re already seeing same-store fleet sales volume decline considerably YoY on a 3 month and 9 month basis. I believe AutoCanada’s new fleet sales are more cyclical relative to new retail sales, especially given the company’s exposure to the Alberta’s oil-centric economy.

“Management cannot confirm, but believes that much of the increase in the overall Canadian new vehicle market can be attributed to increases in fleet sales from 2009.” – AutoCanada’s 2010 Annual Report

Looking at same-store-sales (SSS) in the latest reported quarter can give us a bit of a clue in what to expect in 2015 if we assume the cycle turns in Alberta.

sss

sss 2

As we can see, even with the sizable drop in new fleet volume and fleet SSS, same-store new vehicle gross profits still managed to grow 20.5% and 7.8% on a three and nine month’s basis, respectively; as long as we assume new retail vehicle ASPs remain stable or increase slightly (like they have been), small increases in new retail sales can offset larger fleet sales declines. In the event that even new retail sales volumes decline, I believe it’s reasonable to assume that AutoCanada’s used vehicle gross margins and gross profits will hold up strongly even in a severe downturn, supported by the fact that consumers and enterprises typically trade down to used vehicles to save costs during tougher economic times.

What’s interesting is that even if we look at the latest auto sales data that was released in January 15’, Dec 14’, Nov 14’, etc. there hasn’t been any real indication that there’s been any significant weakness in Alberta vehicle sales. Even if we assume there should be a slight lag in the industry data following oil price movements (oil starting crashing last July), November and December industry sales were both up 4.8 and 4.4 percent YoY, respectively, and nationwide industry sales have also been strong. The provincial data hasn’t been released in January 15’ yet, but overall industry sales are up and light truck sales have been outperforming. Given the recent data, it’s rather perplexing as to why retail sales haven’t been strongly affected in Alberta yet, and there’s even reason to believe that the lower oil prices have been incentivizing consumers to buy larger vehicles. My conversations with some of AutoCanada’s dealers largely confirm this thesis that new retail sales remain strong.

autocanada graph

Finally, the auto dealership model in general has quite a variable cost structure, helping reduce costs in a downturn. The vehicle sales and F&I segments that are most vulnerable to the cycle have the least operating leverage due to the highly variable nature of a car salesmen’s compensation structure.

2) The focus over the next several years should be on P&S, not new vehicle sales

I) I believe the franchise dealership business model is much more recession resilient than what the market gives it credit for. Despite the company’s cyclical exposure to new vehicle sales, parts & servicing (P&S) is where the real money is made, where gross margins are typically 50%+, are much more recession resilient, and recurring in nature. P&S is the most important segment for any auto retailer, and based on my research AutoCanada’s operating metrics are among the highest in the industry. If we look at AutoCanada’s operating history, the business has consistently achieved high “absorption rates” at near 90%, a metric which measures operational efficiency in the P&S segment. P&S is also a relatively counter-cyclical segment as consumers tend to keep their cars longer in downturns, and thus require ongoing vehicle maintenance and replacement parts.

II) As shown below in the excel sheet AutoCanada’s P&S segment is typically between 30-35% of their total gross profit in a mid-cycle year, and this percentage should experience outsized grow relative to vehicle sales when the cycle turns. Furthermore, there is a larger secular growth tailwind at play here as outsized growth in the stock of new vehicles aged between 1-5 years on the road today should boost same-store P&S gross profit growth at high-single to low-double digits (even higher EBIT growth due to operating leverage) well into the end of this decade; many consumers delayed purchasing new vehicles during the last downturn and there are now over 8 million cars over 10 years old on the road today. I believe this is one of the most overlooked key drivers by the market and the Street. AutoCanada’s P&S SSS has consistently grown at around high-single digits for the past couple of years, supporting this thesis. Many industry experts have always assumed this segment can only grew at mid-single digits longer-term; I believe this will prove to be a very conservative forecast, especially given recent strong growth in retail sales in Alberta

III) The P&S segment has the most operating leverage and highest incremental margins, and this is exactly the segment you want the most leverage as it is more predictable and recurring relative to new vehicle sales. I conservatively estimate that around 50% of P&S gross profits flows through SG&A. This segment also has good pricing power as vehicles repair and maintenance work becomes increasingly complex on newer vehicles and warranty contracts continue to lengthen. Light trucks which AutoCanada’s Alberta-based dealerships sell a lot of typically require more maintenance work on a more regular basis due to heavy usage compared to passenger cars.

