blueharbor bank (OTCQX: BLHK) is a ~$600mm asset bank located in North Carolina. BLHK runs an attractive business model driven by three main factors: (1) high returns on assets driven by structural cost efficiencies and a loan-heavy balance sheet, (2) low historical loan losses and meaningful loss-absorption capacity, and (3) a long record of strong deposit growth.

BLHK currently trades at ~8x forward earnings (based on my estimates) and could achieve a 20%+ five-year IRR under reasonable assumptions (see valuation section). BLHK’s stock is very illiquid and trades on the OTC at a ~$116mm market capitalization, which is likely why the opportunity exists.

Share

High Return on Assets

(1) High Cost Efficiency

BLHK is similar to other banks I have written about previously: its high return on assets is driven in large part by cost efficiency. Also similarly, those efficiencies appear to be structural, stemming from a small three branch footprint paired with a relatively large deposit base (i.e., lots of deposits per branch). Here is a simple example:

Take “Bank A”, with one branch and $100 million of deposits, and “Bank B”, with two branches and the same $100 million of deposits. Both banks have the same deposit base, but Bank B requires an extra branch to support/generate those deposits. That additional branch creates extra occupancy (rent, maintenance, etc.) and personnel expense. As a result, even if everything else about the bank’s are identical, Bank B will produce less profits due to its higher cost structure.

One of the best measures of cost efficiency is noninterest expense as a percentage of assets (“NIE/assets”), shown in the chart below. As BLHK has steadily grown deposits over the past decade, its NIE/assets ratio has declined. Again, simply the effect of meaningfully more deposits generated in the same limited branch footprint. Compared with nearby peers, North Carolina banks with less than $2 billion in assets, BLHK ranks #1 on this metric. It is possible that this ratio continues to improve over time, though possibly not at the same pace seen historically.

Another useful way to see this operating efficiency is through assets per full-time employee (FTE). BLHK also ranks #1 on this measure, reinforcing that incremental growth was achieved organically rather than via rapid branch expansion and thus a meaningfully larger employee base.

(2) Loan-heavy Asset Mix Drives High Net Interest Margin

The other driver of BLHK’s high return on assets is an elevated net interest margin. To oversimplify, net interest margin is just the difference/spread between the yield the bank generates on its assets and the cost to fund those assets (mainly via deposits).

BLHK’s loan yields are not much higher than the peer median but they do rank #1 in terms of the amount of loans the bank has in relation to assets (i.e., loans/assets). With loans typically yielding higher than securities/cash (a bank’s alternative investments), BLHK’s overall asset yield becomes elevated due to this heavier loan mix. A high yield on assets combined with a relatively average funding cost on their liabilities (again, mainly via deposits) produces the high net interest margin.

Note that for most/many banks an overly heavy concentration of loans could be concerning. More loans typically mean more risk, at least relative to the securities or cash. But, as I mention in the next section, BLHK seems to run their bank in a very low risk manner.

Low Risk - Combination of Low Loan Losses / High Ability to Absorb Losses

BLHK is a fairly typical community bank with a real estate focused loan portfolio. BLHK is mainly a commercial real estate lender (both investor owned and owner-occupied) and 1-4 family mortgage / home equity lender. They have a self-professed “common sense approach to banking” - which definitely seems to be working.

BLHK’s low risk shines through simply due to having no delinquent loans, ranking #1 among North Carolina peers, with the lowest delinquent loan ratio.

The past ten years have been a similar story with very low delinquent loans with this ultra low (<0.1%) delinquent loan reality beginning in 2019.

Of course it helps when the bank’s officers and directors own ~22% of the bank, with the CEO owning 5% - alignment of interests with shareholders most definitely exists.

Despite loan delinquencies/losses being non-existent for BLHK, the other factor to consider is their ability to absorb potential loan losses. BLHK currently generates ~17mm of pre-tax, pre-provision income (“PTPP income”) that could offset potential losses. In a hypothetical example, where BLHK incurred losses equal to 3.0%/year on their loan portfolio - the highest quarterly loss rate for all U.S. commercial banks during the 2008-2009 Financial Crisis (see chart below) - they would generate ~$15.5mm of loan losses. With PTPP income of ~$17mm, BLHK would still be slightly profitable for that year.

And, since BLHK has much lower historical and current loan delinquencies/losses, with a well-diversified loan portfolio, it is very likely even under such an adverse scenario, they would perform much better than the average bank did during 2008-2009. Of course, every recession is different but this simple stress analysis gives even more comfort in the bank’s seeming low risk nature.

High Deposit Growth

BLHK’s superior profitability and low risk create durable earnings but the ability to generate deposits has helped fuel the bank’s rapid growth. For example, over the past 10 years, the bank has grown deposits at a 15% annualized rate (see chart below). Looking over various time shorter term time periods and this high deposit growth has been relatively consistent.

Below is deposit data for the two counties where BLHK operates. BLHK has two branches their main market of Iredell County, North Carolina via their Mooresville and Statesville branches. BLHK has consistently gained deposit market share here over the past ~10 years.

Two more item to note on BLHK’s Iredell County presence, first, they gained the most deposit market share over the past 5 years versus all competitors in the market. This is despite operating in Iredell since the bank’s inception - no new entry “bonus” for BLHK.

Second, BLHK still has much room to grow and continue to gain share in Iredell County. BLHK only ranks #5 in that market in terms of deposit market share, with the leader - Wells Fargo - at 16.5% share (versus 9.9% for BLHK).

Also, in September 2024, BLHK opened a new branch in the city of Mount Airy - marking their entry into Surry County.

Valuation

Valuing a bank can be simplified down to four main variables: (1) how much will assets grow, (2) what will be the return generated on those assets, and (3) how much of those profits will be excess capital available for distribution to shareholders versus required for growth, and (4) what multiple those future earnings will be valued at.

1. Asset Growth

   1. Deposits fuel asset growth and, as discussed above, BLHK has consistently generated large amounts of deposits. On the deposit growth chart in the previous section, the lowest annualized growth rate was 13%/year, which was over the last 5 years.

   2. Most banks will grow at local nominal GDP (real GDP growth + inflation rate) +/- if they are taking/losing deposit share +/- growth from new branches in new areas.

   3. Specific to BLHK, they should continue to steal deposit share in Iredell County and gain some additional growth via their new Mount Airy branch.

2. Return on Average Assets

   1. At the introduction of this article, I showed a breakdown of BLHK’s current return on assets. One could argue that a certain component is a bit high or low compared to what they might do in a “normalized” future year. But, without overcomplicating, I think those nit-picking adjustments largely offset and five years out, the current ~2.2% return on assets is a reasonable (and likely slightly conservative) estimate.

      1. For those curious about what the “nit-picks” are: (1) current Net Interest Margin / Assets might be slightly high but, (2) Noninterest Expense / Assets is likely to continue to fall over the next five years as deposits continue to build-up within their existing branch footprint. The two small adjustments likely net-out in the future resulting in roughly the same ~2.2% return on assets.

3. Excess Capital

   1. Historically, BLHK has run the bank with a decent amount of excess capital. Their bank currently has an 11.6% leverage ratio, where nationally you might see that figure in the 9-10% range. But it is likely they remain at least somewhat overcapitalized going forward.

4. Year 5 P/E Multiple

   1. Most well-operated banks can trade at a 12x+ forward earnings multiple in a decent banking environment. Of course, BLHK is OTC-traded and relatively illiquid. As they continue to grow, some of that illiquidity could go away. But with BLHK’s strength and growth profile, trading at 12x earnings seems reasonable as a likely $1bn in assets bank - five years from now.

Given all the above, below are simple projections using those four variables under a “base case”, “high case”, and “low case” and the resulting five-year IRR. The point of the below tables is not precision - the tables exist to roughly estimate different scenarios of future value and potential returns for BLHK.

At current trading prices, BLHK seems like a fairly low risk bank combined with the potential for high future returns.

Other Factors to Consider

• Special Dividends + Buyback

  • BLHK has conducted a few special dividends of increasing size since 2024. The latest announced in February 2026 was for $1.00/share.

  • BLHK has also conducted share repurchases over the past few years. Although, likely given the illiquid nature of their stock, the bank has been able to buy a limited amount. This is likely why they began to do the special dividends recently.

Disclosure: I/we currently hold shares of BLHK. I/we may buy more or sell shares at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Share

(1) November 2022 FFDF Initial Article
(2) February 2024 FFDF Update Article

Summary

FFD Financial (FFDF) currently trades at ~7x my estimate of forward earnings (based on a $37/share stock price). Due to this seemingly low valuation, I recently did a basic valuation analysis on FFDF that I figured I’d share.

On a P/E multiple basis, FFDF is trading at one of the lowest public bank valuations I can find, but is likely one of the best/better banks in the U.S. due to a high return on assets and very low historical/current loan losses.

As background, FFDF is a ~$100mm market capitalization bank located in Ohio. As I’ve written about before, FFDF achieves an above average Return on Assets mainly via a lower cost structure.

This lower cost structure is achieved thru relatively large deposits per branch and are very effective at generating additional, low-cost, “core” deposits. Said another way, they have more deposits in a smaller branch structure than most peers - creating lower costs per deposit dollar.

Although very good at generating additional deposits at their current branches, FFDF still expands their branch count when they see opportunity. FFDF recently opened a new branch in Canton, Ohio, which likely amplifies future deposit/asset growth for FFDF.

Finally, and probably most importantly, FFDF has a history of low loan losses and maintained profitability throughout the 2008-2009 Financial Crisis. FFDF’s loan portfolio is well-weighted towards historically lower loss loan types. Even within those lower loss loan categories, they currently have much lower delinquency rates than peers.

To summarize: FFDF is a high performing bank via a lower cost structure, with very low current and historical loan losses.

Bank Trading Comparables

Despite its smaller size, one might expect FFDF to trade at a P/E multiple premium to other banks. After all, it produces a high return on assets, while having low loan losses - likely providing more durable / less volatile earnings than the average public bank. In reality, the opposite is currently true, with FFDF trading at one of the lowest P/E multiples among public banks. Depending on the exact comparable group used, it is either the lowest or close to the lowest using a forward P/E multiple (revise my forward earnings estimate if you see it differently).

Note: Although in past articles, I did a more detailed build-up of earnings, I think the above estimate should get close to the same EPS estimate without all the additional complication (the table in the upper right just annualizes FFDF’s latest 3Q25 EPS and then grows by their historical deposit/asset growth rate of roughly 6-7%).

High-Level Valuation Math

So what is FFDF worth and what could future returns for FFDF look like? Below is a high-level analysis that takes figures from the above bank peer P/E multiple tables and applies them to estimated FFDF future earnings figures. The three below tables are (1) using bank peer midpoint forward P/E multiple of 10.5x on 3-year and 5-year forward estimated EPS for FFDF, (2) using bank peer low 20th percentile of 8.7x forward P/E multiple, and (3) using bank peer high 80th percentile of 12.5x forward P/E multiple.

The ultimate purpose of the below tables is to get some sense of what the 5-year and 3-year IRR’s could be for FFDF if their multiple increases closer to peers. Even using the low 8.7x forward multiple gives a mid-to-high teens IRR return, while using a rough midpoint multiple of 10.5x produces a ~20-26% IRR. Using a higher but still reasonable multiple could push IRR into the 30% range.

