A Review of Our First Year:
We have worked hard since our launch to get ourselves where we are today – with a portfolio of great companies that fit our model for quality, growth and value. Building a portfolio from scratch is never easy but the welcome return of some economic and market volatility enabled us to, at last, finish the process by the end of second quarter. While volatility may frustrate or frighten investors whose time horizon is short or whose thesis is built upon maintenance of a cloudless status quo and/or financial leverage; volatility is mother’s milk to the true long- term fundamental investor who labors hard to find uniquely strong companies at uniquely attractive entry points.
We highlight some of our companies below, and from this point you can look forward to quarterly updates as to our performance and any changes to the portfolio. Periodically, we will also update you on topics of note, or parts of our investment program that we feel are particularly worth highlighting at that time. We hope our communication with you will be insightful and informative, however we also welcome (and encourage) your calls, questions, input and feedback.
Performance:
Performance is laid out in the tables below. The Q4 market downdraft affected us, of course, but we believe our quality business models, underleveraged balance sheets and avoidance of crowded trades served us well relative to the market.
This letter is a review of 2018, however with much interest around short-term performance given the recent market gyrations, we can update you through January 31, 2019 at the same time.
Investment Program:
The hallmark of the Owls Nest Partners approach is the purchase of industry leading growth companies when a temporary headwind has recoiled the fundamental growth drivers and compressed its multiple. This typically happens as hot money “renters” exit and drive the price down. There is no such thing as a free lunch: we can only access high quality business models with liquid and strong balance sheets, proven management and a long runway of growth and margin expansion, if we accept that our companies will appear “catalyst-less” and therefore may be dead money for some time. Of course, the offset to this cost is that these moments are (ironically) when a company can invest in its own business with the highest returns, and there is wonderful optionality associated with a well-run, shareholder friendly, cash-laden company that is able to aggressively put money to work during a temporary headwind.
We have constructed the portfolio being careful to have both pro and counter cyclical names. It is our belief (and experience) that our future outperformance will not be driven by any economic or market forecasting prowess but instead by ten unique investments, each playing out over time. We perceive these investments to have modest downside due to high quality and low expectations, and very significant upside as growth and margin expansion return in spades. We seek reasonable ballast and diversification within the portfolio as a result of our natural conservatism (strengthened by our co-investment alongside clients), an unwillingness to think we can predict markets or economies, and a predisposition to avoid all crowded trades and instead invest in temporarily out of favor areas.
Holdings as of 12/31/2018:
We ended 2018 approximately 87% invested in ten companies, with 13% of the portfolio in cash. The current holdings are as follows (in alphabetical order):
Recent Portfolio Adjustments:
As you can tell whenever you hear us discuss individual names, we are glad we don’t own the entire market but instead own a handful of very special businesses that have secular growth drivers because of their ability to innovate and thrill their customers. To prevent this from being longer than it already is, we have only highlighted in detail our three newest names and three exits, since the discussion of a sale can also provide insight.
Wabtec (WAB) – Sold Q3 2018
In the third quarter WAB announced a proposed merger with GE’s Transportation Business. We believe this is a very positive and transformational deal for Wabtec. It is the sort of unique purchase of such a unique asset with such a logical partner, that the buyer generally massively overpays because the seller is selling at a top and the buyer feels the desperate need to avoid letting the target possibly slip into another’s hands. Since we aren’t GE shareholders, we can happily report that this is not the case. In fact, it is the seller that is desperate and is selling at something of a market trough. We are happy that WAB will close on this transaction in early 2019, and we understand Wall Street’s enthusiastic response to the deal. However, this transaction complicates our ownership of WAB. First, this transaction will leave the company with a significantly leveraged balance sheet on the very low end of investment grade, and we are big believers of liquid balance sheets and the dry powder that comes with that. Second, this will lead to a massive integration exercise, and it seems entirely reasonable if not likely that operational matters will miss some needed attention, increasing the risk of sloppy execution. Lastly, the increase in the share price gave us a fair piece of the upside of the deal. So, we sold. It is not impossible to imagine our owning it again after the dust settles and if a “triple win” situation presents itself. On the sale of WAB we replaced the position with Avalara (AVLR), a software company with a huge runway ahead of it, which is described in greater detail below.