IV) OEM franchised dealerships should continue to take servicing and repair market share from mom-and-pop repair shops that do not invest in the sophisticated equipment and software required to perform repairs and warranties on today’s increasingly complex vehicles. Each OEM requires specialized equipment for their own vehicle models which should freeze out mom-and-pops that under-invest in these areas.

AutoCanada’s Historical Segment and Margin Analysis:

autocanada margin

3) This time is really different, if there is a “this time”; 2009 is a poor precedent.

-Finance & Insurance (F&I) is a sizable portion in consolidated gross profits (90%+ gross margins). Decreased in FY2009 because of tight lending conditions – the company’s largest 3rd party financing partner, Chrysler Financial Canada, declared bankruptcy so they had to switch to GM Acceptance Corporation, which today is the newly re-organized, well-capitalized Ally Financial.
-Despite going through an extremely severe recession, having their largest OEM partner (Chrysler) go through a bankruptcy restructuring which affected the company’s access to floorplan financing to fund inventory purchases (I will touch upon floorplan financing later), AutoCanada’s same-store gross profits fell only 2.6% and 7.8% in 2008 and 2009, respectively; quite impressive for a cyclically exposed retailer
-Despite falling auto demand during the past recession, access to credit was a major issue. Around 85 and 60 percent of new auto and used auto sales today are financed with credit, respectively. Due to the continual low interest rate environment and a healthy credit market, credit should not be a problem this time around
-Not core to the thesis but industry analysts are still forecasting strong light vehicle growth in Canada (~1.8 million vehicles for 2015). The US numbers look strong as well. I believe despite the bear’s concerns about falling employment in Alberta, lower oil prices and the plunging Canadian dollar should help the company’s dealerships outside the province. Also keep in mind that this time the reason why oil took a hit was largely supply-driven. In 2008/2009, it was largely a demand-related shock. I think the recently reported industry data is already confirming that the sky is not falling and light vehicle sales across the country will remain strong.

4) Diversifying away from Western Canada
Despite having 22 out of its 48 dealerships in Alberta, we should really be focussed on new retail sales volume per dealership. Last year AutoCanada acquired a set of 2 powerhouse BMW/Mini dealerships in Quebec, which marks the first time they’ve expanded into the BMW/Mini OEM brand and into the French Canadian province. These dealerships are around 2.5x the size of an average AutoCanada Calgary-based dealership and combined they sold 3,860 and 1393 new vehicles and used vehicles, respectively, in 2013. These figures alone represent ~65% of all the vehicle sales volume of AutoCanada’s Calgary-based dealerships. AutoCanada’s new Montreal BMW/mini dealership alone volumes ~60-65% of all the BMW/mini cars sold in the city. What’s more important I think is BMW/Mini’s acceptance of AutoCanada’s public dealership model, which provides further diversification away from AutoCanada’s heavy D3 exposure. I believe the warranty and maintenance work for higher-end German vehicles is very attractive.
Finally, if we look at AutoCanada’s OEM brand mix, it’s heavily weighted towards the Detroit 3 and Japanese brands. I believe the luxury brands will be more at risk compared to these midline brands if we head into a slowdown. The company only has 1 Volkswagen dealership in Calgary purchased in 2014.

autocanada brand

dealership locations

Quick Industry Overview:
I believe the market currently under-appreciates AutoCanada’s long runway for growth driven by consolidating the fragmented Canadian auto franchise dealership industry. Based on my research, there are ~3,500 Canadian dealerships and more than 2,000 single owners. According to PwC, around 70% of auto dealership owners in Canada are either looking to retire or semi-retire, and selling their dealership is an attractive option. However, there are OEMs that restrict public ownership in Canada; Ford, Toyota and Honda are such brands and currently represent about 28% of all dealerships in the country. Even if we factor in these restricted brands, AutoCanada’s market share (by dealership number) is still less than 3% of all publicly-allowed dealerships in Canada. Due to the sheer number of acquisition targets for AutoCanada, these restrictions still do not derail the growth by acquisition thesis that should last well into the end of this decade and beyond. Also, it’s very possible that these restricted brands may eventually allow public ownership Canada, where it has already happened in the US. I this scenario as an additional free option to the growth thesis.
-Only a few privately-held dealerships of comparable size are competing for deals (Dilawri Group is the largest in Canada), and since they are private, they’ll most likely focus on acquiring non-restricted brands, so I believe given the sheer number of targets and the overall succession issue, average purchase multiples should remain reasonable (within 4x-6x EBITDA depending on the location and OEM brand).