Note that FFDF is beginning to approach the point where one could argue they have a bit of excess capital. Due to this, I just rounded-up on the dividend yield to 4.0% - again, this is just a rough valuation exercise I figured I’d share.

Of course none of these scenarios will be exactly correct but I think it is hard to argue that even a slight re-valuation in multiple for FFDF could produce fairly large IRR’s.

Finally, when you compare these potential returns to what seems like a currently very fully valued stock market might do over the same time periods, and it is difficult to see how FFDF underperforms over the next 3-5 years.

Share

Important Reminder: FFDF is a very small bank with a fairly illiquid stock traded on the OTC.

Disclosure: I/we currently hold shares of FFDF. I may buy more or sell my position at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Phil Ruffin’s life story is one of the more remarkable I have come across. It reminds me of the red paperclip story, where a guy traded his way from a single paperclip to a house, over 14 transactions. Phil Ruffin is that story but on a much larger scale.

In the early 1980’s, Phil Ruffin started with buying one small convenience store. Today, he 100% owns the Las Vegas casinos Treasure Island and Circus Circus, and a variety of other business and real estate assets. In 2025, he stated Circus Circus is worth $5bn.

To achieve this extreme outcome, Ruffin used a combination of (1) a strict focus on a select few industries with good long term futures / economics, (2) intelligent buying and selling of assets, likely aided by #1, and (3) borrowed money that was well-structured.

Share

Beginnings - The Convenience Store + Gas Business

Phil Ruffin, then a college dropout, realized he did not enjoy working for anyone else and decided to buy a small grocery/convenience store in Wichita, Kansas. His dad was in the grocery business and helped him find one for sale. Ruffin says he bought it “cheap” and borrowed from a local bank to complete the purchase.

Shortly thereafter, a very fortunate stoke of luck happened to Ruffin. Wichita passed a law saying if your store was greater than 1,200 square feet you had to be closed on Sundays. Ruffin’s store was just under 1,200 square feet and being one of the few open convenience stores on Sundays created lots of demand. He had close to a Sunday monopoly.

“We had more business on Sunday than you would [normally] have in two weeks...”

With this store’s profits, he began building additional convenience stores. Then, Ruffin seized an opportunity when Tenneco Oil asked if they could put self-service gas pumps on his properties. This was in the era when an attendant still pumped gas for customers, thinking men in suits and women would not be willing to self-pump.

“…eventually I got a call from Tenneco Oil Company. They said, “Your convenience store in Blackwell, Oklahoma is doing great, can we put some self-service gasoline in there? Let the customers pump their own gas.” I said, “Yeah, let's give it a shot.” It was very successful. Then I wanted to put self-service gasoline in Wichita, Kansas, but was illegal at the time. We had to go to court, and we legalized self-service gasoline in Kansas in 1972. My lawsuit allowed us to start putting self-service gasoline at our convenience stores in Kansas. It was a very successful deal. We ended up putting in eighty-one stores over the years. And I always bought the ground—I never leased the ground.”

Turning a 20-year Lease into a Few Billion Dollars

With the success of his convenience store / gas business, Ruffin began to acquire/build other assets. In 1987, he built his first hotel, a Marriott in Wichita. Over time, much of his strategy was: “…[purchasing] distressed [real estate] in prime locations, spruce them up, and make them profitable again”. He also acquired an oil distribution business and hand truck manufacturer but his larger investments all ended up in real estate with a hotel specialty.

But, before all that, he was still primarily a convenience store owner. However, in 1994, Total Petroleum approached Ruffin for a leasing deal of his stores.

“They had a refinery that needed some gasoline sales, and I was doing a lot of gasoline sales at the time. They wanted to lease the stores for twenty years. I took the deal.”

The deal was a 20-year lease that paid $2.2mm a year [Note: Ruffin states that it was a $50mm lease, so there might have been an additional payment, since the math does not work otherwise].

Then the following series of events plays out that turns Ruffin into a billionaire:

1. 1995 - Ruffin buys Bahamas hotel with $0 of his own capital at close.

   1. Ruffin hears a Bahamas hotel/casino, named Crystal Palace is up for sale.

   2. The owner, Carnival Cruise Lines, wants $80mm total.

   3. Ruffin goes to a bank and they agree to lend him $20mm, against his $50mm lease as collateral. He then gets Carnival to issue him seller-financing for the remaining $60mm.

   4. The deal is very successful for Ruffin and eventually pays-off all the debt.

2. 1997 - Ruffin buys Las Vegas casino with $0 of his own capital at close.

   1. Ruffin hears the New Frontier Hotel in Las Vegas is up for sale. The owner, Margaret Elardi, wanted out after a long feud with a group of its unionized employees.

   2. She wants $110mm for the New Frontier.

   3. Ruffin uses the same playbook, but as owner of what is a nearly debt-free Crystal Palace, uses that asset as collateral for $50mm of financing. Elardi agrees to seller financing for the remaining $60mm (payable over five years).

   4. The Frontier was an older casino, at one time even owned by Howard Hughes. Ruffin did not necessarily buy for the casino itself, he bought for the value of the land on the Las Vegas strip.

   5. In 2007, an Israeli company offered Ruffin ~$1.2bn for the land/property. Their plan was to tear down the hotel and build a duplicate of the Plaza Hotel in New York on Ruffin’s land on the Las Vegas strip.

   6. In the deal, Ruffin sold 34 acres of the property to the company and retained 7 acres for himself.

      1. Half of that retained land ultimately became the Trump International Hotel & Tower that is 50%/50% owned by Donald Trump and Ruffin.

3. 2008 - Ruffin buys Treasure Island Casino.

   1. Shortly after his 2007 sale, the 2008-2009 Financial Crisis occurs and the Vegas economy declines substantially. MGM looks for ways to raise capital and decides to sell one of their older properties, the Treasure Island.

   2. In December 2008, Ruffin and MGM agree to deal for Treasure Island at $600mm upfront cash + $175mm in secured note = $775mm total

   3. From a 2009 article:

      1. “[Ruffin] prizes Treasure Island’s location, history, and 3,000 rooms. Ruffin says business is slow and room rates are down “substantially”, but 2010 looks better. He’s let go 500 of the 3,000 employees, but no more layoffs are planned. “Even with the worst scenarios, it’s about a 10 percent return on my money...and it’ll probably go to 20 percent in the next 24 months.” [Note: I assume the return calculation he is referring to is cash-on-cash return since he spoke similarly about other deals.]

   4. In 2025, Ruffin still owns Treasure Island and had the following thoughts in 2020:

      1. “I will encourage [my children] not to sell the properties because of the construction costs. For instance, to recreate Treasure Island, it would cost $3 billion…James Packer bought my old location [of the New Frontier in Vegas] from our Israeli associates, and he was going to put a hotel there, with only 1,000 rooms. The price came to $2.2 billion, so about $2 million a room. It just didn’t pencil out for him or the banks. It’s very expensive to rebuild these things. Fortunately, Genting has money to build what they're building now—Resorts World Las Vegas. They have other assets, or the hotel simply would never be built. At $4 billion, it’s just hard to get a return. The lesson is to hang on to your assets, especially when you know they just can’t be replaced. You wouldn't build Treasure Island again for $3 billion because you’re going to have to make $350 million a year, and you can't do that, it's just too much. These hotels are irreplaceable.”

      2. “And the dirt, it’s just so valuable. It’s like Fifth Avenue in New York—you

         never sell it. You could lease it, but you’re never supposed to sell it. Had I not gotten such a large offer [for New Frontier in 2007]—I only paid $165 million…and got $1.24 billion—well, you do that deal.”

4. 2019 - Ruffin buys Circus Circus Casino.

   1. Ruffin purchases Circus Circus for $825 million from MGM. Circus Circus is one of the older properties on the Las Vegas strip and located in its less-populated but growing northern section.

   2. The purchase includes the 3900-room casino hotel, the Adventuredome theme park, a 10-acre RV park, the adjacent Slots-A-Fun Casino and the festival grounds, all sitting on a total of 102 acres on the Las Vegas strip.

   3. On how he views the purchase:

      1. Ruffin calls it “a land play with cash flow … and oh by the way, we’re the last piece available on the strip.”

      2. “That’s the hook. I really wanted the dirt. . . . So the land with positive cash flow is the optimal thing you can have. Now you get to hold the land and let it appreciate, and it always does. . . . Especially in Las Vegas.”

   4. 65 acres of the 102 acres are empty

      1. Four years prior to the Circus Circus purchase, MGM bought 25 of the 102 acres, paying $444mm (or $17.5mm/acre)

      2. Ruffin’s $825mm deal for 102 acres equates to $8.1mm per acre + cash-flowing casino at reasonable cash-on-cash return

   5. On purchase price:

      1. “Roughly 10 times cash flow [Note: he likely means EBITDA] … It’s got an $80 million-a-year cash flow. . . . So not bad. So roughly I have a 10 percent return on the money already, not counting what else we can do [with the land].”

      2. “Circus Circus, opened in 1968, looks a little tired. But to Ruffin, it’s a bargain. ‘To build a new casino hotel these days, you can’t do it for less than a million dollars a room.’ That would make replacing Circus Circus a $4 billion proposition.”

   6. In 2025, Ruffin announced there is an interest in selling Circus Circus and he believes its worth $5bn:

      1. “Let’s just say there is interest … It’s worth $5 billion. Why do you think I bought Circus Circus? For the 102 acres … That’s the land play. Remember what I did at the Frontier, how the value of the land went crazy [in 2007] —here it’s going crazier.”

Conclusions

Strict Focus on a Few Industries
Ruffin lived his investment life with a pretty strict adherence to a few industries, especially with his larger investments. Ruffin’s early business life focused solely on building new convenience stores. Naturally, real estate location was an important part of this process, so his later focus on real estate properties was not entirely disconnected from his beginnings. The furthest leap he made was opening the Marriott in Wichita, with the transition to hospitality (still with a real estate component). But, after the lease deal of his convenience stores, he stayed almost entirely, with his largest deals, within the real estate / hospitality sectors. In his later life he owned a large group of commercial real estate properties as investor, and as operator of the large casinos in Las Vegas.

Maximized all the investment variables
Ruffin (1) bought cheap, oftentimes due to distress of the owner or economy or both, (2) was seemingly a shrewd operator able to fix properties in distress or cure tough labor negotiations, and (3) showed an ability to sell at peak valuations. Doing all three consistently well over a life time is enough to create a remarkable investment record. When combined with the fourth component, the intelligent use of borrowed money - sometimes purchasing properties with no money of his own at closing - it’s no wonder the result is a man who is now shopping his $5bn 100%-owned casino in Vegas.

Ambition / Desire to “keep pushing” (and the different life paths he could have chosen to take)
Interesting to think about the many different ways Ruffin’s could have played out if he did not decide to keep pushing forward. For example, he could have stayed satisfied with his “Sunday monopoly” store. Or, even after that, he could have stayed satisfied with owning a few stores containing self-service gas stations, surely ending up a fairly wealthy Wichita resident. But, because it turned out that he (1) was an outstanding investor and (2) had the desire to keep pursuing further, compounding changed his life outcome tremendously. He was also aided by making no errors in his large investments, probably helped by his extreme focus on a few industries.

He basically chose a life of continually compounding wealth and through a long series of shrewd deals ended up a billionaire. I’m sure this is likely the story for most with extreme wealth (i.e., an intense “never satisfied” mindset), but it’s still interesting to think about his different potential life paths.