Welbilt (WBT) and TJX Companies (TJX) – Sold Q4 2018
During the fourth quarter we sold our positions in WBT and TJX, and we replaced them with ENSG and FND. Welbilt’s CEO, Hubertus Muehlhaeuser, was poached by CNH Industrial out of Europe early in the quarter to replace the legendary Sergio Marchionne who had died suddenly earlier in the year. We had a great deal of confidence in Hubertus, and his leadership was an important part of our thesis. While the exit of the CEO doesn’t always mandate the sale of our position in a company, we chose to sell in this case because without a clear internal successor we feared the potential hiring of an outsider would possibly lead to turmoil and distraction in the senior leadership ranks.
The sale of TJX was for completely different reasons and is a good illustration of the virtue of patience and the execution of our “forced curve” sales discipline. TJX was a substantial winner for us since our purchase of it on our first day. Since then, the company remedied a few small merchandising issues which drove an acceleration in comparable store sales, and the extreme investor pessimism around the name and bricks and mortar retailers in general, evaporated to a reasonable extent. TJX surprised even us with an incredibly strong Q3 with comparable store sales increase of 7%, their strongest in many years. The company has to deal with a few issues this year, namely wage pressure and freight costs, but they continue to be extremely well positioned. We might have happily held on to our position except for the fact that while it was exceeding expectations another extremely unique, profitable and innovative retailer, with substantially greater growth and margin expansion prospects, was getting bludgeoned due to an inevitable slowdown in business and investor concerns over interest rates and the housing cycle. Whereas one share of TJX could buy about 3⁄4 of a share of Floor & Decor in April, by late October/early November the success of TJX and the punishment of FND meant that a share of TJX could now buy almost 2 shares of FND. Our patience was rewarded, and we effectively swapped our TJX position for a new position in FND.
Avalara (AVLR) – Purchased Q3 2018
Avalara (AVLR) automates the generally manual process of calculating sales and other taxes for the nation’s 270,000 midsized businesses and then filing the monthly sales tax returns on behalf of those companies with all the relevant jurisdictions (there are 11,000 such jurisdictions in the U.S.). On average, AVLR does this all for ~$15,000 per year. With less than $300M in revenue and an extremely strong position in a growing market opportunity of $4B (when most narrowly defined), this company has a huge greenfield opportunity ahead of it. Of course, this is a software company with elegant technology, a recurring revenue business model, and extremely high retention of clients due to its being the go-to brand in the market. But the reason we can get so comfortable with this technology name for the long run is due to their business’s unique content requirements and their well-developed and impractical (if not impossible) to replicate ecosystem and network of partners. To build and maintain, and to guarantee the accuracy of a database that captures the relevant sales tax rate of almost every object across every jurisdiction is a herculean task.
Bagels are not taxed in New York unless they are sliced, in which case it is considered a sandwich and is hence taxed. Unless the purchaser is exempt from sales tax and gives the seller a properly completed exemption certificate (and yes AVLR has a module to check, hold and apply those certificates). Of course, you still have to pay sales tax on that bagel if you intend to resell it, but you may take a credit for that sales tax when you file you your own sales tax return. This is per New York’s Tax Bulletin ST-835 which references Tax Law sections 1105(d)(i)(3) and 1115(a)(1) and section 527.8 of the state tax regulations. And that 8.875% tax is of course owed to multiple jurisdictions – state and city and metro commuter transportation district surcharge – each of which grabs a bite of your bagel as it were. The good news is that if you spill your cream cheese and ruin your shirt, a new shirt is tax exempt... so long as it’s below $110. The point is, more than just software, they’ve built a database that is the best available and in a world of compliance with heavy penalties assessed by bureaucrats, you want the best especially if it doesn’t cost any more than not the best. Even if you know you need an automated solution, you will seldom replace the legacy manual system unless the new automated system is already integrated with your ERP or POS system. This interdependence is where AVLR brilliantly built a huge competitive advantage to which will accrue long-lasting benefits of their network effect. By being first to a cloud product and then building integrations with over 700 ERP, financial and operating systems vendors (and by paying a referral fee for successfully closed introductions), AVLR has become the default choice when a company asks its ERP vendor: “who should I use for sales tax calculation and filing?” It won’t happen overnight; rather gradually as people replace their systems. As with payroll, sales and other tax calculation and filing will be automated over time, and AVLR will be the clear and very entrenched leader.
Floor & Decor Holdings (FND) – Purchased Q4 2018
Lots of people have made lots of money with clever financial engineering. And the really clever financial engineers make money, at least for themselves, even when their deals have gone pear-shaped. It remains a legitimate arrow in the investor’s quiver (Wharton grads are required to feel this way), although not one on which we want to rely: leverage and access to financial markets can be treacherous friends. The retail industry is perhaps my favorite illustration of the point. There are scores of retailers whose market cap is well below what they’ve spent on buybacks, sometimes done under duress with an activist’s short-term oriented gun to their heads. And, of course, the whole industry is in disarray because bean counters focused energy on ways to maximize margins, ROIC, and bonuses while electing not to invest in the tools needed to stay relevant in a rapidly approaching internet age.
