Coming out of business school we imagine you thought about going the traditional buy-side route before deciding right away to start your own firm. What went into that decision?
Adam Wyden: I had spent a summer during college working for a big hedge fund where I learned a lot, but where one of my primary jobs was to go through quarterly earnings estimates of Wall Street analysts and identify the deviations from consensus in each report. I wrote it all up and turned it in and never really knew what they did with the information. It kind of hit me then that I wanted to invest in small companies I knew very well and where I thought I could make multiples of my money over a multiyear period, not just try to arbitrage consensus earnings estimates. That was the strategy I employed in my personal account with good success and I felt like working at a big firm would distract me from that and force me to look at ideas I had little interest in.
Describe the companies you target.
AW: Most tend to be Joel Greenblatt-type special situations, orphaned by the market because they’re too small, or they’ve just been spun off, or they’ve just been reorganized, restructured or refinanced. Management is key – I’m looking for entrepreneurs with fire in their bellies, a lot of skin in the game and a demonstrated track record of success. I will look at asset plays where the existing assets in my estimation are worth some multiple of the current market value, but I’m putting more emphasis as I go along on the ability of the business to reinvest cash flow and grow.
Case studies would appear to be in order.
AW: One of the first things I invested in was a company called Lorex Technology, a Canadian microcap that traded in Toronto. It specialized in do-it-yourself video home security systems, offering what I thought was a differentiated product in a business with nice growth potential. But the stock was trading at something like 1x EV/EBITDA, with no debt, and it wasn’t that difficult to understand why. There was zero institutional interest in the company, it had run operating losses for years, it had just come off a dilutive recapitalization, the shares were extremely closely held, investor communications was bad, and one of the brothers who owned a lot of the stock had just taken over as CEO from the other brother who passed away after a long bout with cancer.
I'm looking for entrepreneurs with fire in their bellies, skin in the game and a demonstrated record of success.
As management got the business on track, we concluded the company was better off selling itself to a bigger player who could invest in the growth potential we saw. At the time we wrote a letter to the board detailing that in April 2012, we owned almost 10% of the shares outstanding. In the end the company in late 2012 agreed to be acquired by FLIR Systems. We began buying in at around 25 cents per share and the deal closed at around $1.30.
Tell us at least the condensed version of your IDT Corp. investment story.
AW: One core holding today is IDW Media [IDWM], a subsequent iteration of an investment I made in IDT near the end of 2009, pre-dating the launch of my fund. Your readers may remember IDT, a media/ telecommunications firm that had been built by Howard Jonas, a serial entrepreneur who while at Harvard was selling Venus flytraps out of his dorm room and ran a travel-brochure business. He had sold a number of IDT assets at full prices to big industry players like John Malone and AT&T, and had turned the company prior to the financial crisis into sort of an incubator for new-venture ideas that had costs that far exceeded revenues. Coinciding with this strategy change, Howard stepped back from the CEO role to just serve as the company’s Chairman and to focus on certain philanthropic efforts.
The 2008 crisis was not kind to IDT. Losses mounted, investors bailed and the shares declined almost 95%. Howard came back as CEO and immediately cleaned house, shrinking personnel and selling many non-core assets. I ended up taking a significant stake in my personal portfolio at about $3 per share, at a time when the company had $10 per share in cash and marketable securities, $10 in tax-loss carryforwards, and a variety of other hard assets and intellectual property. Out of favor, to say the least.
In Howard’s quest to restore value in IDT – which paid off tremendously, by the way – he spun off on the pink sheets a subscale holding company called CTM Media Holdings, which consisted of the same travel-brochure business he started in college and a comic-book business that had its own intellectual property and was doing licensing work for Hasbro, Star Trek, GI Joe and others. That too has been a homerun since we bought it in 2011, primarily due to the expansion of the comic-book business beyond print into the production and distribution of TV shows, movies and videogames. We still see tremendous upside for it as it becomes a legitimate #3 in the business behind Marvel and DC. CTM’s name changed to IDW Media and the stock was upgraded in January to the OTC Best Market from the pink sheets.
The common thread in this IDT story is businesses that are either widely out of favor or mostly unknown, run by entrepreneurs like Howard Jonas and Ted Adams – the founder of CTM, now IDW – who have a unique ability to nurture, grow and monetize the assets under their care.
How about one more example of what attracts your attention: timeshare developer Diamond Resorts?