Share

Sources:

• Las Vegas Sun Newspaper (2009) - "An Empire Built on Assets, Not Debt"

• UNLV Gaming Law Journal (2020) - "Phil Ruffin Oral History"

• Wichita Eagle Newspaper (2019) - "Phil Ruffin’s winning strategy for scoring his latest Vegas casino"

• Forbes (2025) - "Billionaire Trump Pal Phil Ruffin Is Ready To Sell The Aging Circus Circus Casino"

• Speech Video (2016) - WSU Center for Real Estate Life Time Achievement Award

• A few other random articles, mainly sourced via library databases

Disclaimer: I might hold shares for any securities mentioned in this article for myself and/or others. I may buy more or sell my position at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. All posts are for educational purposes only. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Thomasville Bancshares (OTC-listed: THVB) is a ~$410mm market cap bank located in Thomasville, Georgia. THVB’s superior management team created a bank that generates above average returns on assets via (1) scaled branches combined with an operational focus on “doing more with less”, and (2) a large trust division. But, most importantly, THVB has a common sense low-risk culture. Above average returns on assets combined with lower-than-average risk creates one of the better community banks in the U.S.

THVB currently trades at ~10x earnings. With this valuation, mid-to-high teen annualized returns are likely over a five-year investment period. For those willing to wait for higher returns, THVB makes for an interesting bank to watch whenever future forced selling occurs.

Low Risk Culture

(1) Low Credit Risk

THVB employees wear “multiple hats”, not doing any one job as they might at a traditional bank.  In the typical bank, lending is typically separated into two functions: (1) a relationship manager who originates the loan and typically receives a commission, and (2) a credit officer who evaluates that loan and determines whether the loan is funded.  Larger banks may have even more functions, meaning more costs and less speed.

Most relationship managers are compensated by their loan origination volume and not on how their originated loans perform. This dynamic can create bad incentives.  THVB fixes this structure by making relationship managers also act as credit officers.  They wear both hats and are compensated based on the long-term profitability of their originated loans.  Additionally, with less channels to go thru, the loan process is much quicker than at a traditional bank – an important differentiator for many consumers and businesses. THVB has no pure managers at the bank - everyone is expected to be a decision maker.

What are the results of this lending structure?  One only has to look at their losses during the 2008-2009 Financial Crisis to find out.  THVB remained profitable throughout the Financial Crisis, despite Georgia being the state with the highest amount of bank failures. Not only did they remain profitable, but their lowest return on assets was ~1.0%, a figure that most banks strive to achieve in good times.

That extreme credit health remains today. THVB currently has very low nonperforming loans at 0.09% of loans. Relative to some of the banks they compete with, the figures look even better. Peers currently have nonperforming loans of 1.13% (see below).

The final item to note on credit losses is THVB is currently generating around 3.0% pre-tax pre-loan loss provision income to assets (“PTPP / assets”). With loans comprising 82% of THVB’s assets, that implies the bank could generate up to ~3.7% in loan losses (as % of assets) prior to losing money.

According to Federal Reserve data (see chart below), net charge-offs (i.e., loan losses) for community banks peaked at ~2.7% during the Financial Crisis. That means if THVB incurred a similar amount of losses, they would remain profitable due to their high PTPP / assets figures. The next banking crisis will surely be different than 2008-2009, but these figures give some frame of reference for what THVB can handle. And, with THVB’s heightened focus on risk, the loan losses are likely to be lower than the average 2008-2009 bank. THVB is an incredible, low-risk organization.

(2) Low Interest Rate Risk

THVB also avoided the interest rate risk that many banks gladly accepted in 2021 by investing/lending long-term at low rates. When deposit rates rose, securities values declined and margins compressed. THVB avoided these issues with the following philosophy (paraphrased from 2023 Annual Meeting):

1. Don’t lend long, since deposits are short-term

2. Do not chase yield and kept bond portfolio duration at ~1-year

3. Think when times are good that’s when you should put money into loss reserve

4. Be disciplined; don’t follow the herd

This disciplined / “don’t follow the herd” mentality can be seen in the percentage of their assets in long-term assets that re-price in >5 years. THVB operates with only ~9% long-term assets versus peers of ~33% (see below table).

Because most of their loan portfolio re-prices in <5 years, the timeframe most deposits will re-price in, their spread between loan/securities yields and deposit costs (net interest margin) experienced relative stability. Many other banks have seen much more significant changes (good and bad) in their net interest margins over the past five years, as interest rates changed dramatically.

Share

Scaled Branches

THVB’s scaled branches hold more deposits than most banks in the U.S.  THVB holds $381mm in deposits per branch, whereas their competitors hold an average ~$150mm.

The scale simply means THVB does more with less.  Less branches mean less occupancy costs in the form of leases, maintenance, utilities, etc.  Less branches also means less employees are required.  Without extra branch costs, THVB operates with the lowest efficiency ratio among peers.

Due to their high cost efficiency, THVB can effectively pass on some of these efficiencies to depositors via higher deposit rates.  As the below table shows, THVB has the highest interest-bearing deposit costs among its peers. While of course it would be better if they could generate/retain deposits at little-to-no cost, a win-win setup where THVB shares their efficiencies with customers is also a competitive advantage that few can provide their depositors without severely impacting profitability.

Thomasville depositors (where ~90% of their deposits are located) have undoubtedly valued their relationship with THVB as evidenced by their increasing deposit market share of the Thomasville MSA (steadily increased from ~39% to ~57% over the past decade).

Trust Revenue

In addition to THVB’s strong, pure banking franchise, they also operate a growing trust division named TNB Financial. Formed in 2001 has expanded over the years using various methods, including local acquisitions. They now manage $4+ billion in assets for clients and generate $16mm+ of revenue from this asset base.

Although this trust income will fluctuate as market valuations change, it provides (1) an additional income stream to offset any loan losses, fund growth, or go to shareholders, and (2) strengthens relationships with certain depositors who choose to have all of their banking/financial life done by both the bank and trust department (i.e., creates stickier clients/customers).

Return on Assets

Combining the (1) high-level of operational efficiencies, (2) trust revenue, and (3) the low-risk culture allow THVB to generate a return on assets well-above their competitors. In fact, their year-to-date return on assets (2.28%) is nearly double that of the 2nd place competitor (1.41%).

Compared to a larger list of all 132 Georgia banks with less than $2bn in assets, THVB ranks around the top 10% for return on assets and ranks as the #1 public bank in Georgia.

Valuation

Valuation of banks, over say a 5-year period, comes down to: (1) how much in assets will the bank have in the five years, (2) what return will be generated from those assets, and (3) how much in excess capital will be created over those five years that the bank does not need to retain to grow.

1. What will assets be in five years?

   1. Over the last 5 years, THVB has grown assets by ~12% annualized. Over the past three years, they have grown at ~8% annually.

   2. In the long-run banks, typically grow (via deposits) at a bit above nominal GDP growth (real GDP growth + inflation rate). If you assume THVB grows at a more conservative 5-6% over the next five years, they should have ~$2.3bn - $2.4bn in assets.

2. What will be the return on those assets?

   

   1. Above is a breakdown of THVB’s latest quarter’s return on assets (“ROA”). Going forward, with rates declining, THVB is likely to experience slight downward pressure on net interest margin. However, non-interest expense / assets should continue to decline as assets keep growing within THVB’s current infrastructure. A few other small pluses and minuses exist, but overall, I would expect future ROA to range between 2.0%-2.3% in normal economic environments.

   2. If you combine the future asset range of $2.3-$2.4bn with 2.0%-2.3% return on those assets, you get, $46mm-$55mm in net income five years out.

   3. THVB’s low risk means less cyclicality than the typical bank. High quality banks can trade in the 14-17x range, implying a roughly $640mm-$935bn valuation (or $100-$150 per share).

3. How much in excess capital generated over those five years?

   1. Accounting for the capital required to fund growth and different economic environments, THVB likely generates $15-$25 per share in excess earnings (i.e., dividends and share repurchases) over the next five years.

Combining the valuation range with the excess earnings range results in $115-$175 per share of total value in five years. At a current $65 share price, that implies a 12%-22% IRR. An interesting valuation for one of the better community bank’s in the country but one to definitely pay attention to for higher future returns, if forced selling ever irrationally impacts the stock price.

Other Factors to Consider:

1. Insider Ownership

   1. As of 2022 (latest ownership data I know of), ~27% of bank was owned by management and the board of directors.

   2. The CEO, Stephen Cheney, and President, Charles Hodges, own a combined nearly 10% - strongly aligning interests with shareholders.

2. Share Repurchases

   1. In January 2024, THVB announced a $5mm stock repurchase plan.

   2. Although $5mm is a relatively small number for a $410mm market cap company, THVB does have a very illiquid stock, averaging only ~$108k of transactions per day over the last 30 days. The $5mm figure is likely close to the maximum they can in a year without affecting the stock price too much.

Share

Disclosure: I currently hold shares of THVB for myself and others. I may buy more or sell my position at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

“Henry reminds me of De Gaulle.  He has a singleness of purpose, a tenacity that is just overpowering.  He gives you absolute confidence in his ability to accomplish whatever he says he is going to do.  Yet, he is rather aloof, operating more or less by himself and dreaming up ideas in his corner office.”
- Arthur Rock (Teledyne Board member and early venture capitalist)

After re-reading “Distant Force: A Memoir of the Teledyne Corporation and the Man Who Created It”, I added to and re-organized some notes I had on Teledyne and Henry Singleton - this article is the result of that process. Near the end, I included some financial charts/analysis on Teledyne’s figures over Henry Singleton’s tenure as CEO.

Share

Teledyne History

• Pre-Teledyne Background

  • Henry Singleton was born in a small Texas town in 1916

  • When Singleton was young he said he desired to found and run a large company like GE or US Steel

    • As an older Singleton: “He was a student and an observer of the history of manufacturing.  He studied the progress and growth of corporations from the days of Henry Ford to GM and how successful corporations grew by acquisitions.  He studied the behavior of Jimmy Ling and others who were beginning to grow in this manner.  He studied the Littons, the TRWs, the LTVs, the City Investings, the Gulf & Westerns, and today’s largest of all conglomerates, GE.”

  • (interesting side note) Singleton was extremely talented at chess

    • 100 points below Grand Master level and could play blind-folded

    • Singleton would later compare managing Teledyne to a competitive game: “Our objective is to increase our rate of earnings faster than [the competitors].  It is a lot of fun.  As a result, we visualize it as a competitive game.”

  • Attended Naval Academy and then MIT, where he earned PhD in electrical engineering

    • Also worked at the CIA predecessor, the OSS (Office of Strategic Services), during World War II

    • Graduated in 1950 and joined Howard Hughes company, Hughes Aircraft

    • Recruited to Hughes by Simon Ramo, who mentioned Singleton was the only student who had achieved 100s in all his classes

      • Also mentioned how Singleton had “quiet dignity and gentleness and kindly intelligence, with no ego… While the other graduates wanted to deliver prepared recitals of their accomplishments, Henry asked questions…”

  • Eventually was recruited to the conglomerate Litton Industries in late 1950s

    • While there he invented inertial guidance system, still used in aircraft today

    • Became head of Litton’s Electronic Systems Group and grew it to be the company’s largest

• Singleton and a colleague from Litton left to found Teledyne in 1960

  • Initially bought a small electronics company named Amelco

    • Teledyne became public company in 1961

  • Goal was to found a business that was a leader in aircraft/aerospace electronic control systems and other technologies needed to support that business

  • Singleton in 1968, “So we went into [semiconductors] in 1960…We did it because of our conviction that it was necessary for our long-term future growth and not because of any conviction what we would immediately make huge amounts of money.  We decided that if we were going to manufacture, develop and sell electronic control systems, we ought to have a capability in the component area.  That would enhance our ability to design systems because we’d know more about new components we could use; on the other hand, our expertise in systems would enable us to better judge what kind of components to develop.”