Instead, we seek to own companies that fixate on thrilling their customers and executing against a unique and innovative strategy. Floor & Decor Holdings (FND) is a great illustration of our vision, akin (in my mind) to prior investments I have made in companies such as CarMax (KMX) and Ulta Beauty (ULTA).2 At only $20B, the hard surface flooring industry has never attracted the focus of a category killer until FND. Heretofore, the primary ways of buying were through: big box retailers with a very small SKU count and a miserable customer service experience; or through smaller independent stores without the size and clout to source directly and who, as a result, cannot offer remotely the same value or afford to have a meaningful in-stock position, which in turn creates headaches for consumers and their professional installers as product is delayed or unavailable or different from the demo. Floor & Decor has invested the margin dollars from direct sourcing into a completely different experience for DIY customers and professionals alike. Their merchandising is unlike anything else in the industry. At 70,000 sq. ft., the store has large displays that produce a ‘wow factor’ and offer a much better ability to visualize the project. Consumers also benefit from the industry’s lowest prices, an offering of good, better and best, knowledgeable customer service and free design services. The professional gets the advantage of a store designed as a supply house to the trade. With a huge in-stock inventory and free storage for up to two weeks, FND removes the supply chain problems that cost professionals time and money.
The hard surface flooring industry is a great one for a category dominant retailer. Importantly, it is not a brand focused industry. Can you name who manufactured your flooring? As such, the power and economics will accrue to the retailer who has the loyalty and who aggregates demand. Hard flooring has had enormous innovation in the last decade as vinyl and waterproof products have gobbled up share from carpet due to ease, and low product and installation costs. Lower cost has allowed a fashion element to emerge as consumers can swap out flooring more easily. Demographics are great – the median house age in the U.S. is at a record level (37 years, up from 31 a decade earlier), and there has never been a larger pool of houses more than 20 years old in need of remodeling at a time when millennials are entering the home buying years. And although FND has developed a very helpful website to speed and ease the education and purchasing process, online-only competitors cannot compete in this industry given the weight of product and the need to see and touch it.
How are we so lucky to own a company with so much going for it and the ability to grow well north of 20% annually for much more than a decade? The market doesn’t have a favorable view on FND right now, mostly due to concerns of the cyclical nature of the housing market. But just like the analysis of KMX back in the day which revealed the used car industry to be much less cyclical than new cars, the repair and remodel flooring industry is much more stable than new construction, which at this point is a very small portion of FND’s business. Moreover, again like KMX in the early 2000s, with a proven but wildly underpenetrated store model, FND will be able (in our estimation) to grow through any downturn and accelerate its share growth as weaker players fold.
There are other factors at work that have created this entry point, and which provide the fuel for future growth and margin expansion. FND is making big investments in new warehousing and store support facilities, and has invested in a new benefit-laden loyalty program for the professional which will cost a little margin before the top line kicks in. New store opening expense will increase over the next year or two as they open stores in more densely populated markets such as Boston and Seattle, which will have great economics but cost more to open. Freight costs have also gone up, as they have for everyone in retail. And then there is the tariff issue, which has everyone in a panic. FND has a robust sourcing network in 16 countries and mercifully has had time to make adjustments in an effort to minimize the potential impact. But if you think about it, FND is unique because of their large in-stock position. So, if large tariffs suddenly happen, FND inventory will become much more valuable for excess profits or share gaining. And vendors know who can help them grow their business. Would you give your capacity to Lumber Liquidators or Tile Shop both of which have tanked? Or would you give it to someone who can easily quadruple their store count?
Lastly, there is the Houston effect, which in some ways reminds me of the Long Beach effect which was such a good entry point for ULTA a few years back. In that case, ULTA’s big and long-planned promotion got stuck in containers at the Long Beach port during the longshoremen’s strike and never made it to the stores. That didn’t matter an iota in the long run, but when ULTA announced slightly weaker than expected comparable store sales their stock got crushed. In this case, FND has to deal with the fact that last year, as Houston rebuilt from Hurricane Harvey, FND stores in that market had gaudy comparable store sales in excess of 100%. Math is math and same stores sales this year in that market will be down ~50% which will cause a meaningful deceleration in their reported company numbers. Irrelevant in the long run, but scary for short-term holders. All of these factors combined to create an entry point for this long-term, strong share gainer at a price about half of where it had been just seven months earlier.
