Hunting Grounds

I generally prefer to avoid spending significant amounts of time on things that are in the public conscience, so I won’t speculate too much on how COVID-19 will progress. When circumstances change significantly, however, I do want to shift where I hunt for ideas.

For the past year and change, I’ve been primarily digging through equity special situations, with an emphasis on balance sheets and cash flows. The thought is that I wanted to look for places where management was doing something different that demonstrated confidence in the underlying business.

On the other hand, I wanted to avoid “technology”, and viewed implosions such as WeWork, $APRN, $GRPO, $HMNY, and a number of other “tech” companies as signs of increasing duress. I’m putting the quotes on “tech” companies because I believe these companies are actually rudimentary businesses in a more tech-savvy manner.

Of course, the above wasn’t an ideal set up going into COVID-19, as technology is one of the big winning sectors while somewhat surprisingly solid balance sheet businesses with good “normalized” cash flows got sold off. But as with most situations in life, one must live looking forwards. So here are the new hunting grounds:

  1. Financials: Many banks remain off 30%-50% from levels that weren’t that expensive to begin with. Yes, financials were “ground zero” in the last crisis (2009), but it’s hard to fathom a world where the economy (read: software companies) does well and financials do extremely poorly. Yield curve flattening is certainly an issue, but it’s not like it was a great rate environment even before this crisis and banks were earning decent ROEs.
  2. Industrials: This industry is a mess due to weakness in adjacent businesses (oil and aerospace). Historically, industrials are full of small niche businesses (as detailed in this book about “hidden champions”), which makes for a good sector to deploy a small/microcap strategy.
  3. High upside/downside plays: There exist bonds, preferreds, and other less vanilla securities where the prices don’t make much sense relative to equities. Bond prices should not trade like equities for the most part, unless the borrower is in severe distress. Most of the juiciest bits are related to travel, although I’m reverting to looking for asset protection or defensive cash flows in these areas.
  4. Energy: I distinctly remember sitting in an Ivy League classroom back in 2011 listening to a guest speaker talk about how we’ve reached peak oil. I wonder where the poor soul is today. Probably giving lectures in classrooms of other Ivy League institutions telling students how we’ll never see oil prices go up again.

I’m still avoiding technology for the most part, although I have picked up a couple secular growers in $NTDOY and $MTCH. Looking forward, there should also be opportunities to look at some distressed investment opportunities.

Long $NTDOY and $MTCH, no positions in other named companies although I do own $WFC, $COF, and $OGZPY which are part of my financials and energy holdings.

Also, buying the listed book through the referral link will net me a commission. Not that I’m expecting any $$$ from the viewership here but still :).

$WFC: Company-Level Punch Cards

Wells Fargo ($WFC) is a $1.9T asset, $119B market cap money center bank. You may have heard of them. Thesis is that banks should not trade at discounts to tangible book and yet $WFC had $32.90 of tangible book value as of 3/31/2020, or a price to tangible book value multiple of 0.86x. The range I typically see for large banks without esoteric derivatives exposure is generally 1.2x to 1.5x. At the low end of that range, it implies almost 40% upside. In the meantime, you receive a nearly 7% dividend.

Almost everyone knows $WFC had issues. And the issues are symptoms, not the root cause, so it’ll take time for problems to be fixed. But, as a Chinese parable says, “good news, bad news, who can say?” I count three promising aspects of this situation:

  1. The issues are what caused the stock price to drop. No issues, no discount stock price.
  2. As a result of the problems, the Fed has imposed an asset cap on Wells Fargo. This is effectively a company-level “punch card”, which should force Wells Fargo to generally pursue more attractive business opportunities and cut less promising prospects in favor of dividends.
  3. The new CEO, Charles Scharf has a solid background. I like how blunt he is too. On $WFC’s 4Q earnings call, he said that parts of the bank are “extraordinarily inefficient.” He also bought $5M shares on the open market on 3/16 at $28.69/share.

The risks:

  1. Uncertain environment with risk of losses. However, I’d note that bank GAAP accounting requires building reserves to account for expected future credit losses. In 1Q:20, $WFC added $3.1B to loss reserves, which had a $0.56 impact on current quarter EPS. They also saw a $950M impairment in securities. Tangible book value of course can go lower still.
  2. Bank turnarounds can be tricky as these are large organizations with lots of legacy processes. Large bank failures are surprisingly frequent, but typically involve banks with more aggressive asset strategies.