• Diversified over time and eventually expanded into specialty metals industry, among others

  • Singleton said specialty metals expertise was vital to the development of semiconductor components needed for advanced electronic control systems

  • Also realized that advanced alloys were becoming increasingly important in space / military applications

  • Focused on profitable, growing companies, with leading market positions, often in niche markets

• With conglomerates trading at high valuations, between 1961-1969, Teledyne ultimately purchased 130 companies, utilizing Teledyne’s higher P/E to issue Teledyne stock to a target at an acquisition price with much lower P/E (classic P/E arbitrage in M&A)

  • Despite the highly-valued currency, still paid reasonable valuations, never paying more than 12x P/E - purchasing most significantly <12x

    • During this period, Teledyne’s P/E ranged from ~20-50x

• When asked if he was building another Litton, Singleton responded: “Hell no, I’m trying to create another GE.”

  • “Henry’s chose of companies to acquire gradually became more and more diverse.  At first it was a a matter of choosing those companies that were available at a reasonable price, that were within his means to acquire, that fit, however loosely into his government and military business.  Later he would look afield to companies that were less and less related to his original electronics. Government, military markets, but would diversify and contribute to the profitability of his company.”

• Diversification into Insurance & Finance

  • Henry multiple times mentioned a book by the former Chairman of General Motors to Teledyne President, George Roberts

    • In the early 1920s, General Motors had a failed bond offering and the chairman realized an important lesson about having a strong “financial base”

    • Due to this, GM started General Motors Acceptance Corporation and invested in other financial institutions

    • Based on this idea, Henry had previously decided that at some point Teledyne would seek out financial institutions to acquire, with an emphasis on insurance companies

    • During the end of their acquisition period, in 1968, Teledyne made their first insurance acquisition, buying a stake in Unicoa, a life insurance company

• Teledyne stopped acquiring completely in 1969, when (1) Teledyne’s stock began trading lower, (2) acquisition valuations continued to increase, (3) less good companies were available, and (4) thought they could get more money buying less than 100% stakes in companies via the stock market

  • From that point on, Teledyne never did another acquisition

  • Began to focus on improving operations, repurchasing shares, and investing the insurance company portfolio

• Share repurchases

  • In 1972, with everything else still expensive, thought Teledyne’s own stock was the best use of capital and so the company began to repurchase shares

  • Over eight tenders from 1972-1984, repurchased 90% of outstanding shares

    • Average repurchase was at P/E <8, versus average issuance P/E of >25x during Teledyne’s acquisitive years

• Insurance portfolio

  • Singleton took over the insurance portfolio in mid-1970’s

  • reallocated the portfolio from 10% equities in 1975 to 77% by 1981

    • Put 70% in top 5 equity positions, with 25% in top position, which was Litton Industries - Singleton’s former employer

  • Invested in companies he knew very well - many conglomerates like Litton and Curtiss Wright

• In late 1980’s, carried out a series of spin-offs to simplify the company, and began a dividend in 1987

• Singleton ultimately retired in 1989

Investment & Operational Philosophies

• Value investor with strong understanding of opportunity costs

  • “I don’t believe all this nonsense about market timing.” Singleton says. “Just buy very good value and when the market is ready that value will be recognized.”

  • “There are tremendous values in the stock market, but in buying stocks, not entire companies. Buying companies tend to raise the purchase price too high. Don’t be misled by the few shares trading at a low multiple of 6 or 7. If you try to acquire those companies the multiple is more like 12 or 14. And management will say, ‘If you don’t pay it, someone else will.’ And they are right. Someone else does. So, it’s no acquisitions for us while they’re overpriced. I won’t pay 15 times earnings [a ~6.7% earnings yield]. That would mean I’d only be making a return of 6% or 7%. I can do that in T-bills.”

• Concentrated portfolio with emphasis on companies that Singleton knew very well

  • “Currently Singleton has over 50% of his equity portfolio in Conglomerates… All these conglomerates are companies in fields that are related to Teledyne’s own experience.”

    • “Singleton also has a block of oil stocks with good gains, including Mobil and Standard Oil of Indiana. Teledyne companies are in geological, exploration and make drilling rigs; so again, he has chosen a field he clearly understands.”

  • [from 1979 Forbes article] “Singleton’s biggest move was to put over $130 million—25% of his equity portfolio–into Litton. Teledyne now holds 27% of Litton…worth $270 million; and is 25% of its insurance company’s equity portfolio.”

    • “I felt Litton was a sound investment,” Singleton says. “It’s good to buy a large company with fine businesses when the price is beaten down over worry about one problem.” (He refers to Litton’s costly and protracted shipbuilding issues with the U.S. Navy). Singleton added “Litton’s problem was not a general one but an isolated problem—as ours was with Argonaut Insurance. To me it was hard to believe the heads of a $3 billion or $4 billion business would not be able to handle one business problem.”

• Focus on Cash

  • “Our attitude toward cash generation and asset management came out of our own thought process. It is not copied. After we acquired a number of businesses we reflected on aspects of business. Our own conclusion was that the key was cash flow.”

  • Roberts says: “Net income without cash is not necessarily net income. We build cash generation into the system of paying our managers. Bonuses can be 100% of base salary.”

  • Singleton: “If anyone wants to follow Teledyne, they should get used to the fact that our quarterly earnings will jiggle. Our accounting is set to maximize cash flow, not reported earnings.”

• Mindset of long-run optimism, low-risk and maximum flexibility

  • Long-run Optimist

    • [In 1979] “What is Henry Singleton’s own sense of economic reality? At a time when many top businessmen are gloomy about the future of the country, Singleton has this to say: “I’m convinced the coming recession will not be too deep or long and we will have a good recovery following it. It is so fashionable to complain about the restrictive regulatory environment in Washington. That makes people forget how very much worse things could be. Long run, I am happy about the prospects for America, for business and for Teledyne.”

  • Low-Risk Focus

    • “Risk, too, is carefully rationed. A coolly rational man, Singleton, despised surprises. It is company policy that divisions which are federal contractors will remain relatively small. “We don’t want any big prime contracts, says [Teledyne President] Roberts. “We prefer to be important, technically oriented subcontractors who serve those who want to be prime contractors.” That way, if a large contract is aborted Teledyne will not be hurt. The effect of all this emphasis on restricting risk and insisting on high return, Roberts says, is that he’s been able to stop preaching. “Now everyone understands that all new projects should return at least 20% on total assets. When leveraged up, return on equity can be 30% to 50%. This is so ingrained that few lower-returning proposals are ever presented anymore. We hardly ever discuss one.”

    • “Teledyne is like a living plant, with our companies the different branches and each putting out new branches and growing so no one business is too significant.”

  • Maximize Flexibility

    • “My only plan is to keep coming to work…I like to steer the boat each day rather than plan ahead way into the future.”

    • “I know a lot people have very strong and definite plans that they’ve worked on all kinds of things but we’re subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible.”

    • “I believe in maximum flexibility, so I reserve the right to change my position on any subject when the external environment relating to any topic changes, too.” A CEO’s most important job, he goes on, is to anticipate trends and act to help his company.

• Independent Thinker

  • Singleton repurchased shares when doing so was much more rare. Back then, it was considered a sign of weakness - that the company had nothing better to do with the capital than return it via repurchases. Not only did he conduct repurchases, he obviously did them in an extreme size that is rare even today.

    • “In 1997, two years before his death from brain cancer at age eighty-two, [Singleton] sat down with Leon Cooperman, a longtime Teledyne investor. At the time, a number of Fortune 500 companies had recently announced large share repurchases. When Cooperman asked him about them, Singleton responded presciently, ‘If everyone’s doing them, there must be something wrong with them.’”

  • “During the 1968-1974 period he considered bonds as high risk and stocks as low risk, contrary to popular opinion…”

    • Result was the insurance investment portfolio’s shifted towards stocks when stock prices were depressed in the 1970s - a great decision

  • “… [Singleton] believed investor relations was an inefficient use of time, and simply refused to provide quarterly earnings guidance or appear at industry conferences.”

• Decentralized operation with focus on efficiency / high-margins

  • Decentralization

    • “[Teledyne management] manage[s] you by numbers,” says [a] former executive... “As long as you are performing, you never hear from them.”

      • “But the consequences of coming up short can be excruciating. At budget review meetings the craggily handsome Singleton turns “hard, cynical, and cold,: speaking in measured, clipped tones “like he is biting a bullet,” recalls a former associate.”

    • Day-to-day operations were managed by President, George Roberts, with decision-making responsibility pushed down to lowest-possible level

    • However, capital allocation decisions were centralized to headquarters

      • This setup allowed Henry to be mostly involved in big picture strategy and investing the insurance investment portfolios. He figured others could manage the operations better than him, allowing him to focus on the areas where he excelled

  • Attract High Performers

    • “We have what is called a “management inventory.”  We work our heads off to increase our own capability at collecting and promoting the right people.  To the extent we succeed, the whole company will succeed.  We increase our bets on the men who seem to be performers.”

    • Utilized stock options to attract high potential people to Teledyne

  • Allocate Capital To High Return/Margin Subsidiaries

    • “Forget products,” [President George] Roberts begins, “Here is the key: We create an attitude toward having high margins. In our system a company can grow rapidly and its manager be rewarded richly for what growth if he has high margins. If he has low margins, it is hard to get capital from Henry and me. So our people look and understand. Having high margins gets to be the thing to do. No one likes to have trouble getting new money.”

  • Efficient Operations

    • According to one article, Teledyne allocated approximately 55% less to capital spending and 30% less to R&D spending than competitors

Share

Teledyne Financial Charts & Analysis

“Henry Singleton has the best operating and capital deployment record in American business.” - Warren Buffett in 1980

Below is a high-level overview of Teledyne’s financials throughout Henry Singleton’s tenure as CEO.

**********************************************************************************************

Return on Equity & Leverage - The major item to note is the evolution of the leverage utilized. Once Teledyne’s stock sported a high valuation - in the mid-to-late 1960’s - it was utilized as the main currency to fund much of the acquisition growth. Additional debt was used somewhat during the 1970s share repurchases but was never utilized very aggressively.

EBIT Margin - Teledyne President, George Roberts, wrote in the book “Distant Force” that once the Teledyne “acquisition machine” stopped in 1969, they focused on improving operations/margins. He mentions that in 1975, Teledyne began focusing on increasing sales of higher margin product lines and de-emphasizing lower margin lines. This resulted in gross margins increasing by roughly +400bps in ‘75. This trend continued throughout ‘76-’77, with gross margin ultimately expanding from 19% to 26% from 1974-1977. Much of the gross margin increase fell to the bottom-line, with EBIT margins expanding by +~700bps over that timeframe, from 7% to 14%.