Briefly looking upstream:
-Fiat-Chrysler has emerged post-bankruptcy as a strong, re-organized company with a good balance sheet that continues to take overall market share in Canada (only second to Ford). If we look at just light vehicle sales, Fiat-Chrysler actually has top market share at ~18%.
-OEMs were concerned about dealership group concentration in the past when the industry was much more competitive (some D3 franchised dealerships were closed down during the last recession and have emerged as independent used car dealerships), but now they are more focused on dealership profitability and supporting their P&S departments by including longer warranties and service plans on vehicle purchases.

Business Model:

This is a rather good retail business. They have good dealerships in good locations and generate a lot of free cash flow. Inventory risk is extremely low. The overall cost structure is quite variable for a cyclically exposed business. Where there is operating leverage it is where you want it to be (in P&S). This segment continues to take market share from independent garages and has good pricing power. There is virtually no internet disintermediation risk. The business generates high returns on invested and tangible capital; I estimate that AutoCanada generates around mid-20s on pre-tax returns on capital employed. I expect the return on invested capital to continue to improve as they ramp-up newly acquired dealerships and continue to leverage their fixed costs as they scale.
-The business is not capital-intensive (leases are quite low and are not inflationary) and capital intensity is shrinking as they have bought back some real estate; maintenance CapEx runs at ~1.5% of gross profits
-Barriers to entry for franchising an auto dealership are quite high; OEMs rarely allow new dealership openings, especially in areas where there are already enough distribution points, protecting the incumbent distributors. The total number of franchised OEM dealerships in Canada has roughly remained the same over the past decade, and may have even decreased slightly since the last recession due to D3 restructurings
-Competition on the new vehicle side is quite limited; franchised dealerships operate in de facto local monopolies or within a highly oligopolistic industry structure; eg. Only a few dealerships in any densely populated areas are granted franchises by OEMs

Management and Capital Allocation:
Anytime we have an extremely acquisitive company we need to make sure that management have considerable skin in the game, a strong track record of value creation, and incentives properly aligned with shareholders.

1) Ownership Structure:
Canada One Automotive Group (CAG) is a privately-held dealership group controlled by AutoCanada’s chairman and founder Mr. Priestner who has a ~87% equity stake in CAG. CAG owns one Ford, one Lexus, and one Toyota dealership (currently OEM brands that do not allow public ownership in Canada but will most likely be acquired by AutoCanada if this restriction is lifted) and has a nearly 10% stake in AutoCanada shares. If we do the math, the value of Mr. Priestner’s current equity stake in AutoCanada via CAG comes out to roughly $87 million.
-CAG recently sold several GM dealerships to AutoCanada with Mr. Priestner retaining a 15% ownership stake with voting control as owner-operator (a requirement by GM Canada). I believe having the seller retain partial ownership post-sale better aligns the economic incentives between the seller and acquirer when it comes to improving operations post-acquisition.
-The current President Tom Orysiuk was formerly AutoCanada’s CFO when he joined as the CFO of Liquor Stores Income Fund and based on his track record he understands good capital allocation.

