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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

Friday, September 1, 2017

Why I Own Quest Resources (QRHC)

Quest Resources (QRHC) is an asset light waste services company, a waste broker. Their's is a simple business model; connect haulers and customers and provide some value therein, for a markup.

There is no lack of competition in the waste services business and the competitive advantages are few and far between, depending on vertical of expertise. This goes as well for QRHC, which is differentiated from the industry stalwarts - Waste Management, Republic Services, Clean Harbors, etc. - simply through its asset light business model.

The large companies tend to own fixed assets such as incinerators, landfills and trucks and generate a return on these assets through utilization and volume. It is in their interest to push volume into their owned assets.

QRHC takes an asset light / service only aspect to this business. They do not own trucks or landfills or incinerators, and they generate no return pushing volume into their own assets. Rather they solely help their clients manage their waste streams, whether it goes to a landfill, is diverted to recycling or to organic composting.

In short, they are agents. They sell companies with multiple locations on the service of managing their waste stream, providing information on where the waste goes, tracking volumes and how much is diverted to compost and recycling.

Concurrently, they are a hauler's outsourced sales arm. The hauler typically agrees to offer volume at some fixed price and (in an ideal world) receives in return a customer on an existing route at a high incremental margin. This creates a situation where QRHC is a "frenemy" of the hauler, at times generating volume for them, at times creating competition.

So they essentially solve three problems:

1. "one throat to choke" service for their customers who don't have to deal with multiple haulers (by way of example, my brother in law runs a large facility and says he has a list of 80 waste haulers they call on a regular basis).
2. "better information" on volumes and where it goes than what a client or competitor could / would do themselves (thought this seems like an advantage that could easily be competed away).
3. outside sales force for fixed asset owners (hauler, landfill, etc)

Here's a sample of their sales pitch to the construction vertical copied from a video of theirs ...

... nothing terribly ground breaking. It's a "blocking / tackling" business.

As with most agent / broker models, the model works on the bill / pay spread. A wide bill / pay spread + growing customer base on low fixed SG&A means all incremental gross profit flows to cash. [Consider what happens around an event like a hurricane, where demand increases and haulers likely turn away work from QRHC within the impacted region. I imagine there's a narrowing of the bill / pay spread offset by increased volume].

There is no "moat" for QRHC. There is no hidden balance sheet asset. They do not own trucks or incinerators. There is no fixed asset leverage other than SG&A scaling. And as with other brokerage businesses (real estate, insurance) and business services (staffing, construction) there are low barriers to entry in the business. These are not normally the kinds of characteristics that screen for "good investments". So what makes this an attractive investment?

In my opinion, three things ...

First, it seems like the company is at an "inflection point" where gross profits are starting to grow much faster than (and at long last in excess of) SG&A. I have observed that services companies - even those with no moats and with low barriers to entry - "work" when their revenues are large enough to support the business and when gross profits grow materially faster than a flat or declining SG&A. The "operating leverage" generated through this business can be observed across many services companies.

Second, there is a misunderstanding about forecasts for declining revenues. The company has guided to a ~$32M decline in annualized revenue, starting in the back half of 2017 and into 1H18, that arose b/c they fired a large customer (WalMart, I believe). That announcement - and likely whispers about it ahead of time - have contributed to the stock looking like a "falling knife".

What may escape investors is that the this revenue had by our estimate a 1% gross profit margin, meaning the large "headline" revenue hit is close to a ~$320k hit in gross profit. Thus, the stock market reaction - $20M in market cap going away over a $320k decline in gross profit - for a company that will do $17M in gross profit this year - seems over done.

Third, and more qualitatively, the company has been in a turnaround and has hit all its marks. In the nearly two years since the CEO took over the company, he has been consistent with articulating and implementing his plans, with the results towards profit and cash flow finally showing.

I believe there is value in the consistency between a target and actions. I'll admit that I may assign too much value to this. What is the right amount? I don't know. But I met with the CEO Ray Hatch not long after he joined the company in February 2016, and he laid out a plan to fix what he acknowledged was a terrible business and has hit all the benchmarks of the plan to date.

The plan was to ...
  • reverse split the stock to get rid of excess float
  • shrink revenues to get out of low margin contracts  
  • increase gross profit through subtraction (getting out of low margin contracts) and addition (grow new industries)
  • leverage SG&A 
... all reasonable ideas. At the time it was not an appropriate an investment. Too soon. However 1.5 years later, the financial benefits are starting to appear. There have been few surprises. The corner seems to have been turned ...

QRHC has shrunk - and will continue to shrink - its revenue in order to get out of low margin contracts. The "shrinkage" will accelerate in 2H17 as management has guided to a steep decline in revenues  down 20% vs 1H17, as they exit customer contracts. This infers that they will exit 2017 with a run rate $135M in annual revenues.

They are growing gross profit margin and gross profit dollars. Despite the 20% decline in revenues, the company expects only a 2% decline in gross profit 2H17 vs 1H17. This implies ~180bps of margin expansion 2H17 vs 1H17, as well as GP dollar growth of +15% y/y 2H17 vs 2H16, and full year GP$ growth of close to 20%. This is addition by subtraction.

Once they lap these declining revenues, they expect to benefit from the addition of new verticals and industries served, notably the construction markets. Should see revenue growth in a year.

Here is a brief chart of Sales, Gross Profit and Cash SG&A (SG&A less stock based comp) from 1Q15 to 4Q17E. This graph tells the simple story of efforts to date: Shrink revenues, grow gross profits, keep SG&A flat to down.