Overall, I think the discount to tangible book provides the cushion needed. I generally don’t love big companies as I don’t feel like I have much of an edge, but in times of dislocation it’s good to add a business that’s been around forever and survived multiple crises. I’ve got a 1% portfolio stake and may add more opportunistically.

Long $WFC

$TSLAQ experiment

Hope this note finds everyone well. Won’t dwell too much on the portfolio, the quick assessment is I’m down 20% from the high water mark…slightly worse than the S&P 500 but materially better than the Russell 2000 (especially the “value” variant), which is a significant improvement from lagging by as much as 10pp. There’s been a bunch of stuff that I’ve moved in and out waaay too quick to do any sort of writeups on (hello mREIT world).

Anyways. $TSLAQ. I’ve long been inclined to take the under for 7ish years…but never did as I still had vague recollections of the tech bubble from the late 90s. Current thesis:

  1. The auto industry is broadly taking a hit. $FCAU, which has one of the more unlevered balance sheets in the business, is down nearly 50% year to date. There may be a lot of used cars hitting the market soon. And auto vehicles and parts moving via rail has fallen 80%+ y/y this week and last week. Production is currently on hold for many automakers, including Tesla.
  2. Historical short sellers tend to be value investors. This recent drawdown has hit value investors harder than most, and thus there’s increased chances of redemptions and margin calls. Short interest in the past month is the lowest it’s been in a year.
  3. Sentiment check supports a bearish viewpoint. Bulls are celebrating. Bears are laying low. Not linking to the related Twitter posts. But if you’re so inclined…here’s the Twitter home page :). I thought I saw a magazine cover on the short burns too earlier in the year. There doesn’t seem to be any particular reason to be especially bearish on Tesla’s fundamental prospects vs. its competitors in the near term. Precisely the most dangerous hour.
  4. Market Cap and EV of around $130-$140B makes it an unlikely acquisition target, thus removing one potential big risk. It’s simply too big for all but a few companies to buy.
  5. Is it really that differentiated? Fair warning: fairly hot take. The companies that are dramatically more valuable than Tesla are generally more novel and/or profitable. At its core, at best, Tesla came up with a better car. There’s a big hardware component to its business. There’s only one more valuable company that built a dominant business with a heavy hardware component, That’d be Apple. And in my opinion Apple is significantly more unique. Apple revolutionized the music and phone industries and built unquestioned category killers. Could Tesla do this? Certainly possible for electric vehicles to become iPhones…certainly has the buzz factor and the early fans. But it’s not immediately clear to me that Tesla’s products will be as utterly dominant as Apple’s products are today. Of the other companies more valuable, almost all have incredibly profitable software and/or cloud-based businesses (Microsoft, Google, Facebook, Netflix). In short, I have a hard time fathoming that Tesla could be a $400B business, a hypothetical that would result in a loss 200% of my current investment.
  6. Low oil prices are generally unfavorable to electric vehicles.

This call really is 1) a valuation call and 2) a sentiment call. While I never liked valuation shorts and this certainly could burn me, it’s a very small part of the book (hence, “experiment”). Constructive feedback always welcome. And if you want to provide unconstructive criticism and/or make fun of me, feel free, it’ll further support thesis point 3 above.

Short $TSLA small. Long $MSFT. No other positions in other named securities.

$RMR revisted (PT: $60, ~60% upside)

Just added to my $RMR position this past week. I originally wrote it up here:

There isn’t much to add, except that this is now a $25 net of $12/share of cash stock with ~$2.40 in base earnings (4Q annualized) with upside if/when incentive fees come in. Market selloffs can be scary but I always find it interesting when stocks with large cash positions track the broader indices since the enterprise value falls more than the market cap does. When I wrote $RMR up it was trading at $45, or $33 net of cash, so now it’s down 24% on an ex-cash basis vs. down 18% if you keep the cash in. The underlying REITs managed are down 15-20%, but the management fee is on enterprise value so at 50% EBITDA margins base earnings probably are down similar to the underlying REITs. At 20%, that’s $1.90 in earnings, so this is trading at ~13x market cap ex-cash. Can probably get a more precise number, but this should be directionally right and I think is cheap enough to warrant a position.


FVE: Five Star Opportunity for Five Star Senior Living (PT: $7, 50% upside)

Executive Summary:

Five Star Hospitality (“FVE”) is a senior housing manager that was recapitalized on January 1, 2020 via a distribution of equity shares to the REIT (Diversified Healthcare Trust, or “DHC”) which owns the properties it manages in exchange for cash, and the REIT subsequently distributed most of the shares to its unitholders. The distribution of C-Corp shares to REIT unitholders and small size of the distributed entity ($150M market cap) relative to the REIT ($27B market cap) likely resulted in significant selling pressure in a classic (if unorthodox) Greenblatt-style special situation. The financials are messy and there are currently no analysts covering the name (zero analysts bothered to ask questions on the 3Q:19 conference call last November).

I don’t have a precise price target but I think fair value is at least $7 (9x a conservative EBIT estimate of $20M). I’d also note that there are some similarities between this and RMR, which is the ultimate parent of this set of related REITs and companies, which was a C-Corp distributed to REIT unitholders in December 2015 and dipped to a price of ~$14 before marching up to $96 in mid-2018 and settling in around $45 today.

Change in Business Model:

As part of the restructuring, FVE reworked their business strategy. Most importantly, they are transitioning from a business that primarily leases their properties (and pays rent) to a manager of the properties. This can be seen in the pro forma adjustment of rent payments in the first 9 months of 2019 from $121M down to $3M (the remaining rent payments appear to relate to its smaller Ageility physical therapy clinic which is on a $50M/year revenue run rate). As part of this deal, FVE is also pushing $568M of costs related to operating the properties to DHC.

Going forward, FVE will receive a management fee equal to 5% of gross revenues plus expense reimbursement and an annual incentive fee of 15% of EBITDA in excess of a target. The contracts are for 15 years, with two 5-year renewal options. Beginning in 2023, DHC can cancel up to 20% of contracts if they underperform. Underperformance is defined as failing to earn 90% of the EBITDA target in two consecutive years or in 2 of 3 consecutive years.

Effectively, FVE is changing into a management company. Now that they are no longer leasing properties from DHC, the business is much less capital intensive and it should be easier to match costs and revenues.

Pro Forma Financials:

It’s difficult to envision exactly what the pro forma financials will look like. Revenues for the first 9 months of 2019 on a pro forma basis was $170M, which annualizes to about $230M. Management said that pro forma EBITDA for 3Q:19 was ~$8M and pro forma net income was ~$4M. Annualizing EBITDA results in EBITDA of $32M. Pro forma depreciation was $8M, annualizing to $11M. Consequently, pro forma EBIT should be slightly higher than $20M, which is an EBIT margin of ~9%. Pro forma cash by my calculations is around $37M (see table below). By any metric, the current valuations are cheap.

Restricted cash25.05
Total Assets153.65
Current Lease Liability-2.8
ST Mortgage notes-0.4
Security deposits-0.7
LT Mortgage notes-7.3
Lease liabilities-20.4
Insurance Reserve-31.9
Total Debts-63.5
Transaction costs-10.10
Lease inducement12.9
Lease termination cost-55.7
Total Adjustments-52.90
Pro Forma Net Cash37.25

Note that RMR, a related entity, collects a 0.6% fee on FVE GAAP revenues (less “any revenues reportable by Five Star with respect to properties for which it provides the management services”). I believe this means that they will not need to pay a fee any more for anything other than the Ageility business going forward as the remaining business will basically exclusively be managed services.


Five Star had to be restructured due to poor financial results, and while the new entity is significantly different, there’s no guarantee of success either. Senior housing in general was a “hot” sector a short while ago, and while I don’t know the sector that well I suspect there may be some continuing supply overhangs. Insider ownership is also light for my taste, around 6-7% by my calculations.


SSNT: Son of…Who? SilverSun Technologies (PT: $6, ~90% upside)

SSNT is a ~$8M enterprise value ($14M market cap) value-added software reseller. It recently sold off a subsidiary for $11.5M that generated $2M of revenues which helped fund a $0.50 special dividend as well as a war chest of cash to pursue further bolt-on acquisitions. Pro forma revenues are $40M, so the EV/Revenue multiple is about 0.20x. Gross margins are ~37%, and the company has targeted EBITDA margins of 8%. Assuming they can get to 8% EBITDA margins, this equates to an EV/EBITDA multiple of about 2.6x and assuming capex of ~$800K/year, an EV/(EBITDA-CapEx) multiple of about 3.4x. The CEO owns 45% of the common shares, although he does collect a pretty sizeable salary of ~$700K in 2018. I think the valuation should be closer to 8x normalized EBITDA-CapEx, and my target price for this is $6.00 which is 90%+ upside.

Long a bit

RMR Group: High Floor with Upside (PT: $65, 44% upside)

Executive Summary:

RMR Group (NASDAQ:RMR) is a $1.4B market cap REIT management company with $33B in AUM. It trades at 15x base fee earnings (net of cash) derived from 20-year evergreen contracts. The founding family continues to control the entity and owns just over 50%, and RMR pays a dividend in excess of 3%. There’s additional upside if underlying REIT performance improves as they’ll collect higher management fees (which are pegged as a percentage of the lower of cost or market cap) and incentive fees. I think that given the highly recurring nature of its base fee earnings and possibility for further upside from incentive fees, RMR is worth 25x earnings which would result in a fair value of around $65, more than 40% upside from current levels.

Reason the Opportunity Exists:

It’s difficult to figure out exactly why RMR trades at the multiple it does today, but here’s my best guess:

  1. RMR was initially distributed to the REITs and most of these shares were quickly distributed to REIT shareholders. On July 1, 2019, the remaining ~8M shares (of 16M float) that were not distributed by the REITs were sold in a secondary offering to investors at a price of $40.
  2. Underlying REIT performance has been problematic as of late. Notably:
    1. SNH’s largest tenant (and another RMR-managed entity) FVE had the dreaded “going concern” disclosure, which seemed to have trickled through and caused a dividend cut.
    1. OPI performed similarly poorly in its past life as GOV, and addressed its problems by merging with its sister REIT, SIR, on top of a dividend cut.
    1. TRMT underwent a dilutive equity raise at $5 on May 21, 2019, significantly below its IPO price of $20 on September 18, 2017.
  3. The share structure and financials can be confusing.
  4. The company is a controlled company (by the founding family, the Portnoys).

Share Structure:

Normally the share structure isn’t all that important, but this one is a bit unique. There are 31.2M total shares outstanding. 15M of non-traded Class B shares are owned by the founding family (the Portnoys) via a trust. There’s 16.2M of publicly traded Class A shares, of which the Portnoys own another 1.1M of. Thus the Portnoys own 16.1M shares in total or 51.6% of the business. A word of caution: data sources (including Yahoo) sometimes get really confused and list inconsistent market caps ($1.4B, which implies the 31.2M share figure) and share counts (15.2M, which implies a $700M market cap).

The Contracts:

RMR has 20-year evergreen contracts with each of its 5 underlying REITs. This came into being after Sam Zell went activist on Equity Commonwealth and successfully wrested the management contract away from RMR. Now it’s very, very difficult to pull the same stunt and remove RMR as the REIT manager. Even if you have cause, it’s a 10-year term until the REIT can get out of the management contract.

These are the terms of the management contracts:

  • 0.5% fee on assets (the lower of historical cost of AUM of total market capitalization)* managed REIT, excluding the first $250M which has a 0.7% fee: 70%
  • 0.6% fee on revenues of the real estate operating companies: 15%
  • Property management fees for the managed REITs including 3.0% of gross rents collected from tenants and a 5.0% construction supervision fee for any construction, renovation, or repair activities: 15%.

*Note: It’s important to understand here that “total market capitalization” is more like enterprise value and is defined as equity plus debt plus preferred shares.

Benefits of Closing Gap Between Market Capitalization and Cost

Right now, RMR’s REITs are collectively have a market capitalization that’s lower than cost by $7B. With management fees at 0.5% on the lower of market capitalization or cost, RMR is shot $35M in base management fees. Management commented on its 3Q:19 call that all of this $35M falls into cash flows. RMR has roughly 31M shares outstanding, so a recovery to cost would result in more than $1 of incremental operating income per share.

Moreover, because underlying REIT performance has been wanting, incentive fees are also low. For 2019, they’re expecting just $4M from one of their REITs (Service Properties Trust). However, if the underlying REIT’s economic prospects improve, there’s a significant chance that RMR will be receive higher incentive fees. The incentive fee is structured as a 3-year performance period vs. a relevant benchmark with no high-water mark. I’ve always struggled a bit with figuring out a good way to pull SNL index data in a cost-effective method, but at the current valuation any incentive fee can be viewed as a bonus rather than a necessity.

Virtually Non-Existent Capital Needs

RMR is a service business, and spent an average of $700K on capex per year over the past 3 years. This is relative to operating income of $200M in 2019. In addition, RMR’s EBITDA margins hover between 50% and 60%. This is a high quality business where it takes little capital to grow, while downturns can be readily managed via lower compensation costs.