2) Management’s Capital Allocation Track Record:
-Raised ~$200 million in equity financing when shares were near $78 last summer; this represents more than 20% of the entire market capitalization today! At $78 per share, essentially they were diluting the equity at ~32x 2014E earnings, ~26x 2015E earnings, and using the capital to purchase dealerships at 4-6x EBITDA. So issuing equity at a little over a 3% earnings yield to purchase assets at a more than 10% earnings yield. You can call this a “roll-up” if you want but I think it’s a pretty value accretive roll-up.
Furthermore, the company is buying real estate at attractive cap rates at 10% or greater; in fact I believe the 11 real estate related-party transactions that the company bought from CAG late in 2013 were purchased at close to a 10% cap rate. I would have much rather preferred it if management funded these purchases primarily with non-recourse debt. They could have funded these purchases primarily low cost mortgages at 4-5%, so essentially getting a high ROE with very low cost financing.
Some observers have pointed to CAG’s stake being continually diluted down over time via secondary offerings as a concern. For example, at the time of the large $200 million equity issuance last summer CAG exercised its over-allotment option and diluted its stake down to ~9.5% in AutoCanada today. I think we have to put the dilution and over-allotment in context. The stock price was basically trading at 32x earnings, not exactly a low multiple even for a high-growth company such as this one. If I were the largest shareholders I probably wouldn’t mind taking a bit of money off the table given the atmospheric rise of the stock price since the 2009 lows and especially given that the shares were likely overvalued. In retrospect, most of the cash raised at that high share price has been used to acquire additional dealerships at low multiples, so I believe it was a deal in the best interest for all shareholders. I think about it this way in terms of value creation: we’re basically getting a smaller piece of a much larger pie. One thing I should point out is that the over-allotment generated around $203 million in additional gross proceeds for the CAG shareholders. So the only thing that gives me pause or slightly concerns me is that I didn’t see any insider buying by Mr. Priestner when the stock tanked to the low 30’s. I don’t think this is a deal breaker to my thesis, but certainly a bit of a question mark.
-based on their past history, I haven’t seen them dilute the equity at a forward P/E multiple of less than 15x; remember, Mr. Priestner still has a large personal economic stake in the company
– They have a good, stable independent board with decent share ownership that has to approve related-party transactions
-I believe acquisitions remain the highest return on capital option and the best use of free cash flow

3) Alignment of Incentives:
AutoCanada’s management team have a terrific track record in acquiring well-run dealerships (at attractive 4-6x EBITDA multiples and no turnaround plays) at good locations and ramping up newly acquired mom-and-pop dealerships to their full potential after 2 years. 70% of AutoCanada’s “at-risk” dealerships were acquired in 2014, leaving lots of room for improving scale and operational efficiency. As mentioned they are starting to diversify their OEM brand mix and are definitely aware of the concentration of dealerships in Alberta
-President says they are buying dealerships at 5-6x pre-tax income; if they purchased the 2 BMW/Mini dealerships in Quebec within this valuation range it would be well below the range luxury brand dealerships typically sell for (closer to 6-7x EBITDA). They have a track record of improving operations from acquired mom and pop dealerships, leveraging best-in-class IT practices such as CRM, sharing inventory within a close proximity network etc.
-Based on the chairman’s industry contacts developed over 30 years in the business he has somehow managed to convince Chrysler to lift dealership number restriction rules and GM Canada to lift its public restriction
For 2014 the annual incentive plan was 40% weighted to adjusted free cash flow per share, 30% weighted to adjusted gross profit, and 30% was discretionary. In the prior year instead of adjusted gross profit the performance metric was adjusted return on capital. It’s not a deal breaker to me that they changed this metric but I will be seeing if they eventually put ROC back into their annual incentive package which properly measures an acquisitive company’s performance. They typically track this metric in their filings. Executive annual compensation remain a small % of the value of their holdings in the company.
In summary, I believe the AutoCanada’s management team are among the best auto retail operators in Canada. They have a long successful operating track record, and are allocating capital well. My only remaining concern is the absence of large insider share purchases at these current trading levels.

Valuation:
This is a retailer and it’s all about the same store metrics…
Since this is such an acquisitive company that closes deals almost every quarter it’s very difficult to project growth even on a run-rate basis, but I have basically modelled same-store metrics and applied them to the total number of company-owned dealerships on a forward basis. It’s a bit complicated but I believe it is a good, conservative rough estimation of intrinsic value.

Quick summary of Key Business Drivers:
Bear Case Scenario: I have modelled the key drivers for an overly pessimistic, unrealistic “bear case” scenario. I also sensitize the bear case intrinsic value with a “no acquisition” scenario that assigns 0 value to the incremental FCF that will be generated (basically assuming the cash just accumulates on the balance sheet) and an acquisition scenario with 6-8 deals (still below management’s annual guidance of 8-10 deals per year) closed in 2015. For all my key driver assumptions please see the appendix.