Maybe it's still too soon, but the valuation seems attractive to this investor when one considers the benefits of a sound and experienced management team running a simple turnaround business for cash, profit and growth.

That said, and for the benefit of those (doubters) who avoid low moat / low barrier to entry companies, I include here an unedited pre-summer draft of this note when I initially sat down to write it, so that the reader may compare if the idea seems consistent with their expectations >>

"At the current $2.90 it has a $44M mkt cap and by virtue of the roughly $6M in net debt, a $50M enterprise value. This represents a multiple of 0.3x trailing twelve month revenues and 3.4x trailing twelve month gross profits."

<< "serves you right" those moat seekers / barrier investors might say, b/c obviously the stock is much cheaper now, trading for less than half  this value than when I first sat down to write this.

The stock now trades at ~$1.40 / share, implying a $22M mkt cap / $27M EV company, or 1.7x EV / Gross Profit. It is the same business model as before though certainly cheaper.

Let's say the decline in the stock from $2.90 to today is due to the revenue guidance. It might seem material that ~$32M in revenues are going away but if you back out the numbers, and realize it's a 1% GP margin hit, I say: "Sayonara". Keep in mind as well that this decline in revenue is consistent with what management long signaled to investors.

Let's say investors who sold this b/c of the decline in revenues, value it on revenues. It traded at 0.3x TTM revenues at 1Q17. Now it trades at 0.2x against the base runrate $135M, with easy comps / growth ahead. If you believe "the right multiple" is 0.3x, this "should" trade at $1.85.

But this is not about next quarters / next years numbers and the right multiple. And in reality, the stock's decline can be due to many things, a forced seller, someone with information I don't have, etc.

I see a company in the hands of an experienced executive in an industry that is not shrinking (waste is not going away) where changes over the last two years have lead to / are leading to a pathway for cash flow generation and growth, and the market doesn't seem to be assigning much value to this current and future opportunity.

It seems to me that the patient investor has an opportunity to buy something that is under appreciated and unloved with a fairly wide and predictable pathway towards growing profitability, such that over the course of the next few years one could benefit from earnings growth and multiple expansion.

It seems reasonable to this investor to buy at around ~5x expected EBITDA a company that once it laps the easy comps, can grow revenues double digits and grow EBITDA margins to the mid-single digits.

It might not be the greatest investment in the world, but when you can invest with a management team that articulates a plan, implements it wisely, can be acquired inexpensively, is generating cash and can point to a wide pathway for potential profitability and cash flow generation, that seems a good idea. In short, QRHC solves the problem of finding good companies to own at an inexpensive price, at least for this long term investor.

A few notes ...

Mitchell Saltz is Chairman and a principle shareholder. He owns  owns 5.7M shares / 37% of the company as of most recent proxy. "Mr. Saltz founded Saf-T-Hammer in 1987, which developed and marketed firearm safety and security products designed to prevent the unauthorized access to firearms, which acquired Smith & Wesson Corp. from Tomkins, PLC in May 2001 and changed its name to American Outdoor Brands Corporation."

There is a lot of overlap between the boards of these two companies ...

... I don't know much about these folks. There are some shareholder lawsuits against them stemming from 2010 / Smith & Wesson overstating guidance. Did that have merit? I don't know.

Also of note, CEO Ray Hatch has prior experience at Oakleaf, a similar asset light business that Waste Management acquired in 2011 for $425M, or 0.7x revenues. I believe this prior experience to be a materially positive indicator.

However, when you look at old $WM filings, you see this from their 2012 10K ...

"For the year ended December 31, 2011, subsequent to the acquisition date, Oakleaf recognized revenues of $265 million and net income of less than $1 million, which are included in our Consolidated Statement of Operations. For the year ended December 31, 2012, Oakleaf recognized revenues of $617 million and net losses of $29 million, which are included in the Consolidated Statement of Operations."

... which begs a question about profitability.

We do know - without a doubt - that this is a low margin business. The thesis for our investment is that this should be cash profitable in the 4% to 6% EBITDA range and with little CAPEX this is therefore trading around a 10% FCF yield at the base run rate revenue, even higher when you think about where it could be going in the hands of an experienced executive in the waste brokerage space.

But on the face of it, it looks like this "experienced executive" has never run a profitable business.

Or maybe he has? We have to deal with assumptions here but let's say Oakleaf was a 4% EBITDA margins. That's $25M EBITDA. So you'd need to see ~$50M in D&A in the first year of a $425M acquisition to have a negative $25M in net income. Given amortization of intangibles, that doesn't seem far fetched, but it's something to consider.

Finally, you can't consider an agent business without considering the risks that technology disintermediates the agent. Meet Rubicon Global, "the Uber of the waste industry". It has a $500M valuation. Oh wait, it has an $800M valuation. It even has Leonardo DiCaprio as an early investor!

I'm not going to whistle past the grave of technology, even as I make fun of the valuation et al, but there are many examples where an agent model exists alongside a technology model. I think the near term issue is less associated with the technology eating everything than with the likelihood that this private company can sustain losses for far longer than Quest can, meaning it can sign up clients at negative margins.

On the flip side, consider what would happen if Quest made an app and became the Lyft of waste management?

Quest Resource Holdings
Headquarters: The Colony, Texas
Incorporated: Nevada
Auditor: Semple, Marchal & Cooper, LLP
Phoenix, Arizona


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