And this entry point is not just about lower price, more pessimistic sentiment and easier expectations. Just like KMX and ULTA before it, FND has just gotten the flywheel of the virtuous cycle going. It is opening stores with less than a two-year cash-on-cash payback, despite an unaided brand awareness below 10%. Had you ever heard of them? The roll out of the professional loyalty program caused a significant uplift in the two markets where they tested it for 18 months, and now they are about to roll it out chainwide. Their ever-increasing scale will allow them to source even more powerfully and widen that advantage, and they will become the trusted go-to partner for innovative suppliers, just like Kylie Jenner launching her makeup line exclusively with ULTA (don’t ask for my opinion on that...). They will get better real estate deals, and they will grow into their infrastructure. Just as ULTA used this playbook to take EBIT margins from less than 6% in FY ’10 to nearly 14% in FY ’17, FND’s growth and unique model will drive a decade of strong top line growth and margin expansion. If you have any friends in the hard surface flooring business, tell them to sell their business now while it has value (not legal or investment advice).
Ensign Group (ENSG) – Purchased Q4 2018
Backtracking just a little: in discussing FND above, we stated how we want to own companies that “thrill” their customers. Well, ENSG is a fantastic operator with great outcomes in the long-term care and skilled nursing industries. And while they may have a significant impact on the quality of life of their end customers, “thrill” is probably too strong. No one tweets “just another awesome day here in Pocoroba Falls Nursing Home”, although perhaps they should if the nursing staff is helping them get healthier. We also like to talk about “what a great business” this is that we own (i.e. the less than two-year cash-on-cash payback on FND stores). Well, operating nursing homes is demonstrably not a “great business.” It is a very tough business. I am still amazed by the record time it took the industry’s largest player in 2000 to go from opening its new, gleaming corporate HQ to going bankrupt: about 12 months. Not an industry for the operationally sloppy or the debt-laden. And therein lies the opportunity for ENSG as it expands with its proven approach in this enormous and growing industry.
With a strategy refined over the last 20 years that combines centralized services and support and entrepreneurial, sharp and properly incentivized facility and local market management, ENSG has earned its reputation as the industry’s best operator. To an extent, ENSG is borrowing a page from the early days of another long ago – and once again – holding, Allegiant Travel. Rather than taking on debt to buy nice, new shiny planes, ALGT bought used aircraft for the fractions of the cost and put them to work on very underserved routes with great economics (about a two-year payback per plane). This flexible model allowed them to remain profitable and expand during the great airline crisis of 2008 when first high fuel, and then second, a tanking business travel market crushed legacy airlines.
Ensign buys underperforming and undercapitalized facilities, often “onesies and twosies”, for very depressed prices, mostly well below replacement cost. Whenever possible, they buy the physical facility as well as the business. They immediately begin the transition to their model by upgrading the facility and systems and bringing key services in house, most importantly physical therapy/rehabilitation (PT). At this point, they can develop better relationships with referral sources, deliver better outcomes, increase their census (% of beds occupied), and increase the rate at which they get paid by providing more services (such as PT). If properly run, the economics begin to look OK. But wait, there’s more. As they develop these relationships with referral sources, they can expand the continuum of care by developing very profitable and asset light home health and hospice businesses. Playing into this is the inexorable trend to get patients to the lowest cost facility. So, nursing homes are getting sicker and sicker patients, which utilize the in-house skilled nursing capacity and get reimbursed at significantly higher rates. Then, at some point this patient will be ready for home care and ENSG has that teed up. Now the economics begin to look good.
But wait there’s more. This is the page out of Warren Buffet’s playbook of sorts. I’m no expert on Berkshire Hathaway, but it seemed that for a reasonable time the genius of Berkshire’s performance has not been the stock picking (he acknowledges how size is the enemy of performance so we can cut him some slack), but rather the brilliant free leverage from the insurance float. Ensign does something similar. When they buy a facility, that building is tired and associated with a business that is barely profitable, if it all. Hence, the building isn’t worth much. But a few years into ENSG’s ownership and management, the building is upgraded and associated with a profitable business. Suddenly with that value added, it becomes an asset that can comfortably be lent against at attractive rates. And, voila, ENSG can get its original money back and recycle that into the next project without having to issue dilutive equity and all the while maintaining the strongest balance sheet in the industry. Now the economics look really good.