Teledyne EPS & Shares Outstanding (two charts) - The outstanding capital deployment record that Buffett talks about can be summarized in the bottom two charts. High valued shares issued to acquire 130 companies in the 60’s and then repurchased ~90% of shares in the ‘70’s and ‘80’s. Also interesting to see the large EPS jump in 1975, which coincided with the increase in margins. Improved operations combined with 50%+ less shares outstanding caused earnings per share to explode higher.

Share

Sources:

1. Article - Forbes 1978 - "The Sphinx Speaks"

2. Article - Forbes 1979 - "The Singular Henry Singleton"

3. Presentation - "A Case Study in Financial Brilliance" by Leon Cooperman

4. Book - Distant Force: A Memoir of the Teledyne Corporation and the Man Who Created It

5. Book - The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success

6. Underlying data source for financial figures - https://www.turtlebay.io/financials

Disclosure: Nothing said in this article is investment advice. I may buy or sell shares in any company mentioned. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Warren Buffett has spoken about the high returns he earned in the 1950s - especially in his pre-partnership days. Union Street Railway was one of these no-brainer, “cigar butt” investments he made during that time.

The Situation

While Buffett was working for Graham-Newman, he followed-up on a lead from Graham. Union Street Railway was a bus service that operated in Massachusetts (side fact: in an odd twist of fate, it operated in New Bedford, Massachusetts and counted Berkshire Hathaway’s Seabury Stanton as a director).

Union Street Railway was a classic Graham net-net, meaning it was selling at a large discount to current assets minus all liabilities, a conservative estimate of liquidation value.

Not only was it a net-net selling at a ~25% of book value, it had a few other features that made it an incredibly interesting and fairly “clean” investment:

1. Substantial portion of assets in cash plus highly liquid government securities

   1. Was selling at 60-70% of cash+securities

   2. Also had some other hidden cash assets (discussed later)

2. Nearly $0 of liabilities

3. Company repurchased ~16% of stock over last two years at large discounts to liquidation value

As Buffett described the situation in the “The Snowball”:

“[Union Street Railway] had a 116 buses and a little amusement park at one time. I started buying the stock because they had $800k in treasury bonds, a couple hundred thousand in cash…Call it a million dollars, about sixty dollars share. When I started buying it, the stock was selling around $30 or $35 per share.”

Share

Why did the Situation Exist?

The (likely) two main reasons why this highly undervalued situation existed:

1. Incredibly Small, Highly Illiquid Stock

   1. Union Street Railway’s market cap when Buffett was buying was ~$600k (around $6.9mm market cap in today’s dollars)

   2. Very small company meant less investors looking at it and for those that found it, created a highly illiquid situation where buying enough stock was difficult. The company ran local ads itself in the local New Bedford paper in an attempt to repurchase its undervalued stock.

   3. Buffett ran his own ads. Then he realized as a regulated utility he was able to obtain a list of the largest shareholders from the public-utility commission in Massachusetts. He utilized that list to find shareholders willing to sell their stock to him.

2. Declining Business

   

   1. Bus usage, in terms of number of trips, began to decline post-WWII. Public transportation’s share of total transit was on a longer-term secular decline, accelerated by the automobile’s rise. However, during World War 2 a resurgence of public transportation occurred driven by austerity measures such as gas rationing. The World War 2 time period was also when bus usage increased dramatically and ultimately peaked.

   2. In the post-WWII world, Union Street Railway saw passenger count drop drastically. They experienced a -49% decline in passengers from 1946-1953. Despite this, they managed to stay profitable up until 1953.

The $50/share Special Dividend

After purchasing the stock, Buffett went to see management on a weekend. At the end of the conversation, he learned Union Street Railway was planning a special dividend at a per share amount well above the current stock price.

"I got up at about four a.m. and drove up to New Bedford. Mark Duff was very nice, polite. Just as I was about ready to leave, he said, 'By the way, we've been thinking of having a return of capital distribution to shareholders.’ That meant they were going to give back the extra money. And I said, 'Oh, that's nice.' And then he said, Yes, and there's a provision you may not be aware of in the Massachusetts statutes on public utilities that you have to do it in multiples of the par value of the stock The stock had $25 par value, so that meant it would be paying out at least $25 per share. And I said, Well. That's a good start. Then he said, Bear in mind, we're thinking of using two units. ' That meant they were going to declare a fifty-dollar dividend on a stock that was selling at thirty-five or forty dollars at that time."

How the Investment Worked Out

After the special dividend, Union Street Railway traded at $20 per share at the end of 1956. Buffett still owned 576 shares (~$11.5k). A $20/share stock + $50/share special dividend equals $70/share of total value, equating to a likely >100% return over a relatively short period of time (unsure of Buffett’s exact original investment date).

“I got fifty bucks a shares, and I still owned stock in the place. And there was still value in it. The bus companies hid assets in these so-called special reserves and land and buildings and car barns where they kept the old streetcars.”

After the special dividend and accounting for some cash burn, the pro forma book value was likely in the ~$60-$80 per share region in 1956. With the stock trading at only $20 per share, substantial value was still there to be unlocked as Buffett mentions above.

Conclusion

No special insights were necessary to buy Union Street Railway stock. Although the company was likely in a long-term decline, extreme value existed above the stock price - and most of that value was in cash/securities. And, as an added kicker, if the other “hidden” assets were ever unlocked for the benefit of shareholders, all the better - but not necessary for a successful investment.

In fact, the most important factor was likely the hard work Buffett was willing to put in to track down shareholders in order to buy a material amount of stock. This seems to be one of Buffett’s most underrated characteristics: his ability/desire to go the extra mile for an investment (flipping thru 10,000+ pages of Moody’s Manuals, tracking down shareholders to acquire enough stock, etc.).

Ultimately, in Union Street Railway, Buffett was able to get one of the last “puffs” out of this cigar butt investment.

Disclosure: Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Share

I wrote-up FFD Financial (OTC-listed: FFDF), the bank holding company of First Federal Community Bank, in early November 2022.

A very brief summary: FFDF is (1) a cost efficient bank with (2) a long track record of very low loan losses, (3) a dominance in their local markets, and (4) trades/traded at a low valuation. At the time FFDF’s stock price was ~$33/share; it now trades at ~$29/share (current market cap = ~$87mm).

Despite the decline in stock price, the value has likely increased mainly attributable to the increase in core deposits. Due to this, I think a 25%+ IRR is currently possible with FFDF over the next five years. I encourage reading of the previous write-up before reading this update.

Core Deposit Growth

Core deposits for a bank are supposed to represent the “stickiest” customer deposits. The definition typically removes large deposits over the $250k FDIC limit and other deposits obtained via a broker or listing service.

Following the deposit run and subsequent failure of Silicon Valley Bank and a few others, deposits shifted drastically for many banks.  Large movements quarter-to-quarter are rare.  The bank failures of 2023 provided interesting insight into where consumers trust their deposits.  Many of the largest banks benefitted as people viewed them as a source of strength.  But certain community banks benefitted too with FFDF one of these winners.  FFDF ranked in the top 10% of all Ohio banks for growth in core deposits in 2023 and #2 among its direct peers (see below).

Even more interesting, core deposits increased ~4% in 1Q23, the quarter Silicon Valley Bank failed.  While a 4% change in a quarter might not sound like much, that equates to 16% annualized.  Compare that to the average year for banks where deposits increase 4-5% per year.

Net Interest Income Growth

The additional deposits also allowed them to escape much of the collapsing spread that certain banks experienced.  Many banks tightened lending standards in 2023, slowing loan growth.  Meanwhile, deposit costs continued to creep higher.  Due to the lack of loan growth, new higher-yielding loans could not help offset some of the higher deposit costs. 

FFDF’s situation was different.  With the influx of extra deposits, FFDF was able to invest the deposits at high rates, either via lending or simply in cash instruments earning 5%+.

Either way this allowed FFDF’s earnings to increase in a year when many banks saw their earnings remain flat or decline. FFDF’s one-year net income growth ranked in the top 20% for all Ohio banks and #2 among their direct peers.

Share

Conservative Loan Portfolio & High PPNR

Outside of the benefits of extra deposits, FFDF continues to be a well-run, conservative bank ending the year with the best loan delinquency metrics among its closest peers. Loan focus continues to be on 1-4 family mortgages and owner-occupied CRE (meaning, not investor owned CRE) - these categories are traditionally lower risk.

FFDF also is the leader, among direct peers, in pre-tax, pre-provision income (“PPNR”) as a percent of assets. PPNR can be thought of as the first line of defense against loan losses. Before a loan loss impacts capital, it will first be absorbed by income - specifically, PPNR income. Only once PPNR is fully exhausted by losses, is capital impacted. I wrote about this in more detail in the November 2022 write-up of FFDF.

With a strong ~1.9%-2.0% PPNR/assets, FFDF could incur ~2.5%-2.6% annual loss rate on their loan portfolio (including foregone interest) before reporting an overall net income loss. FFDF’s highest year of loan loss provisioning during the Financial Crisis was ~0.5%. Although every recession is different, it’s just another example of FFDF’s strength - and, shareholders are fortunate to have the same management team running the bank today.

This ability to incur substantial losses, while also being the leader in low loan delinquencies, creates a large safety net for FFDF shareholders.

Valuation

If you think about business owner returns, FFDF currently earns $4+ per share and trades at ~$29 per share, implying a ~14% yield. Of course, management is not simply paying out every dollar as a dividend - so, looking at it that way is a bit irrelevant. However, the non-dividend, retained earnings have historically become worth more than dollar-for-dollar as the business produced a high-teen returns on that invested equity.

A bit of a deeper dive into FFDF’s financials/valuation below:

FFDF’s PPNR/assets has increased over the past 10 years as each branch has grown deposits/loans and therefore, provided additional revenue within their existing branch cost structure.

This dynamic pushed down non-interest expense / assets, while the revenue components of PPNR (net interest margin + non-interest income) remained roughly the same as a percent of assets (see below chart).

FFDF has the potential to increase PPNR/assets above 2.0% sustainably, if they can continue to generate deposits within their existing infrastructure. As mentioned in the previous write-up, FFDF does dominates its markets so the extent of growth available in markets where they have 50%+ deposit market share remains to be seen.

However, if FFDF only maintains at ~2.0% PPNR and you assume a 0.2% normalized provision, that implies 1.8% pre-tax income / assets. After a 17-18% tax rate (lower due to non-taxable municipal bond income), that math produces a ~1.5% net income / assets.

While FFDF has historically grown deposits at 8-10%, if only 5-6% growth rate is achieved, they should have roughly $1.0bn in assets in five years. A 1.5% return on $1.0bn in assets is $15mm or $5/share. At 15x earnings, implies $75 per share value. FFDF will also likely produce ~$15 of excess earnings over that period available for dividend. This produces $90 per share in value (inclusive of dividends) in 5 years - a 25%+ IRR on the current $29 stock price.

However, if FFDF manages to grow deposits out of their current branch structure (or opens new branches as they have done successfully in the past), decreasing non-interest expense / assets further, PTPP/assets could be even higher in five years. Running the math under these best-case scenarios produces $115+ per share of total value in five years (inclusive of dividends) - a 30%+ IRR.

Of course, a recession could occur, where loan losses increase for a period. This scenario would mainly reduce excess earnings over the next five years, and have less impact on the ultimate terminal value of FFDF. Even if there is some permanent impact, say, from a sustained lower interest rate environment compressing net interest margin, there is still a large cushion available with such a high return seemingly available at current prices.

Combined with the low risk attributes mentioned earlier, FFDF at current prices presents an interesting potential investment.

Important Reminder: FFDF is a very small bank with a fairly illiquid stock listed on the OTC.

Disclosure: I/we currently hold shares of FFDF. I may buy more or sell my position at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here.

Share

“Investing is most intelligent when it is most businesslike.” - Benjamin Graham

The math discussed below is not original but hopefully the connection to valuation math provides a slightly different lens to think about this concept.

Part 1: Business Owner Returns

The return on any investment is the function of three factors: (1) price paid per share, (2) dividends paid to the owner during ownership, and (3) sale price per share.

Many public equity value investors think thru investment return math as, “ABC is trading at 8x today and has historically traded at 15-20x. The business will be able to correct ‘current issue X’ and once the clouds clear, ABC will trade back up in the normal P/E range.” While there is nothing necessarily wrong with that approach, it does rely on the market agreeing with you on a future valuation multiple.

There is a simpler approach - what I call “business owner returns”. Effectively it says (1) given the current market valuation, what rate of return do I get on returned capital, plus (2) how much in value growth should the asset experience due to distributable cash growth.

Distributable Cash Yield (in dividends + share repurchases)
+ Growth in Distributable Cash Yield
(=) Business Owner Return

In simpler words, it can be thought of as dividend yield + EPS growth, while assuming no change in the P/E valuation.

If a company chooses to distribute 100% of their earnings to shareholders, then the return equals the dividend yield (unless it is a special company that can growth without reinvestment, like a royalty company). And vice versa, if a company chooses to reinvest 100% of their earnings, then the business owner’s return will be equal to their earnings growth. And, to add one complicating factor, that growth will equal the return achieved on that incremental equity invested.

Of course, the ultimate return includes the change in valuation from investment to sale. However, if you can buy into a business at a very attractive “business owner return”, any increase in the valuation is just an added extra.

“This is the cornerstone of our investment philosophy: Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.”
- 1962 Letter to Buffett Partnership Investors

Part 2: Connection to Valuation

”Business Owner Returns” are really just a re-arrangement of the Perpetuity Growth Formula - a core concept in valuation math.

Again, the focus is no longer necessarily on what an asset is worth (i.e., a P/E approach) but instead looking at what the market is “giving you” in terms of implied future returns.

Viewing an asset this way should solidify what is really important:

1. Is current distributable cash expected to continue (i.e., durable?)

2. What is the return on future equity invested?

3. What % of future distributable cash will be paid to investors vs. retained at the above estimated rate of return (i.e., #2 * #3 create growth as shown below)

And it should come as no surprise that the most important factor in determining #1 and #2 above is the competitive advantages of that business/industry - a determination requiring more than just math. As the Ben Graham quote states, “Investing is most intelligent when it is most businesslike.”

Disclosure: Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

1. Overview

2. Long-Term Trends

3. Competitive Advantages

4. Industry Economics

5. Post-COVID Industry Situation

6. Future Risks/Changes to the Industry

7. Overview of the Public Auto Dealers & their Capital Allocation Strategies

8. Summary

1.) Overview

Every U.S. new car dealership is four businesses: (1) new car sales, (2) used car sales, (3) parts & service, and (4) finance & insurance.

Although new and used car sales drive most of the revenues, they do not drive most of the profits. As an example, although ~78% of revenue generated by AutoNation is derived from vehicle sales (new+used), those sales only generated ~32% of gross profit. And, those figures are slightly distorted due to new vehicle shortages still temporarily inflating 2023 new vehicle gross margins.

Explaining this revenue/profit mismatch is the margin differential between business lines. Pre-COVID, new car margins were ~5% and used car margins were ~7%. However, parts/service margins are ~45% and finance commissions ~100%. Understandably, the ~10x higher parts/service margin substantially shifts the gross profit contribution mix substantially.

The benefit of a business model based on parts/service is more resiliency during bad economic environments. In 2008-2009, new car sales dropped by ~50%, while dealer parts/service revenue only dropped by single-digit percentages. Due to this, the public auto dealerships were all cash profitable during the Financial Crisis.

The industry’s highly variable cost structure aids this profitability during recessions. Auto dealer’s costs mainly consists of employees and advertising. Both of which can be cut quickly as car sales begin to decline. And, with commission-based sales at dealers, much of the costs cuts are “automatic” (i.e., less sales = less commissions)

The extent of the franchised dealer’s variable cost structure is actually pretty extreme. For example, GPI states in their latest investor presentation that parts/service gross profit covers 110% of total company fixed costs + parts/service variable selling expenses (the “Absorption Ratio”). Said another way - without any car sales, GPI’s parts/service gross profit can cover all their fixed costs and still produce a decent profit.

Overall, this industry structure creates a very defensive business model. The industry could not be more different than the U.S. auto manufacturers, which requires large CapEx and high fixed costs - both causing equally high operating losses during the recession of 2008-2009.

Share

2.) Long-Term Trends

(1) New car sales - in the long-term - are primarily driven by population growth. New car sales have increased steadily over the decades, exceeding 17mm per year in the many years prior to COVID. Post-COVID sales growth has been restrained by both a chip shortage, and now a desire by auto manufactures to produce less cars, but sell them at higher margins to help fund the expensive EV transition (more on that later).

In recent history, ~12%-13% of U.S. households purchased a new car yearly (see chart below). Recessions might drive this figure below 12% temporarily and booming economic environments might drive it to 13%+.

(2) U.S. households increasingly shifted to multi-car households.
Fifty to sixty years ago many households were one car households. Decade-by-decade the average U.S. household increased their car ownership, as shown in the chart below. Even in the past decade, with the rise of Uber, the number of owned vehicles has stayed fairly consistent.

(3) Car repair inflation exceeded overall inflation while new and used has lagged.
New and used car pricing has lagged overall inflation over the past few decades, while vehicle repair price increases has consistently exceeded inflation. The data also shows how new/used inflation has been flat since the mid-1990’s (prior to the COVID shortages).

The interesting point with all the repair inflation, much higher service margins might be expected at auto dealers. However, using AutoNation as an example, parts/service margins were ~43% in 2001 and now are ~46%. The small margin increase despite the substantial price increases implies high cost inflation for service departments as well.

Summary of thoughts on the data:

1. Averaging the economic booms and busts, ~12-13% of the U.S households buy a new car yearly. This is subject to change now that the auto manufacturers might produce less vehicles going forward, and therefore, new car prices may be higher relative to household income.

2. The U.S. has become a multi-car household over the past fifty years. The rise of ride-sharing in the past ten years has seemingly not decreased ownership.

3. In recent history (excluding COVID), new/used pricing is flat, while car repair inflation continues to increase at a rate faster than overall inflation.

4. All this adds up to a slow-to-no unit growth industry, with overall revenue growth likely running below inflation (0%-2% growth). Of course, dealership groups located in geographies with above average population growth could experience slightly more favorable growth. But at best, this is a slow revenue growth industry.

3.) Competitive Advantages

The auto dealership industry does not have many of the typical competitive advantages. Scale advantages are mostly not available. Certain back-office functions can be consolidated - creating some small scale efficiencies for larger dealership groups. But, a 2-store dealership group, will buy their new/used cars at roughly the same prices as the 20-store dealership group.

Below is a discussion of competitive advantages by business line:

1. New Cars

   1. U.S. franchise laws restrict new car dealership competition. For example, two Toyota dealerships will not be located next to each other. There might be another one 15 miles away but not right next door. This helps limit competition and creates more sales per dealership, aiding margins.

   2. Further, the number of new car dealerships has declined from ~30k+ many decades ago to ~17k today. This has occurred while the number of new cars sold has increased over time as the U.S. population expanded and many households became owners of multiple vehicles. This further reduction in new car competition helps dealership network margins, with more vehicles sold from less sites.

2. Used Cars

   1. On used cars, new car dealers also compete against used car only competitors. New car dealers do have a lower-cost sourcing advantage, driven by trades for new cars increasing that dealership’s used car supply. Think about this versus the purchase of a used car: when a used car is purchased, the purchasing consumer can only maintain that dealers used car supply (buy one used, trade-in one used). Whereas when a new car buyer does a trade-in of their used car, they are effectively increasing the used car supply of that dealer. Without this, additional used cars would need to be found via other sources, mainly auctions that require various fees and transportation costs (and added time, and thus increased depreciation).

   2. New car dealerships also benefit from lease returns, creating a “built-in”, ongoing source of used car supply.

      

3. Parts & Service

   1. In some ways, franchised new car dealerships operate under the razor / razor blade model: sell the original product for cheap but create a higher-margin recurring revenue stream. This concept definitely applies to dealership’s selling new cars and receiving the much higher-margin warranty work (typically 55%+ margin). Although, once the warranty expires, customers are no longer tethered to the dealerships.

   2. New car dealers largest competitors in service are independent repair shops. To my knowledge, no one has ever gone to a dealership for service cause they thought it was the lower-priced option. Rather, people choose dealerships due to better service quality (real or perceived). Dealerships do have highly-trained technicians that specialize in the brand and use manufacturer (OEM) parts. Also, cars are increasing in complexity, requiring additional investments that might be too large for mom-and-pop independent repair shops.

   3. Regardless, since price seems to be a secondary consideration for people choosing service from a dealership, this does create some pricing power. Of course this depends on the car. Although I have never seen the data, I would assume luxury dealerships retain a much higher percentage of their customers for service work than, say, an import brand’s service department. Also, the newer the vehicle, the higher the retention rate at dealerships for service (see chart from GPI below).

      

   4. Dealership’s parts department also sell their auto manufacturers parts to independent repair shops. So even when a customer leaves a dealership’s service network, that dealership can still benefit by selling parts to wherever that customer chooses to have their vehicle serviced.

4. Finance & Insurance

   1. On finance, most auto manufacturers own their own finance companies (“captives”). Since most auto manufacturers want to incentivize additional new car sales, they will periodically offer 0% APR deals on new vehicles. For a customer considering both new and used vehicles, and seeking financing, this can be a powerful incentive to choose new over used.

   2. Overall, a customer choosing to get finance/insurance offers at a dealership is choosing convenience. For example, they do not need to shop around for loan rates prior to visiting the dealership - it is handled all on-site. In exchange, the dealership receives its commission from the lender for acting as a middle-man.

4.) Industry Economics

“The car dealership business, if run well can be a very good business. You have no receivables to speak of, you floor plan your inventory, you can lease your real estate – we don’t do that, we own 95% of our real estate – but you can have very little capital actually invested in the business and you can do a large volume…You work on fairly narrow margins and still earn a high ROC if you don’t tie too much capital in the business.”
- Warren Buffett in Fortune interview after Van Tuyl dealership acquisition

As Warren Buffett states, auto dealerships can be an asset light business, creating fairly good economics.

This is mainly due to zero need for net working capital. Sales are not outstanding for long to consumers, creating a small amount of receivables and net-out against the similarly small accounts payable. The largest working capital component, inventory, is funded by floorplan financing - floating rate debt backed by inventory.

Also, a dealership’s branches can easily be leased or bought and debt-funded, further reducing the shareholder equity needed in the business.