AW: We follow insider buying and what caught my attention in Diamond was a substantial buy a few years ago by Richard Daley, the former mayor of Chicago. What’s a guy who may not have that much money doing investing this much in this company? I looked at the board, which was impressive. I saw that insiders owned 50% of the shares. I also knew that investors generally disliked timeshare businesses, which had a history of overextending themselves at exactly the wrong time.
Diamond was created in mid-2007 by Stephen Cloobeck, who had previously developed and managed timeshare resorts on his own and with the help of high-profile partners like Starwood Capital. He had sold the majority of his holdings to Marriott and was looking for the “next big thing,” which he found in buying a deeply troubled timeshare company called Sunterra, renaming it Diamond Resorts, and using that as a platform over the next couple years to buy distressed properties for far less than their replacement costs.
The company went public in July 2013 at $14 and we started buying in the first quarter of 2014 in the $16-17 range. It traded at something like a 30% free-cash-flow yield – pro-forma for an imminent refinancing – which we attributed to negativity toward the timeshare business, the lack of brand profile in an industry where brands were perceived to matter, and a misunderstanding of the balance sheet, which was actually minimally levered at the corporate level. We thought management could deliver on its strategy to upgrade property quality, emphasize management fees and de-lever the balance sheet, in an industry that was poised to improve overall. But nobody seemed to care – that’s often the case when we first get involved. [Note: Diamond Resorts was acquired last September by private-equity firm Apollo for $30.25 per share.]
Are there industries you tend to avoid?
AW: We avoid financials, energy or anything commodity-based, and healthcare and biotech. With financials, I learned the hard way in 2008 the dangers of their balance sheet opacity and natural levels of leverage. With businesses tied to commodities, I’ve concluded I don’t want to invest in situations where I can get the micro story dead on but not get paid at all because a commodity price goes against me.
I'm not comfortable with businesses where the government actively tries to see that it makes less money.
With healthcare maybe it’s tied to my personal background and the fact I grew up in Washington, D.C., but I’m not comfortable with businesses where the government is actively trying to see that they make less money. [Note: Wyden’s father is the senior U.S. Senator for Oregon, Ron Wyden.] I’ve also found that for smaller companies in this field outcomes are too often binary. I run a very concentrated portfolio and I can’t make a big bet when the potential downside is catastrophe.
You mentioned earlier the importance of management. How do you inform your opinions there?
AW: I’d like to believe I have the requisite technical skills and value investing background necessary to do this job well, but one way I can differentiate myself is through my interpersonal skills. Again, maybe it’s my background, but I’ve learned the importance of closely observing people, of finding the right sources who have real insight into a situation, and of building alliances. I think of myself as much as a private detective or beat reporter as I do an investor. That’s particularly important in developing a profile of top management. You just have to be persistent and relentless and never be afraid to pick up the phone and try to find the next person who might tell you something valuable.
You also can’t underestimate the importance of understanding the incentives of management and aligning yourself with people whose bread is getting buttered with yours. This is critical in the small-cap space, where people make such a difference. Incentives drive all behavior – if they’re eating buttered bread while you’re going hungry, that’s a recipe for disaster.
Most investors focused on small caps tend not to concentrate their portfolios as much as you do. Describe the rationale beyond your approach.
AW: I think about risk in terms of the quality of the business, the price I’m paying and, of course, the possibility and potential magnitude of permanent capital loss. If I’ve done my due diligence correctly, I’m willing to bet heavily on stocks that make the cut and have the potential over time to return multiples of what I’m paying. There aren’t a lot of these at any given time, so I’ll stock up when I find them. It’s not unusual for us to have 75% of the portfolio in our top five positions.
To give an example of what I won’t make a 10-15% position, we invested at the beginning of 2012 in Headwaters [HW], a building-products company that we thought we were buying at the bottom of the housing cycle in the U.S. It had acquired a number of high-quality building-products assets from 2003 to 2007 at too-high prices, leaving it levered at 5x net debt to EBITDA. There were refinancing options and we were pretty comfortable that housing starts couldn’t go much lower, but at that leverage ratio the stock was vulnerable if industry conditions got worse rather than better. I could devote 5% of the portfolio to that, but not a lot more. [Note: Headwaters, whose stock at the beginning of 2012 traded below $3, has agreed to be acquired by Australia’s Boral Ltd. for $24.25 per share in cash.]