Adam Portnoy is son of the founder who unfortunately passed away in 2018. He makes $4M a year, which is very small relative to his 16.1M in share holdings which are worth north of $700M. Moreover, his compensation is more or less in line with the other two EVPs (one is higher at $4.6M while the other is lower at $3.3M).


The big concern is underlying REIT performance. For example, RMR has stated that SNH may have to divest up to $900M in assets, which would result in a reduction of roughly $4.5M in base management fees (or $0.14/share).


The best part remains the valuation. RMR trades at $45/share but roughly $12/share of net cash so the effective price you’re paying is actually around $33. RMR’s earnings next year should be roughly around $2.20/share, so the P/E net of cash is right around 15x. Perhaps you can argue that given Portnoy owns more than half there should be some discount both on the multiple and in the net cash. On the other hand the $2.20/share earnings stream is as predictable as they come and can almost be considered a bond-surrogate, not to mention that there’s further incremental upside if the incentive fees come in, which they eventually should given that they reset on a 3-year rolling basis. The way I view this, it’s a buy on the base recurring earnings, and becomes a strong buy if any incentive fees start coming in. I think a 25x multiple is reasonable, putting fair value in the high $60s.

As a rule of thumb sanity check, investment managers which receive higher incentive fees tend to be worth 2.5%-7.5% EV/AUM (hat tip: this awesome blog post on asset managers by Wexboy). Alternatives that charge incentive fees typically are closer to 7.5%. $65/share on 31M shares puts us $2B, or $1.6B net of cash. On $33B of AUM, that’s basically precisely on the midpoint of 5%. On $26B, which is the actual fee-paying AUM (due to book value exceeding market capitalization), it’s 6%.


SRL: What Is Dead May Never Die (PT: $26, ~150% upside)

Note: all dollar amounts converted to USD unless otherwise noted

Current price: $10.35

Basic shares: 12.5M

Options: 0.5K

Market cap: $130M

Market cap (fully diluted): $131M

Net Cash: $49M

Adjusted run rate EV/EBIT: ~7x

Executive Summary

Scully Royalty Corporation is primarily a semi-hidden iron mine royalty company that’s trading at ~7x run rate EBIT (based on mine operator-reported August production data and current iron ore prices) or ~2x EBIT on guided 2021 production numbers. The primary asset is “semi-hidden” as the underlying mine only restarted operations in June of this year. Moreover, SRL has not officially announced current production levels as they only report results on an annual basis despite an NYSE listing (minimum requirement of Cayman companies). I believe the opportunity exists primarily because this company is a complicated hodge-podge of disparate deep value assets and most investors aren’t yet aware of the restart of the mine. I believe SRL has upside potential of $26 (150%) on a 10x EV/EBIT multiple driven by royalty payment increases and downside risk to net cash at $3.75 (-65%).

Snap calculation results in undervalued company on current production numbers, could be a home run on guided numbers:

The key asset here is the royalty on Scully, an iron ore mine in West Labrador in Canada. The terms are 7% net on revenues from iron ore produced through 2055.

SRL has ~$3.75 in net cash (net of a loan payable). At a current stock price of $10.35, subtracting the excess cash on the balance sheet gets us to a price of around $6.60. Assuming August 2019 run rate iron ore production (1.8M tons annualized), we get a EBIT/share of $0.65 (1.8M tons * $80/ton spot iron ore price * 7% net royalty * (1 – 20% royalty tax rate)/13M shares), so on the royalty asset alone SRL is currently trading at nearly a 10% pre-tax yield. The mine operator has guided to 6M tons per year production in 2021, which would result in an EBIT of ~$2/share or an obscene ~30% pretax yield.

You could argue that there should also be some administrative expenses incorporated. Labrador Iron Ore Royalty Corporation, which receives a royalty on an iron ore mine that is basically right next door to Scully, shows 2018 royalty revenues of $105M and $3M in G&A expenses ( Or you could just assume SRL’s 2018 operating loss of ~$11M (~$0.10/share) is all attributed to the royalty asset. Regardless the current numbers are great, and the potential 2021 figures make this a potential home run.

Not to mention, there’s still some other assets on the balance sheet to account for that we’ll get to a bit later.

Recent developments at Scully are on schedule, on budget, and impressive:

Tacora is the mine operator that bought the assets in 2017. They have been providing regular updates on their progress, and the most recent one is really impressive:

The key points:

  1. Ramp in production (slide 11):
    1. June: ~23K tons
    1. July: ~82K tons
    1. August: ~153K tons <- 1.8M annualized run rate
  2. Schedule and 2021 guide (slide 15):
    1. 6MTPA (million tons per annum) guide for 2021
    1. Almost everything is on schedule if you compare with their November 2018 deck.
  3. High grade ore with good characteristics (slide 6)
    1. 65.9% iron, better than industry benchmark of 62%

A bit about the underlying mine economics. Cliffs shut down the mine in 2014 due to high costs. Tacora secured funding from Cargill and a few funds to purchase the asset in 2017 (Cargill also agreed to buy 100% of the produced iron through 2033). They claim to have a cash cost of ~$41/ton (slide 7 here).

Keep in mind the royalties are a percentage of revenues, so cost matters most if prices hypothetically decline to level where Tacora decides to quit producing. As a point of reference, iron ore prices troughed at $63 during the Great Recession and $39 in late 2015, the latter of which is slightly lower than the claimed “cash” cost per ton, so it seems that the mine would produce in all but the worst cases and in at a worst case $40 scenario, your valuation multiples would simply double (since royalty revenues drop straight to marginal operating income) and remain undemanding.


Little idea. Really. But the hellish last 5 years in commodity-land combined with unfortunate Vale issues has me thinking that pricing will more likely go up than down.

Other assets add a bit more value:

Scully Royalty Corporation used to be known as MFC Bancorp (and MFC Industrial previously…and Terra Nova Royalty Corporation before that…). The point is that this was a holding company with a bunch of assets as a consequence of its misadventures ranging from foreign miners (MFC Industrial) to merchant banks (MFC Bancorp). As a consequence of all this, there’s still a bunch of far-flung zombie assets on the balance sheet. By my calculations I’m arriving at another ~$1.50 in value:

Subtracting this $1.50 in addition to the net cash results in a 7x run-rate EBIT multiple and 2x on 2021 guided numbers. Saying this again, this is potentially a 40-50% pretax yield.

Management and Insider Ownership:

Michael Smith is the Chairman and CEO and has been with the company since 1996 with a brief hiatus as major shareholder Peter Kellogg won an activist tilt against the company. Executive compensation seems reasonable to me, with Michael Smith taking in $630K last year and the CFO taking in $300K.

Executive share ownership is a bit of a worry, with Michael Smith only owning 0.9% of the company (~$1M). However, there’s a bunch of well-known microcap investors involved. Peter Kellogg owns 33%, Lloyd Miller’s estate owns 15%, and Nantahala owns 7%. And to reiterate Mr. Kellogg has shown that he is willing to get his hands dirty, going activist and electing himself onto the board in 2014 (before stepping down again in 2015).

Valuation and risks

I view downside as pretty limited since there’s $3.75 of net cash on the balance sheet, so in a bear case I don’t think the stock would go down materially below this level (~65% down). On the other hand, applying a 10x EBIT multiple on the royalty asset and adding in cash and other net assets, we get an upside valuation of $26, an 150% increase from today.

As a point of comparison, Labrador Iron Ore Corporation ($LIF.TO) which was mentioned briefly before, trades at a ~$1B CAD enterprise value ($1.45B market cap with ~$80M in net cash and $380M in equity in its underlying iron ore mine) and did ~$100M CAD in EBIT last year (when iron ore prices were higher than today in 11 of 12 months) for a 10x EV/EBIT multiple.

There’s a litany of other risks, led by commodity price fluctuations. The complexity of the organization also introduces risks (anybody have any clue about Maltese banking laws, Ugandan environmental obligations, or Chinese eye care regulations?). There’s also a strange loan payable at a subsidiary that SRL is fair valuing at $4M despite an undiscounted obligation of $42M. SRL says that this is a non-recourse loan that a former subsidiary owes, so it would seem that the true liability should be even less than $4M.

Disclosure: Long

Chronicle of a Cheap Canadian Consolidation Play: CRH Medical (CRH/CRHM)

Price Target: $5.80 (~70% upside)

Note: all numbers are in $USD.


CRH Medical (“CRHM”) is an extraordinarily cheap $250M market cap consolidation story in the gastroenterology anesthesia services business. It’s just about the perfect setup. It trades at ~10x EV/EBITDA and has historically made bolt-on acquisitions at 4-6x EBITDA, typically using cash and sometimes topped off with earn-outs and/or deferred obligations. Capital expenditures are basically non-existent ($125K in 2017), and thus EV/(EBITDA-CapEx) is also at ~10x. Plus, there’s almost certainly further upside in cost and operational synergies, and these multiples don’t even back out the typical “non-recurring” acquisition costs which would make the valuation even more attractive. 3Q:18 EBITDA attributable to shareholders was up 10% y/y, despite a 10% y/y headwind from reduced reimbursements from changes in CMS 2018 Medicare Physician reimbursement codes. Perhaps the only glaring negative for this company is that insider ownership of shares is just 4% (with about another 3% in options and share units), but the company has repurchased shares in the past year and, with the renewal of its repurchase program on November 5, will likely do so over the next year as well .

I think this business should be worth 15x EBITDA-CapEx at the very least, and likely closer to 20-25x due to the consolidation opportunities. Moreover, there are two imminent catalysts:

  1. CRHM will convert to U.S. GAAP and file a 10-K for 2018. This would increase the ownership base to many indices/mutual funds that cannot own non-GAAP filing companies. Right now, index ownership isnon-existent.
  2. The aforementioned 10% y/y EBITDA headwind due to changes in CMS 2018 reimbursement codes goes away beginning 1Q:19.

At 15x EBITDA-CapEx multiple, the target price is $5.80, or 70% upside from current levels. The company is dual listed on the TSX (ticker: CRH) and NYSE (CRHM).

Legacy Business

CRH Medical’s legacy business sells disposable ligators for hemorrhoid treatment (their “CRH O’Regan System”). It accounts for just ~10% of the business today and is declining high single digit percentages y/y, and really the story doesn’t depend heavily on this. The primary U.S. and Canadian patents for this system expired in March 2016, which drove management to evaluate strategic alternatives and led to the move into the anesthesiology business. All you need to know is that hemorrhoids are a gastroenterology issue and thus a history of selling product gives CRH Medical access to and credibility with gastroenterology physicians that they can leverage in their consolidation efforts in the gastroenterology anesthesia services business.

New Direction

The gastroenterology anesthesia services business is a full turnkey model which CRH Medical launched with a $73 million acquisition of its first gastroenterology anesthesiology practice (by far its largest acquisition) in December 2014. CRHM becomes the exclusive provider of anesthesia services at gastroenterology practices (operating outside of hospitals). CRHM handles everything from recruiting, staffing, and accrediting anesthesiologists to collecting and billing patients. The main motivation for practices to sell is to outsource the paperwork and regulatory complexities to a third party, and is the medical practice equivalent to companies outsourcing non-core functions (real estate, payroll, etc.) to focus on their core business.

Notably, CRHM only acquires the exclusive professional services agreement and the ultimate ownership of the practice remains with the physicians (CRHM only goes after practices where the physicians have an ownership interest in). Hence, this is a very capital-light acquisition, not to mention a much easier integration process than most consolidation stories. Again,these have historically been acquired with an average valuation of under $15 million at multiples around 4-6x EBITDA. There is also a long runway for growth with an estimated 800-1,000 total practices in the U.S.

This is a Quality Business

CRH Medical provides Propofol anesthesiology which puts patients to sleep for the duration of an endoscopy procedure, which a quick review of literature suggests has faster recovery times relative to other sedation methods and fewer side effects. Like many anesthesiology practices there does exist controversy (Consumer Reports advises patients to use the lightest tolerable sedation methodology),but I’d note that this is an accepted practice by Medicare which surely has done its vetting. There has been a trend towards increased use of Propofol for endoscopies in recent years, and my belief is that medical practices are generally slow to change but changes tend to stick.

Anesthesiology EBITDA margins are between 40-50% and capital expenditures are virtually non-existent. This business is also virtually recession-proof.


CEO Edward Wright has a luxury brands background at Cartier,while CFO Richard Bear previously worked at ID Biomedical which was acquired September 2005 for $1.4B. Management generally seems pretty good, and the recent transition into anesthesia was an excellent move. Since CEO Edward Wright joined CRHM in September 2006, CRHM’s stock increased at an 8% CAGR which comfortably outpaced the S&P 500 (+6% CAGR) although not exceptional.However, since they transitioned into anesthesia in December 2014, performance has been excellent if volatile at a 24% CAGR (vs. the S&P 500 at 9%).

The only unfortunate aspect, again, is that management and directors owns a mere 4% of outstanding shares (~$10 million), while their total comp is quite high ($4 million each for the CEO and the CFO in 2016).However, I’d note that a lot of this is incentive comp (base is $350K and$325K, respectively) and the 3-year average compensation is about $2 million for both the CEO and CFO. Ideally I’d like to see insider ownership in the 10%-30%range but this is really the only quibble I have with this idea. Execution of a successful consolidation story is very hard work and good performance should be rewarded with good compensation.

Again, this is counteracted by share repurchases. The prior repurchase conducted over the past year cancelled 2.2 million shares at an average of $2.39.


However, there are obviously risks. The near-term risk is changes in reimbursement fee schedules, which is precisely what happened this year. However, historically, reimbursement fees are changed only once-in-a-while, and with the change as of January 2018, it should be at least a few years before the next one. Moreover, CRHM managed to grow EBITDA materially despite the headwind, an indication of the strength of the business.

A mid- to long-term risk is medical innovation, namely fecal and blood tests. This is more troublesome to me and as a generalist is much more difficult to ballpark. Management thinks that the impact of such tests are not necessarily negative: in their view these tests will bring a significant portion of the population who are not currently complying with colonoscopies into compliance, and these tests would result in increased need for colonoscopies to follow up on fecal and blood tests.

Valuation and Summary

Most consolidation stories trade at materially higher EBITDA multiples (even on a post-synergy basis) and also have much greater execution risks as they typically take over entire businesses instead of just a small part of continued operations. I think a 15x EBITDA-CapEx multiple is very fair ($5.80 or 70% upside). However I wouldn’t be surprised if this trades at 20-25x (135%-200% upside), and the lower end is roughly where CRHM traded at all-time highs in March 2017.

Initial credit for this idea goes to PSDFinancier via the excellent Microcap Club.

Disclosure: long

Don’t Oversubscribe to the Benefits of Subscription Businesses

This insight ought to be somewhat controversial: the celebrated subscription aspect of SaaS businesses is overrated. A SaaS business is dominant not because of the recurring aspect of its business model but rather because of its competitive position primarily and ideally buttressed by excellent products and customer service. While this may not seem that revolutionary, there are a lot of investment theses out there that generally follow this script: 1) high near- and intermediate-term growth and 2) eventual high margins. As David Einhorn pointed out in his 3Q letter (the catalyst for this insight), “It turns out that businesses that matured into very high margin businesses generally demonstrated strong margins at relatively low revenue levels.”

What’s the reason high margins don’t materialize? That’d be competition. If the business plays in a commoditized market with low barriers to entry and low switching costs (think: most food delivery apps), it cannot afford to lower sales costs and/or raise prices. There’s always someone willing to do it for cheaper. The biggest curse: eye-popping growth numbers, sky-high total addressable market size, and impressive theoretical “steady state” profit margins all conspire to increase competition and reduce actual “steady state” profit margins.

So that’s why you need a dominant competitive position. There are few viable alternatives to winner-take-most businesses such as Microsoft Office or Adobe Acrobat, which is why their eventual SaaS dominance is virtually assured despite near-term transition pains. Google Search is the same way, although it’s not a conventional “subscription” business (but is a SaaS business). A dominant competitive position gives you pricing power to maintain those precious margins.

If  your competitive position is not nearly as dominant, excellent products and customer service is the next best thing. Without excellent products and customer service, you’re extremely dependent on switching and/or search costs to keep customers.

So the fundamental question shouldn’t be “does this business have recurring revenues?”, but rather, “does this business have a competitive advantage?”. The subscription model is superior to the transactional model because of 1) better insights into customers and 2) more predictable revenue streams, but the business model is a secondary consideration to the business’ quality.

Moreover, while subscription businesses are growing rapidly today, it is unlikely that growth rates can persist at double digit rates in perpetuity. Eventually, greenfield opportunities will dry up because there are limitations to how much and how fast the pie can grow. When that day comes, subscription businesses will increasingly look at introducing services in adjacent domains in an effort to maintain growth. A subscription business lacking a dominant position and still fighting with other competitors will likely struggle to compete against new competitors who have successfully achieved dominance in adjacent domains.

Subscriptions are good because of the recurring revenue and payment upfront (resulting in negative working capital), but ultimately what matters is the competitive position, products, and customer service. In other words, it’s still not all that different this time.

Disclosure: Long MSFT