Combining zero net working capital need and zero need for real estate capital means sales can organically grow at a dealerships without additional capital required to generate those sales. Although low net margins exist for dealerships, their asset-light balance sheets typically create high returns on tangible equity/capital.

However, floorplan financing creates interest rate risk. By utilizing this floating rate debt, dealerships become interest rate sensitive. Due to this, certain auto dealership groups (like GPI), choose to use interest rate swaps to swap most this floating debt to fixed. However, the auto manufacturers do provide “floorplan assistance” - payments made to dealerships to help offset some of the floorplan interest expense.

5.) Post-COVID Industry Situation

The new car auto dealership industry encapsulates the COVID shortages and ensuing inflation. As COVID hit, the auto manufacturers reduced vehicle production and auto dealerships reduced employee counts. As the U.S. economy reopened, juiced by ample stimulus money, demand fully returned for vehicles but supply could not keep up. Combined with a computer chip shortage (cars today require 1,000+ chips), the amount of new cars manufactured was highly limited up until the beginning of 2023.

With high demand and not much new car supply, order books were created, with many Americans buying and not driving away in those new cars same day. This dynamic created skyrocketing new/used vehicle prices and much higher margins on new/used cars.

The supply/demand mismatch meant advertising was less necessary, lowering overhead. Similarly, less employees were needed. Overall, it created a dream scenario for auto dealers - sell less cars at higher margins but with low overall overhead.

The big question for dealers is where do margins end up once the industry fully “normalizes”. The two components that need to be understood are (1) gross margins and (2) overhead.

1. Gross margins are mainly inflated due to new car margins remaining elevated as inventory levels are still low. The argument is often made that the auto manufacturers will keep production restrained to help keep new car margins high. They state that this higher profitability will help them fund the large capital expenditures required for the gradual transition to electric vehicles.

   1. But, the auto manufacturers are prone to acting poorly for the sake of market share. Even if today they do stay restrained on producing vehicles, it just takes one or two who realize they can push increased units at these higher margins. The others, seeing these strays make easy profits from their restraint combined with watching market share losses to them, seem likely to react by also producing more units. A weird game theory issue develops, where the industry ends up back over-producing vehicles at low margins.

2. During and post-COVID, dealerships were able to sell vehicles with less employees and advertising. Almost every public auto dealership group loves to cite how each employee is now much more productive (i.e., more sales per employee).

   1. I do find it suspicious that dealers found these efficiencies once new car shortages started. Of course in a shortage environment they will sell less cars at higher margins, need less employees and less advertising to sell those fewer cars, etc. If the changes were truly structural I’m surprised you did not see this in the years immediately preceding COVID.

So how to get comfortable with downside if margins fully revert? I think a simple analysis helps. As mentioned, public dealerships used their windfall 2020-2023 COVID shortage profits to make acquisitions and/or repurchase shares. If you assume the new level of estimated revenue and shares outstanding but then assume net margins fully revert to 2019 levels, you get some interesting conclusions.

Even under this full reversion scenario (see above), the implied P/E ratios for some are around the ~10x earnings range that public dealers traded for pre-COVID. And, this assumes that the reversion occurs “today”, meaning the excess earnings stop immediately which seems very low probability. Also, many of the dealers have structurally increased their margins for various reasons. For example, GPI sold their low-margin Brazil operations in 2022. ABG sold their low-margin Mississippi dealerships, while purchasing high margin, high quality dealerships such as the recent Jim Koons Automotive acquisition.

This article is not meant to be one on valuation but some of the current valuations from a downside perspective are possibly interesting.

6.) Future Risks/Changes to Industry

Economic risks to auto dealers are low. However, they are interest rate sensitive due to the floorplan financing funding their inventory. That means in a sustained high interest rate environments, dealers must choose to either equity fund some of their inventory to reduce interest costs or incur the profit hit from their higher interest costs. Since auto manufactures provide floorplan assistance, they do help offset some of this risk. And, dealers can always choose to use interest rate swaps to fix the debt - although they need to make this decision before rates are expected to be high.

Outside of interest rate risk, the major non-economics risks are outlined below:

1. Parts/Service business lower profitability from transition to electric vehicles

   1. The verdict is still out on whether the switch to slow change to electric vehicles (“EV’s”) will help/hurt/do nothing to dealership’s service business. Electric engines versus internal combustion engines have many less parts. Less parts means, less breakage and less for service departments to do.

   2. While most public auto dealership CEOs agree on the above, they differ in the ultimate revenue impact. Some argue that although EV’s come into the service centers less, when they do come in the order ticket is larger - creating a net zero impact to revenue. Some argue the opposite or argue somewhere in-between.

   3. The EV shift could push more service work to dealerships as opposed to independent repair shops who are unable to make the required upgrades to service EVs. Also, in the early generations of EV production it is likely that more issues could occur (as with any newer technology).

   4. Five years from now, with more EV’s on the road and less being first-generation, we’ll know much more on where on the spectrum of revenue impact the truth lies.

2. Increasing market share of Tesla and other non-dealership utilizing auto manufacturers

   1. One of the less cited risks is the rise of Tesla. Every sale of a Tesla or other vehicle outside the traditional dealership network is a lost revenue dollar. The more Tesla and others grow and gain U.S. market share, the more of an impact they will have on traditional dealership groups. Less sales out of the same number of dealerships means negative operating leverage. For a low-margin business this could have an out-sized impact.

   2. Of course, the industry might adjust by increasing margins on one of their business lines. The industry did operate with roughly twice as many dealerships in the U.S. at one point. Overall, tough to tell the ultimate impact but is definitely an area to watch.

      

3. Switch to Agency Sales

   1. Agency sales means the auto manufacturers sell the vehicle and the auto dealer receives a small commission as a middle-man. This means less revenue for the dealer but the actual profits generated in the transaction is what matters.

   2. Certain brands are beginning to implement an agency model in the UK. The early response on agency is minimal-to-no profit impact. For example Penske, which operates UK dealerships, said the gross profit per unit sold (including F&I) under an agency model is higher than what was generated in 2019, prior to elevated car prices/margins.

   3. The other benefits for the dealer are no marketing costs and no floorplan interest expenses, since no inventory is actually owned by the dealer. This makes an asset-light business model, currently curtesy of inventory floorplan financing, a truly asset-light business model - no inventory owned whatsoever. For people worried about the economics of this model, so far the worries seem much over done.

   4. The other important fact, specific to the U.S., is that auto manufacturers are not allowed to sell direct to the consumer in nearly all states. For the agency model to arrive in the U.S., this would need to change.

7.) Overview of the Public Auto Dealers & their Capital Allocation Strategies

Given the asset-light nature of the industry and defensive business models means dealerships continually produce cash available for management to allocate. Prior to COVID, most public franchised dealership groups chose a mix of buying additional new car dealerships and repurchasing shares. Post-COVID, some have chosen to become more aggressive with acquisitions and others are choosing to venture out of buying only new car dealerships.

Below is an overview of each public new car dealer, with an emphasis on their current capital allocation strategies.

AutoNation - “The Share Repurchase Machine”

AutoNation has a focus on the Sunbelt region of the United States, where more desirable demographic trends exist. Long-time CEO, Mike Jackson, retired in 2021, with former CEO of Fiat Chrysler (now Stellantis ), Mike Manley taking over. Mike Jackson was CEO since the early 2000’s and was instrumental in transforming AutoNation when it was a hodgepodge of auto assets formed by Wayne Huizenga (billionaire of Waste Management and Blockbuster fame). Jackson shrank the business by closing its money-losing used car only mega stores and spun-off its car rental business.

Jackson gained respect as a capital allocator as he aggressively bought back shares when undervalued. AutoNation’s share count shrank by ~80% throughout his tenure as CEO (until his retirement in 2021). He was not against buying other dealerships bought often found buying back shares to be the better choice for capital and often did so aggressively.

He also mentioned that AutoNation’s large size was an issue in acquisitions. When seeking to do an acquisition of a certain brand, that brand’s manufacturer would apparently make the approval of the acquisition conditioned on AutoNation putting additional capital into current owned stores. This often created undesirable acquisition economics (which the auto manufacturers seem to have eased up on) for AutoNation specifically - another reason share repurchases became so emphasized.

One of the last moves Mike Jackson did prior to retirement was to start a standalone used car business called AutoNation USA. AutoNation is still in the beginning stages of introducing these stores but they claim desirable economics (see below).

When Mike Manley initially came in as CEO he seemed to indicate a desire to shift to growth. But, so far, he has not shown a “growth-at-all-costs” mindset. AutoNation continues as a large repurchaser, especially when undervalued in 2022. The following quotes sum up their approach so far:

CEO Mike Manley (on 22Q4 Earnings Call) → “the very first thing that we think about is what is the best use of capital for our shareholders' perspective. And clearly, you have seen over the last 2 years, given the market conditions and the overvaluation of assets out there, the best return was to return it to our shareholders, and we're very clear on that, and we'll continue -- our discipline will continue to be with that in mind. … Our approach is to firstly maximize the assets that we have in place and in appropriate circumstances to add to that, that will broaden our geographical coverage but be very deliberate.”

COO Joe Lower - was CFO at time of comment (on 22Q4 Earnings Call) → “let me just add, I'll call a boring finance answer to some of this. Because strategically, Mike was, I think, very clear in [articulating] what we're trying to do. When you match that with the financial or capital strategy, we have a first-class problem. We have robust cash flow and a very strong balance sheet. So then the question is how do we utilize that and maximize the benefit of it? And it's not surprising to most. It's an IRR-driven approach, and we look at what the return is on each opportunity. We have, obviously, as Mike mentioned, in the recent past viewed share repurchase as an extremely attractive opportunity.”

“As we look forward, we have found some opportunities that offer very, very compelling returns. And as we think about capital going forward, we will deploy it in a similar fashion and identifying where there really is truly incremental value. And I think you were going to ask about the Finance business, and I think we've been very clear that, one, we're going to be delivering this growth, and we will utilize facilities that we are not funding all of that directly from our balance sheet as it's typical and in some ways, similar to the way you think about floorplan. So we're not going to be putting dollar for dollar behind the capital business at the expense of other opportunities.”

AutoNation under Manley has done two non-traditional acquisitions. In late 2022, they acquired CIG Financial, to serve as their captive lender for $85mm.

AutoNation also announced in late 2022 the acquisition of RepairSmith, a mobile auto service provider for $190mm. This allows AutoNation to reach customers that leave service department of an AutoNation store. And although RepairSmith offers mobile service, if the issue is complicated enough, the car will be transported to the nearest AutoNation for service.

Both of these acquisitions are relatively small compared to AutoNation’s ~$6bn market cap but provide interesting potential.

Group 1 Automotive - “The (possibly) Reformed Capital Allocator”

Group 1 Automotive has a heavy geographic concentration in Texas (represents ~37% of GPI new car sales in 2022), one of the fastest-growing states in the U.S. GPI also owns dealerships in the U.K. (~19% of new car sales) and previously owned franchises in Brazil prior to sale in 2022.

Prior to his retirement at the end of 2022, GPI was run by long-time CEO, Earl Hesterberg. He became CEO of GPI in 2005 and ran what was frankly a sub-par operation with lower-than-peer margins and questionable capital allocation decisions with a large focus on acquisitions.

The worst period was post the Financial Crisis from 2011-2014, where stock was issued to grow rapidly via acquisition. Revenues increased from ~$6.5bn to ~$10bn over the time period but earnings only grew modestly and EPS remained roughly the same due to the share dilution.