P&S Segment:
Based on my conversations with some of AutoCanada’s dealers, I believe ~50% of gross profits from P&S should flow through SG&A; (eg. if P&S gross profits grow by 5%, EBIT should grow by ~7.5%). I assume same-store P&S gross profits grows at low-to-mid single digits which I believe will prove very conservative.

New Vehicles Segment:
Fleet vs Retail Sales:
-Fleet is more cyclical, due to activities of major companies and being concentrated in Alberta which is a more cyclically exposed province due to oil industry exposure -> lower gross margins due to bulk wholesale pricing
-Fleet should decline more than retail sales; I assume company-wide new vehicle gross profits decline by high-single digits, driven largely by new fleet (largest decline) and retail sales (more muted) in Alberta, and even a single-digit decline in rest the rest of the country
Retail sales – on average, light trucks have higher ASPs (higher gross margins) vs passengers which are lower ASPs (lower gross margins); I assume a slight decline in average selling prices (ASPs) as consumers trade down to lower-priced cars even though the most recent data is showing that light trucks sales are growing faster than passenger vehicles

Used Vehicles Segment:
Management expects used vehicle ASPs and gross margins to continue to be pressured in the future. I assume a decline in same-store used vehicle sales, but more muted than new vehicle sales since consumers typically trade-down to used vehicles in downturns

Finance & Insurance Segment:
-Tied to new and used vehicle sales and their ASPs and to health of the credit markets
-I model a SSS decline in-line with same-store new vehicle sales; again this should prove very conservative since vehicle leasing and financing has been growing steadily due to the growing availability of credit

SG&A: I model this at 79.5% of gross profits, a nearly 200 bps increase from 2014E levels. I believe this is an extremely conservative assumption especially after the fact that the company purchased the real estate of 11 of its dealerships that it used to lease in late 2013; this should decrease their lease expense ~$10 million on an annual run-rate basis. Also they now have 48 dealerships which is ~50% more than in 2013 year end. Some cost savings and synergies on these additional dealerships acquired should be easily realized.

Capital Allocation and use of FCF:
I’ve layered in 6-8 acquisitions to my valuation with the deal assumptions shown below which conservatively leads to a few dollars of incremental value per share. I also have a scenario where the company closes no deals which is essentially assuming that the ~$65 million in incremental FCF that will be generated in 15’ piles on the balance sheet (highly unlikely for a management team that have consistently allocated capital at a high rate of return).

acquistions

Bear Case Summary and why this scenario is overly pessimistic:
Aside from the points I’ve already made in my thesis:

-We still have to take into account the typical 2-year ramp-up period and larger size of the most recent acquisitions outside of Alberta over the past year. Last year alone the company acquired/opened 16-17 dealerships which should boost FCF dramatically
-I arrive at a consolidated negative gross profit growth of 8.7%; just to put this figure in perspective it is a greater decline than in 2009 where same-store gross profits fell by less than 8%
-Most of the publicly-traded US auto dealer groups have been recently reporting high to single-low digit SSS growth in their P&S segments, which is supporting the young vehicle age growth thesis in North America
-Only a few good acquisitions are needed to fully offset any temporary weakness in organic growth, and the company certainly has the balance sheet to execute. Based on management’s track record this is almost a near certainty. I view further acquisitions as rather low risk since they are small in size, will have low valuations, and are not dependent on synergies for accretion

Unrealistic Worst Case Summary: Still upside in an Armageddon-like scenario

bear case

A Quick and Dirty way to sanity check my bear case valuation:
I took my bear case projected adjusted EBITDA figure and divided it the number of dealerships to get the average EBITDA per dealership. By this measure, the implied average EBITDA per dealership is ~$2 million. I simply believe this figure is far too low. If we look at the average deal size over the past 25 or so acquisitions that company has completed, and assume a 5x-6x purchase multiple range (mid-to-upper point range of management’s guidance) for these acquisitions, it implies that the most recently acquired dealerships should be generating on average at least $2.5 – $3 million in EBITDA. Also, remember that these dealerships haven’t fully gone through the 2-year ramp-up period, where better operational efficiency, and cost and revenue synergies can be easily realized. Therefore, I believe my bear case sanity check supports the case that this scenario is overly conservative.

bear case sanity

Base Case Valuation Summary:
$61-$65 target price by 2015 year end

base case

I believe AutoCanada should trade at a slight premium (1 – 2 turns) to Asbury Automotive Group, AutoNation and the other US publicly-traded auto dealership groups (which are arguably undervalued as a whole sector). These comparable companies are trading at around 15x-16x forward P/E multiples, and 10x-11x forward EBITDA multiples and should have lower growth prospects. On an absolute basis an 8% FCF yield is quite attractive for this business. Another way to look at the current valuation is that we’re essentially getting a lot of future growth for free.

valuation

The Bull Case is straight forward: I think this business could potentially be worth $100+ per share 3 years from now. This implies a valuation of 29x – 30x 2015 free cash flow per share of $3.30 – $3.45. The key drivers here are an acceleration in accretive deals as the business scales and P&S gross profits continue to grow at high single-digit rates. I don’t believe this scenario is too far out of reach.

Valuation and Target Return Profile:

irr

Why does this opportunity exist and what’s my edge?

1) The stock doesn’t screen well on an EV/EBITDA metric and appears over-leveraged given the large floorplan financing. EV/EBITDA should be adjusted for floorplan financing, which I treat not as debt but a use of working capital. AutoCanada’s floorplan financing has consistently been below inventory levels, indicating that the dealerships are turning over inventory efficiently within the 45-60 day interest-free period and that there is actually excess cash hidden in the floorplan.

2) This is very acquisitive company so the GAAP accounting is very messy. Obviously, the company has been making a lot of acquisitions, which obscure the true profitability of the business. Projecting forward earnings has to take into account both organic and inorganic growth which isn’t a simple task. The company also doesn’t break out the same-store figures from the growth from acquisitions.

3) Panic selling caused by retail investors and a short-term market overreaction to oil’s crash and its implications to AutoCanada’s intrinsic value

4) Small-capitalization company so more under the radar

What can go wrong?

-Similar to my DirecTV idea, I really don’t see anything that can “torpedo” my thesis. Even if we were to assume that Canada enters into a very deep recession, acquisition targets should remain plentiful and could likely increase due to owners worried about the cycle turning, and as mentioned AutoCanada’s cost structure is very variable. The only scenario I see that can cause permanent impairment of value at this price is management destroying shareholder value. Given the arguments I made above, I believe this is an unrealistic scenario.

-Oil continues to crash, causing further employment losses in Alberta; although I have argued that this is already largely priced in

-Interest rates spike up substantially. This is very unlikely. In fact the Bank of Canada just recently cut interest rates

-Auto credit bubble, Canadian housing bubble, record Canadian household debt-to-income levels all happening simultaneously stymieing demand for vehicles

Event Path and Catalysts:
These things are not important to my thesis since I believe that the shares are trading at such a discount to intrinsic value that 1 year from now I expect the stock to be trading much higher. I would also like to hold this business for the longer-term as long as it remains reasonably valued and provides a high IRR given the long runway for high-quality growth. Also as highlighted above, I think it’s a pretty good retail business that I would be happy to own longer-term.
1) WTI begins to sharply recover, and ACQ follows suit.

2) Announcement of large accretive deals; the company definitely has the balance sheet to execute.

3) This is a great example of how prices are much more volatile than underlying business values; prices can overshoot to the upside and to the downside; the core growth thesis remains intact and once the markets starts shaking off the oil plunge fears this stock can take off very quickly again and re-rate to a 20x multiple to properly reflect the growth prospects. This is a very likely scenario since this is a high-growth dividend-paying stock that should attract a lot of interest again especially as Bay Street will continue promote the stock. 

4) Monthly industry data continue to point to strong performance and less muted effect of lower oil on vehicle sales in Alberta.

5) Fiscal year 2014 year end results will be reported in March which will show strong inorganic and acquisitive-driven growth.

Summary:
1) This is a high-quality compounder with plenty of growth that has temporarily fallen out of favour – a classic “value investment”.

2) We have a fantastic management team focussed on driving shareholder value, are well aligned with shareholders, and are experienced in the industry with a suburb operational and capital allocation track record.

