About Me

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Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Thursday, July 7, 2016

How to not chase a stock ($TAYD)

While doing work on my last post, I came across Taylor Devices $TAYD on a screen for companies that - similar to $ARIS - have been generating cash and reinvesting it at high rates.

$TAYD is a $61M mkt cap / $55M EV company that makes products that solves problems caused by recoil, sway and / or vibration. These are generally called "dampers" or "shock absorbers" or "snubbers" and they make all kinds of them for two general types of applications: Construction and Aerospace / Defense.

In the construction side of the business, which is now about 60% of revenues, their dampers - including fluid viscous dampers - offset the sway of buildings, bridges and other structures where wind and / or earthquakes effect such things. One of the most recent / high profile applications is in the 432 Park Ave residential tower that blights rises over the NYC skyline like an oligarch's middle finger a tall reed of grass in the center of Manhattan.

On the aerospace / defense side the company sells components of military equipment to stabilize or isolate weapons and radars, personnel or equipment, like on the seats of naval craft or in the hold of the space shuttle.

An interesting tidbit around the history of the company is that it has deep roots providing fluid viscous dampers for the military (ie in the housing of MX missile silos so they would survive a nuclear blast) and then transitioned into the construction side after the end of the cold war, as per this short quote from an article in the January 2008 issue of the Journal of Structural Engineering:

"A major reason for the relatively rapid pace of implementation of viscous fluid dampers is their long history of successful application in the military. Shortly after the Cold War ended in 1990, the technology behind the type of fluid damper that is most commonly used today (i.e., dampers with fluidic control orifices) was declassified and made available for civilian use ( Lee and Taylor 2001). Applying the well-developed fluid damping technology to civil structures was relatively straightforward to the extent that, within a short time after the first research projects were completed on the application of fluid dampers to a steelframed building (Constantinou and Symans 1993a) and an isolated bridge structure ( Tsopelas et al. 1994), such dampers were specified for a civilian project; the base-isolated Arrowhead Regional Medical Center in Colton, Calif. Asher et al. 1996."

In short, this is a business with a long history making a high value product in an unusual niche; just the kind I like to invest in.

Through FY2015 ending May 31, 2015, the company sold $31M worth of these products generating profit of $2.2M, reflecting a net profit margin of 7.1%, impressive.

Even more impressive is that through the first 9-mos of fiscal 2016, the company generated $27M in sales - nearly matching the prior year with a quarter to spare - with net income margins above 10% for 1Q and 2Q and ~14% for 3Q. (The FY16 year end has closed but company won't report until August).

And most impressive of all is that 10-years ago, this company was levered 3x EBITDA, had $86K in the bank and did 1/2 the revenues as they do today, with 92 employees ($130k / emp). Today, they have $7M in net cash, twice the revenues and a stock trading at 3x backlog, with only 112 employees ($275k sales / emp).

How the company turned around its business was a function - like all success stories - of many things happening at once but a few things stand out:
1. wider acceptance and regulatory approval of fluid viscous dampers in earthquake prone areas
2. expanded production facilities with better equipment that improved turn times
3. larger production facilities to accommodate larger products
4. better tax management, (ie lower tax rate), which means IMHO that mgmt is actively working hard to generate higher returns.

Some of the improvement is structural but some benefits from a cyclical real estate / infrastructure tailwind. Such is the nature of all industrial businesses.

And it is the nature of the stock market - especially in smaller niches of the market - to occasionally be imperfect on valuing stocks. To mine eyes, after digging into the company's business and financials, the valuation appears to reflect a mistake by the market, erring towards a rather common mistake of a stock responding to earnings growth rather than the order book.

In short, the stock appears to be violating the old adage regarding investing in industrial long-cycle businesses to "buy in the order cycle / sell into the delivery cycle".

It does not take long for an investor to observe that backlog is declining, avg project sizes are declining, and that book to bill ratio is 0.5x, meaning the company is burning backlog at twice the rate they are bringing in new business.


For those more inclined to visual displays of data, here is a graph of TAYD's backlog activity layered on top of sales activity. It is quite easy to see how the two generally move in the same direction sales lagged one period.


Here is a graph of TAYD's sales and net income. Again, quite easy to infer a relationship between the two, except in the most recent period.

Why would it be that Net Income would suddenly diverge from declining sales? I'd hazard a guess that on large fixed price projects the company can harvest awards on completion, as is the case with many construction related businesses.  And with backlog coming down, one can infer that several large projects have recently completed.


Here is a graph of TAYD's Net Income layered over "price to backlog" a valuation methodology typically used for companies that generate income off of backlog. You can see how investors reward the company with a higher multiple during periods of strong earnings




And finally, here's a chart of the median quarterly price of the stock layered on backlog.


