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This is written with serious investors in mind. I'm a former reporter, private investigator and institutional equity analyst who digs deep to find niche undervalued and undiscovered securities. I manage money for individuals, institutions and family offices via my business Long Cast Advisers. This blog is part decision-diary, part investment observations and part general musings about Philadelphia sports. It should not be viewed as a solicitation for business or a recommendation to buy or sell securities.

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

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.

-- END -- 


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