3) The bear case has no legs, and even if it does, there is virtually little to no downside at current trading levels. In fact there is plenty of upside since we are getting such a bargain price as until the market comes to its senses. I believe this situation exemplifies Monish Pabrai’s famous quote: Heads I win; tails I don’t lose much.

 

“In the short term the market is a voting machine, in the long-run it is a weighing machine” – Benjamin Graham
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” – Warren Buffett

 

 

Appendix:
1) Modelling Assumptions: Bear case and Base Case

modelling

Base Case: Average Dealership Financial Estimates:

sssss

Base Case same-store estimates (assuming no acquisitions):

ssssssssss

Base Case Unlevered FCF reconciliation:

reconcilation

Adjusting TEV by hidden excess cash in floorplan

Adjusting TEV by hidden excess cash in floorplan

Thoughts about Risk and Portfolio Management

I once watched a video of a very old speech Buffett gave to MBA students. In it he talked about the failure of Long-Term Capital Management (LTCM) – formerly led by a notable team including 2 Nobel Prize Winners.

Here’s the link:

 

In this speech he explains a simple risk management concept in investing by using the game of Russian roulette as an analogy.

 

Let’s do a quick thought experiment. Suppose we have a once in a lifetime potential investment with a 99% chance of 1000000000000% upside and a 1% chance it goes to 0 in 1 years’ time. Some (or many) of you may think I’m crazy or stupid but I would allocate maximum only 10% of my book in such an idea. Why? Because any more than that then I may be at risk of failing to reach my long-term return goal. I can probably afford to have 1 bad year, but I definitely can’t afford to be out of the game permanently. Some people may look at the risk/reward and say “but that’s crazy, that’s an amazing risk/reward, you should definitely put 50-100% of your book in that idea”. If you’re thinking to put somewhere between 50-100% of your portfolio in such an idea, you run the risk of losing everything or at the very least setting yourself up in an almost unrecoverable position. My point is that no matter how miniscule the probability is, in reality the 1% chance can happen. In order to build a great long-term track record, these situations always have to be sized appropriately. I think it’s safe to say that LTCM took outsized risk.

 

How this applies to my favorite investment heroes Buffett and Malone:

Buffett could have easily used more leverage in Berkshire and become even richer than he is today, without increasing the probability of a permanent impairment of value. He simply chooses not to use more leverage. Back to Buffett in a later point.

 

Many value investors might not like Malone’s use of substantial leverage in his companies, but I do. Malone is a genius in applying just the optimal amount of leverage. This doesn’t mean he doesn’t consider having a large margin of safety when using the right amount of leverage. He understands his industry incredibly well, including the nature of the business and the financial structures of all the major players involved. Even in a realistic worst case scenario, he knows that the equity will not be permanently impaired in value. He is, after all, typically the largest shareholder in his companies. Malone is probably greedier than Buffett today. He typically likes his companies undervalued so that they can buy back more stock at cheaper prices and at a discount to intrinsic value. (I hope he doesn’t see this because I love him and should have sent him a Christmas card over the holidays).

 

Buffett obviously has superb portfolio management skills. In his earlier days when running his private investment partnership he would have 40%+ positions, and he was ultimately right. If in reality the “right” weighting for a certain investment in a portfolio is 25%, Buffett would probably figure that out and allocate somewhere between 24-26% of his portfolio in it – that’s how good he is.

 

I think portfolio management is much more of an art than science. Most professional fund managers diversify in over 100 names because they probably think that makes a much “less riskier” portfolio. They certainly teach you this bullshit in business school. According to modern portfolio theory these idiots (oops, pardon my French) tell you that the greater number of names in your portfolio, the greater the diversification and the less “riskier” a portfolio is. This is obviously wrong, because the right definition of risk is the probability of a permanent impairment of capital. In order to avoid a permanent impairment of capital you need to buy – at the right price – shares in a business at a deep discount to intrinsic value. To arrive at a business’ intrinsic value involves conducting intensive, deep, fundamental research, especially for industries and businesses with a lot of moving parts. See where the art part is coming from?

 

So back to my original point: How the fuck is any portfolio manager supposed to know the risk/reward in over 100 portfolio names, especially in this complex, ever fast-evolving capitalist economy. The answer is he/she doesn’t, because as far as I know we as humans can only store a limited amount of knowledge in our brains at any given time (doesn’t mean we can’t compound general knowledge over time). If you don’t know the risk/reward in all of your portfolio names, well then guess what? Maybe your portfolio is riskier than you think it is. Remember, the price you pay is the ultimate factor that decides your margin of safety. My point is that I think the chances that one investor finds over 100 great investment ideas at any one time is pretty close to 0 – especially in today’s ever increasing efficient stock market. If one day you wake up and know the risk/reward in over 100 public companies given their current market prices, you might have turned into a super intelligent alien. The last time I checked, Sir Isaac Newton was still dead. Maybe Elon Musk is a candidate.

 

“Diversification is a protection against ignorance” – Warren Buffett

 

Michael Mauboussin, Howard Marks and Thinking about a Probabilistic World

I think the art of winning in poker has a lot of similar aspects to being a successful investor. Poker, like investing, is largely a zero-sum game. In poker, you have to know how to size your bets, and you absolutely have to understand risk management. The best portfolio managers know how to best size a position – whether it should be a 30% or 10% weighting for example – and they definitely know what they know and know what they don’t know. As value investors we should be obsessed about the downside. I personally ask myself before I make any investment: what can go wrong? Like it or not, I think this point is even more important for concentrated investors. As concentrated investors we may hold only a handful of names at any given time. Let’s just say if we’re wrong on any of these names, we can potentially get fucked. I talked about how having over 100 names in a portfolio can be risky, but what can potentially be even more risky is a concentrated bet with a miscalculation of the downside. I see a ton of fund managers in Canada that seem to have a love with investing in resource-based companies because they think commodities will go to the moon. I’m no commodity expert, but even I’m smart enough to know that if the underlying commodity tanks – which it easily can, or certainly there’s a real probability of it happening – your gold or gas or oil or whatever project can become permanently uneconomic. These fund managers probably aren’t stupid, but don’t properly control risk. On the other hand you have to know when to bet big when the odds are clearly stacked in your favor. If you think in the worst case scenario you’ll still make money then you should clearly size the position as a top holding. I don’t think it helps if you’re constantly scared of losing money. I think the best investors, like top poker players, probably have some sort of “desensitized” relationship with money. You have to think rationally to perform your best. In essence when you transact it’s an act of arrogance, as Klarman says, and you better not be the sucker at the poker table. It’s hard and often it takes “second-level” thinking, especially for well-followed, liquid companies.

 

One in a Million
My final point is that there are tons of very smart, great analysts out there who can regularly find great investment ideas. But only a tiny fraction of these guys will ever achieve legendary-type returns (if they attempted to) because of poor portfolio and risk management. I really don’t know if you’re “born” a great investor or not, all I know is that it’s pretty fucking hard. Of course achieving great returns is waaaaay easier said than done, and a lot of it has to do with having the right temperament and psychology. I’m not talking about just beating the S&P for 100-200 bps by the way (which most people fail to do), I’m talking about 20%+ annualized over a 20+ year period. The best we can probably do is to study the great investors we admire, reverse engineer their best investments, apply their lessons and mistakes learned in your own portfolio by developing your own theses, and in time you’ll start developing pattern recognition skills. Did I mention that you should read a shit ton of annual reports?

 

I think on both ends on the spectrum (being concentrated versus being “widely diversified”) there are lessons to take away from this. Personally I’m a concentrated investor and will likely remain that way for the rest of my life. I seem to have a style that is a mix of Malone, Buffett and Greenblatt. I love to dive deep into companies and industries and learn the most important things and key drivers I need to know to have an edge over the person on the other side of the trade. I also think it’s important to identify catalysts that will unlock value or else it’s a value trap and I won’t know what the fuck I’m doing. It’s important to discern whether you’re catching a falling knife from the 30th or 2nd floor right? And that’s why I love this field. It’s more of an art than a science, and if you want to compete with the very best analysts out there and generate legendary-like returns you will be constantly intellectually stimulated. Hopefully in this blog you’ll see what I’m talking about.

 

So the next time you’re thinking about putting on a huge weight on a company that has even a slight chance of going to 0, think about that revolver with a million chambers in it, but with 1 bullet, and pointing that at someone you deeply care about, or at yourself.

 

Back to reading eBay’s 10-k and learning about John Danahoe’s brilliance.

 

-R