It is certainly possible that the market knows about some orders on the horizon that will boost backlog or potentially future opportunities for sustained margin expansion.

It is possible that the company has been "re-rated higher" b/c of its prior capacity expansion, with another capacity expansion currently under way, that will enable the company to build even larger product and capture more share of the market.

But it is not possible for the company to generate strong results without strong orders, and the orders of late have been lagging.

At $60M market cap, this remains, to the wider market, an "undiscovered gem" and perhaps even a good idea for a long term investment. I don't yet understand enough the competitive landscape to make that decision. But I do know that if the pull of orders tugs earnings down, and momentum buyers flee, there will likely be another bite at this apple at lower prices for patient investors.

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ALL RIGHTS RESERVED. THIS IS NOT A SOLICITATION FOR BUSINESS OR A RECOMMENDATION TO BUY OR SELL SECURITIES. DO YOUR OWN ANALYSIS OR CONSULT WITH AN EXPERT BEFORE MAKING INVESTMENT DECISIONS.

Friday, July 1, 2016

$ARIS: Generating FCF and reinvesting it at high rates ...

This post is a look at the financials of ARIS, a company I've written about before and have followed for awhile. It's been throwing out tremendous amounts of cash and reinvesting it at high rates, a characteristic typical of a kind of investment known as "compounders".

The last 1.5 years - and most notably the last half - have shown quite spectacular results, with FCF returns on equity of +17% and FCF margins of 16%.

Using a screen, we compare the company's recent results to other stocks listed on the major US exchanges both with limited mkt caps (under $1B) and unlimited and find it to be in rare company.

Whether or not those results can be sustained is obviously most important. At $70M mkt cap it's still not in "orbit" so to speak. Over the next 2-4 quarters perhaps, investments in the business to meet growing demand, reduce churn and lower turn time will likley negatively impact margins so that's a near term headwind to sustaining current rates of return.

But if those investments ultimately return what the current business is doing - or more - it's possible to consider that this company is doing something unusual and special as it appears that it might be.

In my effort to learn more, I am seeking out knowledgeable folks with experience in small dealer markets (1-10 doors) or dealer services markets in the areas that ARIS serves: powersports, RV's, medical equipment, marine and wheel / tire. Please ping me if you or someone you know fits that bill so we can be connected for a brief chat.

***

I like it where ideas converge as recently happened here in the last two weeks ...

First I reconnected with an old friend who runs Greenlea Lane Capital and shared some ideas with him. I know few investors as focused, disciplined and patient as he and I treasure his time and counsel. Were he older, I'd perhaps call him wise but that's a sobriquet for the old and an epithet for the young, and he is young and his success to date hopefully precedes a long career ahead.

He solely seeks out compounders and while I own companies for a handful of reasons I shared with him one that I've previously written about here - $ARIS - that seemed like it fit that bill, meaning that it generates cash and reinvests it at high rates of return.

ARIS is a small software / technology company that serves the dealer markets, primarily for powersports (motorcycles and ATV's), RVs, wheel / tire and home medical equipment.

While many dealer services companies serve the back office, ARIS goes to the consumer facing side, developing websites (~50% of sales) and offering eCatalogues (~35% of sales) so that dealers with 1-10 doors can be online, showing, selling and managing product. At $4.15 it sports a $74M mkt cap / $80M EV trading at 14x TTM EBITDA, neither terribly cheap nor terribly expensive, but a discount to peers.



That idea turned the conversation towards another more mature and well known compounder - $CSU.TO - which is also a software company serving vertical markets, and got me revisiting Mark Leonard's brilliant shareholder letters, notably the most recent one about high performing conglomerates.

Independent of all this, but around the same time, someone directed me to Base Hit Investing's post on ROIIC, another great read by John Huber. The nut of that piece is how to calculate and - more importantly, internalize and understand the meaning of - returns on invested capital.

Between those concurrent events, I decided to dive more deeply into $ARIS to see how it stacks up financially against more well known compounders and to get a sense if maybe it has an opportunity to be something special.

I am a shareholder - and I don't know the future - but their recent cash flow generation has been lights out and maybe that bears out the possibility that this company could be something special. I definitely see something in the results and quality of mgmt that is unusual in a company so small.

I'll start with most recent results ...


... The 17% topline growth is ~5% organic with the rest from three acquisitions last year that enabled the company to more deeply enter the wheel / tire services space ...

TCS Technologies (Sept 2014). A dealer services company in the wheel / tire vertical that not only does websites but has an integrated point of sale / integrated inventory management piece.

TASCO Software (April 2015). Also in the wheel / tire vertical with more business mgmt / back office related offerings.

DCi (July 2015). eCatalogue in the wheel / tire / auto after market space.

... if all this sounds boring and uninteresting ("websites?"), when you look online at products for sale, you are likely looking at a picture / price / sku sourced from some kind of catalogue. In short, eCatalogues are an essential part of the infrastructure of internet commerce.

Small dealers who don't own entire catalogues essentially rent them from a company like ARIS. It is a competitive business for sure - there is no end to small companies doing it - but it is scalable, low touch, high return and - with enough subscriptions - a cash flow engine.

For ARIS, this cash flow engine has generated low dd / mid-teen FCF margins for the last 1.5 years. 

Prior to 2015, the company was working its way through an acquisition of a distressed company (50below) that created a short term blip but enabled them to substantially grow their websites business. In that case, the acquired subscribers had already paid the target company, which squandered the cash, meaning ARIS essentially acquired the liability of having to provide a service to the subscriber, but not the cash. But that is all in the past.

What is in the future?

Even as the catalogue business churns out cash the websites business is like the yin to the catalogue yan; high touch - it takes time to get a dealer website set up - and high churn - they lose about 15% of sales / year when customers jump ship to competitors or close their doors.

Just to reiterate, 15% organic growth every year is churned away. That means every basis point reduction in churn is an increase in organic growth. Reducing churn is therefore something the company is focused on though some churn is structural to the business, a factor investors should consider quite carefully.

On the most recent conf call, mgmt indicated a number of investments to speed website turnaround, reduce churn and meet growing demand. Having too much work is what I call a "high class problem" but its a problem nonetheless and the investments will be headwinds to margins.

About these investments, in their words ...

1. General investments in the business:

"As we look ahead to Q4, I want to make a few points. First, we had another quarter of strong sales bookings. This means we will continue to apply resources into translating those bookings into revenue as quickly as possible. And as such, I suspect that will continue to impact the gross margin in a way similar to what we experienced in Q3 [ie down to the high 70% / low 80% range]. 

"The flipside of that is that we are aiming to maintain organic growth rates in Q4 similar to what we experienced in Q3. Second, as I noted previously, our profit performance in the first nine months of the year has exceeded our expectations. We anticipated that there would be some investments in Q3 that would prevent us from improving upon our Q2 performance. 

"While we did make some of those investments and still improved upon our performance, some of those investments did not hit in Q3 from a timing perspective and as a result will likely materialize in Q4. These investments include, among other things, our ongoing investment in our India office, consulting fees to upgrade and optimize our data centers and the rollout and go live of our enterprise wide CRM system."

2. Platform upgrades to websites and eCatalogue:

"We have several active projects including extending and improving our core website lead gen and e-commerce platform, developing a new next-generation version of that product, and developing the next generation of our core eCatalog technology. 

"The first item extending and improving our [existing] platform is pretty obvious and has resulted in a substantial increase, in some cases a triple digit increase in leads to our dealers. These improvements have resulted in strong new bookings this year and improved churn. We remain committed to building and delivering the best platform for lead generation and e-commerce in the markets we serve. [The existing platform is internally called "endeavor" and has been around for +10 years]

"The second item is a total rewrite of that platform ... The re-write is internally code named Domino, and Domino is a product that will openly replace Endeavor. It'll be our platform for the future. It is written to be a responsive design platform. It will be much, much faster. It actually will drive much more leads. It has a tremendous amount of flexibility to be able to appeal the different vertical markets as we continue to import medical data and the entire data and other types of data. And it also is going to have significant impact on our cost structure to deliver and maintain new customers.

"... We will start porting dealers over August or September, so we will begin porting dealers over to Domino and that process will take a minimum of 12 months, it might take a little bit longer than that, but that migration effort is not going to be incremental to our cost structure today. We've had a plan to do that for a long time, and we will be porting those guys over to Domino and eventually we will retire and cut down Endeavor and all the data center that goes along with it."

"In terms of eCatalog, we have spent the last year developing the next generation publishing tools that we expect to dramatically reduce the amount of time it takes our OEM customers and our internal teams to create new content and update older content. What previously took days or weeks will now take seconds or minutes with this new platform. We developed this as a global solution from day one and designed it for use in the markets we serve as well as any other market where the equipment is complex and requires repair."

3. Opening an office in New Delhi

"We continue to build out capacity in the US and India to lower our backlog and cost structure. While our overall numbers for the quarter were quite good, our revenues would have been even higher had we been able to deliver all customers in under 30 days which is our target.

"As we discussed in the last call, one of those initiatives resulted in opening an office in New Delhi, India. Almost a year ago we assigned a senior operation resource to investigate building additional capacity in India, we conducted a comprehensive review of the options and hired a VP General Manager in November and have continued to add staff. We now have an operations team up and running in India, the leader of that team was trained in our Duluth office for three weeks and one of our senior US resources is in New Delhi now completing that team’s training. We expect this team to start working on our backlog in the next few weeks.

The nut of these investments means on the plus side, they are investing in their business to upgrade their platform and reduce churn ...

... but on the negative side, near term margin impact and with the distraction of platform upgrades and ERP / CRM systems rollouts, I'm sure we've all seen how that can get off the rails pretty quickly. Again, things investors need to consider.

How the company manages the transition will be critical to the next years results and that's really the most important thing, despite prior year results that have been exceptionally impressive. I have been focusing on how to gain insight and comfort with these changes and if anyone has networks into dealer services software that I could chat with for 15 minutes, that would be most helpful. 

Back to recent results, here is a summary of TTM figures ...



... growth, margin expansion and FCF generation.

Putting it all together with some balance sheet data gives a sense of returns on capital ...



... 17% FCF return on equity and 12% return on total cap seem impressive to me.

As BHI discussed in his post, some use in the return denominator Total Capital less Goodwill & Intang (53% on TTM FCF) and others just use Tang Capital (89% return on TTM FCF). I don't think it's appropriate to exclude goodwill / intang for acquisitive companies b/c it is an essential element of deployed capital, even as it just sits there.

I've seen a table recently that showed how an index of "compounders" generates FCF return on equity in the 19% range vs the MSCI index in the 14% range, so ARIS is somewhere between the two.

Are these exceptional results?

I try not to get bogged down in parsing return numbers so finely. What matters to me is consistent and long term growth in BVPS and cash flow generation as proof that mgmt is adding value.

In ARIS case, a lot of the growth is through acquisition and in the past they've definitely overused stock for acqs, but at 17M shares outstanding it hasn't been inappropriate given the need to expand liquidity and especially when at one point there were paying as high as 14% interest on debt. Based on a prior correspondence with the company, I believe they will be much more parsimonious with using stock for future acqs.

As for how they compare to other companies, I created a screen to see who else might fit the bill. (I think I shared a version of it on screener.co called "Companites that look like ARIS"). I used the following parameters that shared the same recent dynamics as ARIS ...

TTM Rev Growth > 20% 
( total revenue(i) + total revenue(i-1) + total revenue(i-2) + total revenue(i-3) ) / ( total revenue(i-4) + total revenue(i-5) + total revenue(i-6) + total revenue(i-7) ) > 1.2

TTM EBITDA / Total Cap > 15% / 14% / 13% for last three quarters
( ebitda(i) + ebitda(i-1) + ebitda(i-2) + ebitda(i-3) ) / ( Total Debt(I) + Total Stockholder Equity(I) ) > 0.15

( ebitda(i-4) + ebitda(i-1) + ebitda(i-2) + ebitda(i-3) ) / ( Total Debt(I-1) + Total Stockholder Equity(I-1) ) > 0.14

( ebitda(i-4) + ebitda(i-5) + ebitda(i-2) + ebitda(i-3) ) / ( Total Debt(I-2) + Total Stockholder Equity(I-2) ) > 0.13

EV / LTM EBITDA < 14
built in parameter

FCF margin > 20% / 10% for last two quarters
( Total Operating Cash Flow(I) - Capital Expenditures(I) ) / total revenue(i) > 0.16

( Total Operating Cash Flow(I-1) - Capital Expenditures(I-1) ) / total revenue(i-1) > 0.1

** note that in my model, I appropriately calculate free cash flow net of capitalized software development, but screener doesn't have that parameter, so the comp margins are higher ** 

... and there are 13 US-listed companies not based in China with $1M > mkt caps > $1B. If you look at the screen you won't see ARIS there - strangely enough - and when I looked at the raw financial data noticed it didn't match the Q. This of course begs a whole host of other questions ... but that age old complain "until I can afford to get FactSet, its all I got to work with here".

Casting a wider net, when I lower the rev growth rate hurdle to 10%, raise the valuation hurdle to 20x and expand the market cap to $500B (also a shared screen "All cap blog screen"), the list grows to ~125 companies with a list of compounders that will be much more familiar to investors, topped by GOOG:, GILD, RAI, PYPL and ORLY to name a few.

That is good company to keep.

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THIS IS NOT A SOLICITATION FOR BUSINESS OR A RECOMMENDATION TO BUY OR SELL SECURITIES. I OWN ARIS FOR MYSELF AND CLIENTS. DO YOUR OWN HOMEWORK OR CONSULT WITH AN ADVISER BEFORE MAKING INVESTMENT DECISIONS AND DO TRY TO IDENTIFY AND STAY WITHIN YOUR CIRCLE OF COMPETENCE. TRY TO EXPAND IT INCREMENTALLY AND OVER TIME.