Why are you currently high on Imvescor Restaurant Group [IRG:CN]?
AW: Imvescor is a Canadian company that owns multiple restaurant brands and generates revenue in three ways: from royalties on sales at franchised restaurants, from selling products to franchisees, and from pure licensing, say on consumer packaged foods sold under restaurant or other brands the company owns. It’s all asset light – maintenance capital spending is probably C$100,000 a year to generate roughly C$50 million in revenues – and returns on invested capital are very high. But when I found it, the stock was trading at 5x EV/EBITDA, roughly half the peer-group level.
Why the depressed multiple for a highly profitable business?
AW: The company under family leadership had overpaid to expand, put too much debt on the business and then distributed all the cash flow through an income-fund structure. When they had to recapitalize the company they brought in a new CEO who was just a financial engineer, looking to extract as much value from franchisees while cutting back on the quality of products supplied and on advertising and promotion.
As the business floundered, the board put the company up for sale, a process that ultimately went nowhere, but did result in the hiring of a very capable operator, Frank Hennessy, as CEO. He had a great track record in turning around Bento Sushi for a private-equity sponsor, and since coming in he’s putting emphasis back where it should be on treating franchisees like customers. The more money they make, the more likely they are to reinvest in their existing business and to open new stores.
Among other initiatives, Imvescor is spending its own money – contributing C$4-5 million, 10% of the total cost – to help renovate up to 80% of its restaurant locations. That’s helping repair the relationship with franchisees and is generating significant gains in comparable-store sales in the upgraded locations.
Does the company have any appetite for M&A-related growth?
AW: Imvescor's general and administrative costs as a percentage of revenues is much higher than that of larger peers. Management argues they need a minimum amount of G&A to run the business, which indicates there’s a strong rationale for buying additional brands that could generate franchise and licensing revenue that falls almost directly to the bottom line. In February the company closed on a deal to buy Ben & Florentine, a terrific breakfast concept that has enormous, maybe even game-changing, upside potential. I think they’ll continue to buy these types of assets and they have a balance sheet that supports their ability to do so.
How are you looking at upside from today’s C$3.50 share price?
AW: I estimate the company can earn C$28 million in EBITDA in 2018, so on that level the shares trade at about 7.2x EV/EBITDA, with an unlevered balance sheet. MTY Food Group, a successful roll-up of Canadian franchise restaurants, trades at 12.3x 2018 EBITDA. It’s not unreasonable to assume Imvescor can trade at that level, which would put the stock on 2018 numbers at around C$5.70.
Playing a little bit with the possibilities, if the company acquired an additional C$20 million of annual EBITDA at a multiple of 5.5x, taking on C$110 million of debt, I think the stock could trade at closer to C$8 per share, an undemanding 12x EV/EBITDA multiple.
You seem to be exploring new territory in buying something like Fiat Chrysler [FCAU]. How did that come about?
AW: I’ve never been interested in the auto business, where manufacturers have a tough time earning their cost of capital. I’d read the sum-of-the-parts analyses on Fiat Chrysler, which I found interesting, but not convincing. What changed my mind was the announcement in the second half of 2015 that the company was spinning off Ferrari and that it was going ahead with a mandatory convertible bond issue to be back-stopped by the Agnelli family, which was investing an additional nearly $1 billion into the parent company.
John Elkann is Fiat’s chairman and is also chairman of the Agnelli family’s publicly traded holding company, Exor [EXO:IM]. He spearheaded Fiat’s turnaround – including recruiting CEO Sergio Marchionne – and I believe he's in the early innings of establishing himself as one of the great capital allocators. That he was putting up new capital told me this is something I should look at more carefully.
When we first bought Fiat stock – at around today’s share price – I could make the argument that Ferrari alone was worth more than the then market capitalization of the entire company. That meant you were getting Jeep, RAM, Chrysler, Dodge, Alfa Romeo, Maserati and other viable assets for free. As the company has executed its operating plan, our conviction on Fiat is even higher and we’ve also made Ferrari [RACE] a core position.
Describe why your conviction on the traditional business is higher.
AW: The profile of the business has changed. Dodge is effectively only a muscle-car brand. Chrysler is muscle cars plus minivans. Overall the company has deemphasized small-car production, leaving it with a higher-margin product mix. It has also largely completed a massive capital-spending program, which should translate into big increases in free cash flow in coming years.
There are cycles to think about, but I’d argue that works more in the company’s favor than not. The Latin American market is rebounding. In Europe you have a change in mix and a market that is coming off the bottom. Even if the North American market contracts, the change in product mix there will mitigate the impact.
How are you valuing the shares at today’s price of $11?
AW: I can come at it in a variety of ways to conclude the shares are extremely cheap. I believe the earnings power of the business is between $5 and $6 per share. These earnings estimates seem to be eye-popping to most, but in reality they come directly from the company’s 2018 plan. The only adjustment we make is to adjust interest expense to be more in line with Wall Street expectations. Assuming all the businesses are worth the same 5x multiple – which they are not – on that earnings power you’d get a share price of $25 to $30.
Take just two of the operating units, Maserati and Magneti Marelli, which produces automotive components. Maserati last quarter did €184 million of EBIT, for an annual run rate of about €750 million. Based on the valuations being discussed for a flotation of Aston Martin – over 10x EBIT – Maserati today would be worth €7.5 billion. Magneti Marelli does €8 billion in revenues. If it can get its margins in line with peers, it could be worth at least 1x revenue, or €8 billion. Add those two units together, plus the €5 billion in net cash the company expects to have by the end of 2018, you’re at a market value of more than €20 billion. The entire market cap today [for the Milan-traded shares] is less than €16 billion. Even if Jeep, RAM, Dodge, Chrysler and Alfa Romeo were worthless – which they’re certainly not – you would still have a margin of safety.
What’s your case for Ferrari being a comparable bargain?
AW: The convertible-bond offering for Fiat Chrysler contained some segment financials for Ferrari, and reverse engineering the capital expenditures I was blown away by how little the capex requirements for it were. When you strip out the capital spending on the Formula One racing team, the automotive capex associated with incremental production is only around €100 million annually. By my estimate – which was confirmed by a former top executive at the company – the incremental margin on even a low-end Ferrari, costing around $300,000, is around 65%. Ferrari’s maintenance capex per unit of revenue is actually lower than what luxury-goods manufacturer Hermes spends.
The company’s gross margin last year of 49% reflects the effect of slack capacity. Having built another facility to increase production, the company has said that it doesn’t require any additional fixed investment in order to scale. At the incremental margins I’m seeing, I expect to see dramatic margin improvement as slack capacity gets utilized.
What argues for the slack capacity being utilized?
AW: The number of high-net-worth individuals and their aggregate wealth have compounded at an average annual rate of 8.6% over three decades, while Ferrari has only increased production by 2.5% per year. That means while the wealth of the highly affluent grew by almost 10x, Ferrari production only doubled. The company can’t and shouldn’t try to bridge that gap overnight, but it signals to me that there’s plenty of room to raise production. Too much economic value is now being lost by the company to the secondary market.
Do you value the shares, now at $74.50, like a car company or something else?
AW: I actually believe that a luxury-sector multiple is justified given Ferrari’s capital intensity, incremental EBIT margins, operating leverage and the price inelasticity of its product.
Wall Street is modeling a 21% EBIT margin for the company in 2018, which we believe is way low. On production of 9,000 units and assuming a 3.5% average unit price increase, our base case is for €1.4 billion in 2018 EBIT, a 35% margin. At that EBIT level the stock trades at an EV/EBIT multiple of less than 10x. Hermes on a comparable basis trades at more than 22x. For a one-of-a-kind asset like Ferrari, that discrepancy doesn’t make sense to me. Just splitting the difference and using an EV/EBIT multiple of 16.5x, would result in a U.S.-listed share price today of more than $130.
Hitting my margin estimate may take longer than I expect, but offsetting that as a risk is the fact that I haven’t included any value from outside the core automotive business. We believe ancillary revenues from licensing and particularly the white-labeling of Ferrari engines could generate €300 million to €500 million in EBIT over the next several years.
I tell people this is my See's Candies, with great pricing power, limited economic sensitivity and low incremental capital requirements. It’s such a better business than people seem to think.
Turning to one of your favorite growth ideas, describe your interest in laundry-equipment company EnviroStar [EVI].
AW: At the University of Pennsylvania one of my fraternity brothers was A.J. Nahmad, the son of Albert Nahmad, whose company, Watsco [WSO], is a roll-up of HVAC-equipment distributors and has been one of the best-performing stocks on the New York Stock Exchange. It's a great business with high returns on invested capital that isn't going to get disintermediated by Amazon.
Henry Nahmad, Albert’s nephew, worked in corporate development at Watsco and was looking for a similar type of industrial-distribution business to use as a platform to build upon. In March 2015 he took control of EnviroStar, where he’s following the same playbook. The process is the same, the multiples paid are the same, many of the people are the same, but now instead of selling heating and cooling systems, the company sells and services commercial laundry machines.
Is this such an attractive market in which to play?
AW: Laundry is water- and energy-intensive, so there's a move towards increasing energy efficiency and water reclamation, which typically requires updated equipment and regular servicing. We estimate the total addressable market at $5-6 billion, which is much smaller than the HVAC-equipment market, but the laundry market remains much more fragmented and we think has the potential to grow faster given the ability to expand the service side of the business.
There’s also less competition for deals in laundry equipment and services. The guy doing $3-4 million in operating profit isn’t thinking, "I'm going to build a $100-million platform out of this." If he’s looking to sell, he doesn’t want to sell to private equity because he’s afraid they’ll come in and fire all his people. And anyway, private equity isn’t spending much time looking for assets with $3-4 million in annual EBIT.
You’ve emphasized the importance of incentives. How are you looking at the incentives here for Henry Nahmad?
AW: I've met a bunch of his investors at the annual meeting and it's his mom and dad, it's his sister, and it's his friends from growing up. His stake isn’t publicly disclosed, but I estimate it’s probably two-and-a-half to three million shares. So you have a 38-year old guy who owns perhaps $60 million worth of stock, taking a modest salary and earning the rest of his compensation from very long-dated options. Unless the company is sold, the options only fully vest after a 28-year period. I think our incentives are very well aligned.
The stock, now around $19, is up sharply over the past 18 months. How are you looking at valuation?
AW: Assuming no additional deals, I think the company can earn $12.5 million in EBITDA this year, which puts the current EV/EBITDA multiple at around 16.5x. That’s a similar multiple to Watsco’s, which is a $5 billion company growing at only 3-5% per year. That means to me that I'm not really paying for EnviroStar’s potential growth.
What could that growth be? I believe the company by following its established playbook can compound EBIT at 50-100% per year for the foreseeable future, without putting on a lot of incremental leverage. If that turns out to be right, it’s not unreasonable that the stock could earn the 30-40x EV/EBITDA that a company like Fastenal earned in its early years. At 30x our 2017 estimated numbers, the stock would trade at $36.
Given your performance there probably haven’t been many so far, but describe a mistake you’ve made recently and any lessons learned.
AW: We invested in 2013 in a company called USA Truck [USAK], which had a truckload-freight business that we thought was underearning and would improve, and a logistics business that was growing and generating high returns but wasn’t receiving the credit we thought it deserved from the market. We believed in the operating team and plan in place, augmented by what seemed to be a competent and newly constituted board. The stock was cheap at around $10, which was close to book value per share.
Things started out fine, and by early 2015 the market started to get excited about the company’s turnaround and the shares got to around $30. But it became increasingly evident that the truckload business was going to be harder to turn around and more cyclical than we expected. After the third CEO in three years put out great forward guidance that the company missed dismally in the second quarter of last year, we sold out of our position entirely.
ON AVOIDING HUBRIS:
If we start hitting the wall on performance and I feel I can't replicate the returns, we'll start returning capital.
As for lessons, I would say I’m unlikely to invest in trucking again, which is too close to a commodity business for comfort. I also don’t think incentives here ended up at the management and board level to be as aligned with ours as they should have been. Most of the shares they owned were in outright grants, and everyone seemed a bit more interested in keeping their position than pursuing all avenues to create shareholder value. No one operating the business had enough of a vested ownership interest in it. [Note: USA Truck shares closed recently at $7.30.]
The investment business has a way of bringing managers with outsized returns back to earth. How do you keep that from happening?
AW: I’m just putting one foot in front of the other, trying to stay within the boundaries of what I’m good at. I think the fund can get bigger and still make good returns, as some of our positions can support a lot more capital. But we’ll think long and hard about taking new money once we get to $250-300 million in assets.
What I tell people is that I’m right with them every step of the way. I’m the largest investor in the fund and I expect that to probably remain the case. If we start hitting the wall on performance and I feel I can’t replicate the returns, we’ll start returning capital.