And to revisit an earlier theme, ENSG is poised as a beneficiary of that favorite topic of mine – financial engineering gone wrong. This is a tough business with occasional moments of decent profitability (this is not one of those “occasional moments”, by the way). A decade or so ago when the industry last had decent profitability, the friendly investment bankers charged in to explain how they could create shareholder value. The idea was to spin off each operator’s real estate into a REIT because the cap rates were so low, and they had the remarkable ability to sell it. Given the low cap rates many of the leading operators did exactly that, and to maximize that windfall they agreed to rent escalators that would please the REIT investors. In doing so, they sealed their fate as operators. Soon a difficult environment descended and the rents became untenable, resulting in these leading players retaining investment bankers to help them go through bankruptcy, sell off assets, restructure leases or employ other survival tactics. These financial engineers are clever, indeed – they made themselves lots of fees!
Anyway, perhaps because management of ENSG owns north of 15% of the company and because they want the most flexible balance sheet to execute the enormous opportunity ahead of them, ENSG was more immune to the siren song of clever bankers. Yes, they created a REIT too, but they refused to put in onerous escalators. As a result, their REIT has done fine (no tenants going bankrupt), and they have the financial strength and operational profitability they need in order to party on. Please appreciate the enormity of their opportunity. Despite being the strongest guy in the space, their 200 facilities constitute about ~1% of this incredibly fragmented industry. And they are even less of the fast-growing home health care business. The runway is never ending.
We have gotten involved with ENSG now because the industry’s challenges – stagnant census growth, reduced growth in reimbursement, terrible balance sheets – has made it largely uninvestable. Further, ENSG has had to work through some issues of their own as they finish digesting (with a little heartburn along the way) a couple years of particularly aggressive growth that strained their management and execution. And now the industry faces a new payment methodology in “patient driven payment method” (PDPM). PDPM introduces risk and outcomes measurement into a mix that was straightforward fee-for-service before. It creates opportunities for those who can really manage the care, but it requires a huge upgrade in systems and will clearly benefit those of a certain scale who can most easily develop and implement best practices and spread an ever-increasing overhead burden across many facilities. This huge change creates margin opportunity in the long run for ENSG and will create an enormous backlog of eager/distressed sellers to fuel ENSG’s near and intermediate term growth.
Interestingly, no one reading this will recall the great “baby bust” associated with the Great Depression, when that ultimate consumer discretionary item – a child – became a much scarcer item. But it was a very real event. Fast forward 85 years, and the echo of that event is a decline in census in long-term care that has been a recent plague. But that is on the verge of stabilizing and then giving way to the mother of all demographic trends (baby boomers), when it will be very easy to imagine a scarcity of long-term care beds especially since regulation and low profitability have made new construction economically unfeasible. Buy your long-term care insurance. Or better yet, up your investment in Owls Nest Partners to help you cope with the costs your loved ones will face.
Closing Thoughts:
Our path to owning ENSG reveals our process. While we find ideas in many ways, our favorite way and the method that over time has proven most reliable (and most fun to execute) is the “scuttlebutt method” in which we talk to all the various constituents in an industry and ask “who is the best operator?”, “who is the best and fastest growing customer (or supplier)?”, “who has the best management team and vision?”, “who is doing something innovative that no one else is structured to accomplish?” and so on. Our work related to our investment in Healthcare Services Group (HCSG), a provider of housekeeping and dining services to the long- term care industry on an outsourced basis, led us to a slew of players in the industry all with different perspectives, including direct competitors of ENSG. As the mosaic was built, it clearly revealed ENSG was special. We didn’t decide this from an ivory tower. Instead, we listened to those on the front lines who know the answers better than we do. A concentrated portfolio and our structure allow us to do this work. And yes, this is also the best way to know when to sell.
Lastly, the addition of a pro-cyclical name like FND and a non-cyclical or even counter cyclical name like ENSG (unemployment is their industry’s friend as it reduces wage pressure) reveals something about how we apply our respect for uncertainty to portfolio construction. Rather than bet our dollars on our ability to predict the economy (or actually, to predict the economy more correctly than the collective inputs from all the other players in the market setting market prices), we would much rather assemble a portfolio that doesn’t depend on a strong economy, especially in the short run. Our performance, instead, will be driven over time by the idiosyncratic returns of our company specific investments where we feel we have an edge. It’s still early days in the life cycle of our portfolio, and we look forward to great returns as our thesis on each individual name plays out.
Thank you for the support and the decision to have your money working alongside ours.
Gratefully,
Philip & the Owls Nest Partners team
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PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS