The investment business can be brutal on the psyche. Any given investment is rarely bought at the true bottom and sold at the true top. Investments that appreciate significantly could almost always have been bigger; investments that lose money could have been smaller. Then there are the errors of omission, which are the investments that were considered but not executed. This is to say there is no shortage of ways for a portfolio manager to beat himself/herself up. In 2016, we made several prescient investment decisions which led to investments appreciating more than 50%, including RMR Group, IDW Media, Diamond Resorts, and Iteris. The steady flow of new funds from new and existing limited partners, as well as our desire to be tax efficient and avoid short-term gains, led to ending the year with almost 20 positions. This is at the very high end of where I feel comfortable. We made three investments (outlined below) in the fourth quarter alone. I would be very happy to slow this pace down and get back to owning approximately 15 positions. This may result in a coming quarter or quarters where we add no additional companies to the portfolio. I think that would be ultimately healthy. For 2017, less is more, fewer is better.
The smallest investment we made in the fourth quarter was in a company called RMG Networks, which I have been studying for almost a year. I went to visit the Dallas headquarters over the summer, but did not invest at the time. RMG is a business in transition. They historically sold the screens that digital advertising is shown on. This is a bad business with little differentiation, low margins, and little recurring revenue. Couple a bad business with the bad strategy of the last CEO who tried to build a media company, and the result is bad financial performance. The stock chart of RMG Networks is a black diamond ski slope with the price declining from more than $10 to less than $1 in less than three years. So far, nothing outlined above would have piqued my interest. Why travel to Dallas in July? The primary reason was that Eric Gomberg from Dane Capital had prodded me to meet with the CEO in the spring. Eric described the CEO, Bob Michaelson, as an incredibly high quality leader for a sub-$50M market cap company. Per usual, Eric’s assessment was spot on. The trip to Dallas was to understand if Bob had been able to build a team – or if he was “all hat and no cattle.”
One method I use when evaluating management is imperfect, but it is the “What Would Scott Miller Do” (WWSMD) test. In the case of Bob Michaelson, the only move he has made to date that fails the WWSMD test is accepting the job as CEO, stepping into the top role at a money-losing company pursuing a money-losing strategy with a constrained balance sheet. I would have never taken the job in the first place, but once in the CEO role, he has done everything I would have done and then some. He (and his team) sold the money-losing media business, radically restructured the digital screen business by taking out 30% of the operating costs and lowering the breakeven points, invested in new products, and improved distribution. Bob and his team are de-emphasizing the low-margin hardware and emphasizing the higher-margin recurring revenue software and services. Bob is focusing on what goes on the screens that are sold. Bob has added distribution in specific verticals, giving up some economics in order to leverage their sales forces. Specifically, he partnered with Manhattan Associates, a public company 100X their size, Ragan Associates, a leader in internal communications, and DS-COMM, a unit of Boeing. This is a low-cost, potentially high-reward strategy (nice work, Bob). None of these changes “screen well,” but they matter – the fundamentals matter.
Almost all of Bob’s progress outlined above (except the partnerships) was evident in our July visit when the shares were trading at just over $1, but I still decided to wait and watch as I am not a fan of the hardware business. This waiting and watching ended in December, when two other factors drove the investment decision. First, there appeared to be an indiscriminate seller – the portfolio manager at the second largest stockholder had turned over, and whoever inherited the position wanted out of what effectively amounted to a rounding error in their overall portfolio. An indiscriminate “seller “of size” in an illiquid stock creates an opportunity. The second and final piece to the puzzle was RMG’s fully backstopped rights offering. In plainer English, in order to strengthen the balance sheet, the company raised $4M in additional capital by offering every existing shareholder the right to buy shares at $0.62 (for every five shares an investor owned, s/he could buy an additional share). The largest shareholder, who has a board seat and is presumably quite informed, indicated that he would participate on his pro rata basis and would backstop the offering by taking additional shares, if necessary, to sell the full $4M. A fully backstopped rights offering can be a way for existing investors to buy more shares on favorable terms. As a point of reference, our IDW Media shares, which we bought in their fully backstopped rights offering, are up more than 100% in less than a year. While RMG Networks shares will likely not perform as well, the stock is trading at a depressed valuation and is at an inflection point where the product investments and partnerships will begin showing up in the financials. I was thus happy to participate in the rights offering alongside the largest shareholder who was committing additional capital as the long-term opportunity had improved while the stock had gotten cheaper. Over time, improved profitability should come from the distribution partnerships and reduced cost base. We may also benefit from multiple expansion as the company emphasizes software with recurring revenue and services over hardware.
Investors Are Bad at Math
The other two investments that we made in the fourth quarter are detailed in my 30+ page presentation for The Manual of Ideas’ Best Ideas Conference 2017. The presentation is up on our website (www.greenhavenroad.com) under the Investor Letters tab. The abbreviated version is as follows: investors are bad at math and underestimate the power of compounding. As you will see if you go to the deck, there is a very large difference between money that grows at 10% vs. 20% over a long period of time. The example I used was 100,000 growing at 10% vs. 100,000 growing at 20% for 30 years. At the end of Year 1, 10% growth gives you $110,000, while the 20% pile is now $120,000 – a $10,000 difference. How big will that difference be after 30 years? For the answer, you can 1) use Excel, 2) go to the presentation on slide 7, or 3) see the postscript at the end of this letter. Bigger than you thought?
The second theme of the presentation and the new investments this quarter is that “Boring is Beautiful.” Boring businesses can deliver outstanding returns. The road to wealth is not only paved by discovering oil, finding a cure for cancer, or social media. The presentation profiles a “boring” business, Watsco (WSO), in the air conditioning business. Watsco has executed a “buy and build” strategy. They have acquired dozens of companies at favorable multiples AND improved them. The share price appreciation has been anything but boring. Over the last 30 years, revenues are up 53X but share count is up only 5X, resulting in the stock price being up 60X. The math of using shares that are trading at 15X EBITDA to buy businesses that are trading at 5X EBITDA, and then improving those businesses, is very powerful.
New Investments in Boring Businesses — EnviroStar and Limbauch
We did not invest in Watsco. Instead we made an investment in a “boring” commercial laundry equipment distribution company, EnviroStar, Inc. (EVI). The company has no sell side analysts, no investor presentation, and conducts no conference calls. Adam Wyden of ADW Capital owns more than 5% of the company and was very helpful in connecting the dots here. As outlined in the presentation, EnviroStar is an investment predicated on the “jockey” – in this case second-time CEO Henry Nahmad, who previously spent eight years at Watsco, where he had a front row seat watching his uncle execute the “buy and build” strategy as CEO. Influenced by this approach, Henry Nahmad raised money from friends and family and invested personally to create two partnerships that bought control of Steiner Atlantic, a publicly traded nanocap commercial laundry distribution company that has subsequently been renamed Envirostar. Commercial laundry is not coin-operated laundromats, but rather specialized, centralized facilities in high-volume laundry environments such as hotels and prisons. The industry is attractive: with five primary manufacturers of equipment, there is a slow rate of technical innovation, but the machines do break, which provides opportunities for a higher-margin service business. The distribution agreements with manufacturers typically call for geographic exclusivity and distributors carry little inventory beyond replacement parts. In summary, you have geographic monopolies in an asset-light business with little risk of technical obsolescence. Henry has completed his first major acquisition and secured debt, both on favorable terms, while also building out his management team. There are plenty of risks with his “buy and build” strategy, including a reliance on a “favorable currency” in the form of a high stock price. The shares have appreciated significantly, as a value investor, buying a stock that is up more than 4X from the lows is not a natural act. However, the current multiple is lower than Watsco on current year EBIT and the company has a clear path to doubling earnings this year through acquisition while increasing share count less than 20%, which will make us yearn for current prices. Run the numbers, if Envirostar can continue to grow earnings with minimal dilution a few times over, boring will not only be beautiful – it will be quite lucrative for all involved. Remember, investors are bad at math.
The second new investment in the Q4 is a similarly “boring” company, Limbach Holdings, Inc. (LMB), which, like Watsco, is primarily in the air conditioning business. Limbach specializes in installing and servicing non-residential HVAC systems, focusing on hospitals, education institutions, and entertainment venues. The company has a centralized engineering staff to assist general contractors and architects with the design of complex systems, which can bring down project costs and increases win rates. My presentation goes into greater detail on Limbach, but at a high level, the company has a strong CEO, a healthily business backlog growing 30% y/y, and is valued at a discount to its peers. There is a clear path to continued organic growth and margin expansion. Limbach also has the opportunity to selectively grow through acquisition, expanding geographies as well as business lines (electrical and fire suppression). Couple this with aligned incentives from the CEO owning 6% of the company and the SPAC sponsors owning more than 40%, and this has an opportunity to be a lucrative investment as well. We own the common stock as well as the long-dated warrants.
This post has been excerpted from the Greenhaven Road Capital Q4 2016 Letter.
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