Beginning around 2015, GPI began to do less, while focusing more on repurchases. As shown in the above table, average diluted shares outstanding declined at a ~6% rate from 2013-2019. Their “tune” on earnings call also shifted, increasingly mentioning that acquisitions were over-priced and therefore chose not to participate.

From my GPI write-up last year - summary commentary on their capital allocation considerations:

“However, like any good operator, GPI has evaluated many of these ventures that the other public dealers are choosing to take on.  On starting their own captive finance company, GPI noted on their 22Q2 earnings call, they are not interested – believe they have supportive finance partners currently and don’t want to add fixed costs to their business model.  On standalone used car sites, mentioned as far back as 2015 how hard it is to make that model work, while discussing how three of the other public dealers failed in their attempts at starting standalone used-car sites.

GPI has intelligently realized that there is an opportunity in the used car space but they think they can utilize their existing infrastructure.  In 2018, GPI introduced “Val-U-Line” used car offering which is just GPI retaining more of 6-10 year old cars instead of sending those to auction. First, this allows them to capture the margin they previously gave-up on those sales when offloading these types of cars in bulk to auctions.  Also, GPI could not get the math to work on standalone used car stores so this was their version of it, allowing them to sell additional cars without additional fixed costs / infrastructure (along with their online selling portal discussed in next section).  GPI believes this can also help increase the number of people coming to the dealership for service.  They have stated they are not necessarily looking to sell cars to people far outside of their current markets.  They want to retain their customers and gain future, higher margin, service work from them as well.

Final point on GPI’s capital allocation – they have shown the rare willingness to shrink their business when it makes sense.  GPI purchased a Brazilian auto dealership group in 2013.  Although they attempted to grow in Brazil, GPI ran into two main issues.  One, they could not make additional acquisitions in Brazil it if they did not accept existing liabilities in deals related to tax/employees, and (2) the exchange rate kept deteriorating.  Due to these factors, GPI divested their Brazilian operations in July 2022 for slightly less than $100mm (4-5% of current market cap [at time of writing in October 2022]) and can now re-deploy that capital towards better uses.”

…And re-deploy the Brazil capital they did - helping to increase their already large 2022 share repurchase (~18% of total shares repurchased in ‘22). Most of these shares were repurchased at ~4x next-twelve-months (peak) earnings.

One of the unique items about GPI is that they utilize interest rate swaps to hedge the floorplan debt interest rate risk. The swaps mean that ~65% of their total debt is effectively fixed. GPI has done this for many years, which seems very prudent for a business with lots of floating rate interest.

Regarding management, Daryl Kenningham, former President of U.S. Operations since 2017, became CEO after Hesterberg’s retirement at the end of last year. Not much seems to have changed, with both Kenningham and Hesterberg having similar operational backgrounds. Kenningham does seem to have a slightly higher desire for acquisitions. We’ll see if GPI’s capital allocation discipline can be maintained going forward.

Share

Penske Automotive Group (PAG) - “The Well-Run Diversified Dealership”

Penske Automotive Group is one of the larger Penske Corporation’s non-fully owned subsidiaries (they own ~51% of PAG). Penske Corporation is the holding company for billionaire and former race car driver, Roger Penske.

PAG is different from the other public auto dealerships, both in their auto dealership mix and by also owning non-auto dealership businesses.

First, their auto dealership mix has a much higher non-US mix and is heavily weighted towards the Premium/Luxury segment. To put numbers behind this, PAG generates 58% of their revenue from the U.S., with the other 42% coming from outside of the U.S. (primarily from the UK). Additionally, ~70% of revenue is from Premium/Luxury brands such as Audi, BMW, Land Rover, Mercedes-Benz, and Porsche. And in the UK, 93% of unit sales are attributable to Premium/Luxury. As an interesting note, PAG has 35% of Ferrari sales market share in the UK.

Second, PAG owns a few other businesses outside of auto dealerships. The two other major business lines are (1) Penske Premier Truck Group - truck dealerships for medium-to-heavy duty semi-trucks and (2) Penske Truck Leasing - lessor of semi-trucks, managing a fleet of 400k+ trucks/tractors/trailers.

Trucking represents 35% of PAG profitability, while auto represents the other 65%. The truck business is an interesting with a very large service component, along with strong monopoly-like competitive advantages.

Commercial truck business commentary from a November 2021 conference:

• Seeing multiples in the 6-6.5x range versus auto dealers in the 8-10x range

  • Currently “better return on capital” than auto dealer acquisitions

  • Generate 60-70% of gross profit on truck side via repairs and services

• Also less capital intensive since do not need to build fancy dealerships

  • “just a big … truck box out along an interstate somewhere”

• More of a monopoly than auto dealers

  • “the difference between a truck dealership and a car dealership is if you're in a given area and you have a car dealership, you may see 3 or 4 different Toyota stores, and they're all going to be owned by somebody else, right? You're not going to dominate or have one market where you own all the stores in the marketplace. On the truck side, we own Dallas. We own Kansas City for that brand. …so they give you these big markets instead of just one store in a given market.”

PAG also owns a few other small businesses including a growing used car business called CarShop. They have done well with this diversified approach, providing themselves more areas to allocate capital - especially via acquisition. Despite this, they have also intelligently repurchased shares at appropriate times.

Commentary on share repurchases vs. acquisitions at November 2021 conference:

“But in most cases, we don't want to pay for a dealership there more than what our stock is trading at. We've got the different alternatives. And if we can buy back stock at a lower rate than it takes to invest in store, it just makes more sense to us.”

Overall, PAG is a very well run diversified operation.

Lithia (LAD) - “The Highly-Aggressive Acquisition Machine”

After the Financial Crisis, Lithia completely transformed their business operations and capital allocation. This transformation occurred when founder, Sydney DeBoer transitioned the CEO role to his son Bryan DeBoer in 2012.

First, the business was morphed into a much leaner organization - often running at the lowest SG&A/gross profit in the industry (a common cost measurement KPI for auto dealers). Although tough to tell as an outsider, Chris Holzshu, current Chief Operating Officer, seemed to be the force behind the operational/cost change. On quarterly earnings calls, he has usually been deferred to on anything concerning operational efficiently, cutting costs, etc.

Second, the LAD team applied the same approach and turned into an aggressive acquirer of dealerships, many of them underperforming. LAD would cut costs, and apply best practices in a private equity like approach to these acquisitions. LAD was extremely effective at this strategy and mentioned in 2020 that they achieved 25% rates of return historically on these underperforming acquisitions.

The combination of better-run legacy operations and lots of revenue acquired at cheap pro forma earnings created an earnings growth machine. From 2006-2019, Normalized EPS grew at 14.6% per year - the best among the public auto dealers.

In 2020, LAD transformed from an aggressive acquirer to an ultra-aggressive acquirer, announcing a 5-year plan to reach $50bn in revenue by 2025. To achieve this goal, LAD could no longer buy only small underperforming assets - they needed to acquire much larger dealership groups, many of them high performing.

They admitted as much in their 3Q20 earnings call that their return thresholds will have to be reduced in order to achieve that growth:

Bryan DeBoer (CEO) - “Now when we think about the 5-year plan to grow at $4 billion annually for an aggregate of $20 billion … we really look at that our typical strategy of buying value-based strong assets that aren't really performing at the strong level, we're only going to be able to buy about $1 billion to $1.5 billion of that, which is our traditional model levels of growth, okay? So about 3/4 of the future growth will come from these … type of acquisitions that are better performers.

So the return dynamics still will be over the 15% after-tax return thresholds. Because doing the value type investing, we've achieved over 25% after-tax returns over the last 10 years. And there's some -- we have the ability to still be able to do that while buying a lot better acquisitions that are much easier to integrate and have a much higher probability of success.”

To fund some of this growth, Lithia also issued ~$2bn of additional stock over 2020-2021, increasing shares outstanding by 25%+. Diluting shareholders is not typical behavior of shrewd capital allocators but, admittedly, the 2021 stock issuance was at a $322/share, a price above where they stock trades today.

LAD also ventured into a few additional areas:

1. Driveway

   1. Driveway is LAD’s online, used car platform. However, it differs from Carvana and other online-only sellers in that the existing LAD dealership network can fulfill most of the required functions. Mentioned in a special investor call in 2021 on Driveway that LAD only uses 25% of storage capacity and 50% of reconditioning capacity. This means no incremental infrastructure capex is required besides some additional technology costs.

   2. Due to the above, Driveway (and other traditional dealerships), can use these online selling platforms to sell used cars with advantages versus the online-only players. Little additional infrastructure capex, combined with lower vehicle sourcing costs from their existing new dealership network allow for powerful advantages.

2. Driveway Finance

   1. As discussed, most auto dealers simply take a commission for connecting consumers with finance providers. Driveway Finance is Lithia acting as a direct lender option to consumers, funding the loans themselves. Driveway Finance then bundles those loans and securitizes them for sale.

   2. Lithia believes by directly lending this is the higher profitability path, as opposed to a pure commission finance model. This operation has only been active for a few years and remains to be seen how it does in the long-run.

3. International Acquisitions

   1. In addition to aggressively pursuing in the U.S., they are also looking internationally. LAD announced the acquisition of Canadian-based Pfaff Automotive in 2021. In 2023, LAD expanded into the U.K., by acquiring two large dealership groups (Jardine Matheson and Pendragon).

4. Non-Auto Dealership Acquisitions

   1. Lithia is attempting to do some of what Penske has done by expanding outside of only owning auto dealerships. Lithia seems to want to grow into even more niches than Penske and have mentioned selling anything from RV’s to agricultural vehicles.

Lithia is attempting to achieve much all at once - not an easy feat. There is no doubt that their historical track record of acquiring underperforming auto dealerships is second-to-none but they are now venturing in new directions. If they can pull off all their grand visions, future performance will likely be a Grand Slam. Regardless, Lithia’s story will be an interesting one to watch unfold over the next 5-10 years.

Asbury (ABG) - “The Aggressive, High Quality Dealership Group”

Asbury dealerships are mainly located in the southern and western U.S., in better demographic areas. Similar to Lithia, transformed over the last 15-20 years. The transformation began during the 2008-2009 recession and continued when the then CFO, Craig Monaghan became CEO in 2011 (joined ABG as CFO in 2008). At a 2012 investor conference, Monaghan details the 2008-2012 years well:

“If you would take us into a 2008 timeframe, you would have seen a company at that point that was really run as a holding company. We had six regional platforms and each of those six platforms was very much an independent entity making its own technology decisions, its own marketing decisions, had its own personnel philosophies and it was a holding company that was located, the headquarters was in New York City managing this group of companies. So here we are at that time we were sitting in New York City, we were managing the six different platforms, relatively heavily indebted and the recession hit.

Recession hit and it hit us hard…and we actually got [a going] concern opinion from auditors caused a number of covenant issues for us and really forced us to step up and make some hard decisions….there were some severe cutbacks in the way we were spending our capital. We became a much smaller company. We left New York City and moved to a suburb of Atlanta and really went through some pretty draconian changes.

And today I would tell you that we are a very, very different company from what we were just 12 to 18 months ago…We had a heavy-duty truck business, we sold it. Over the past 12 to 18 months we have paid down over a $100 million worth of debt. We have been very aggressive in buying back leased properties [at double-digit effective rates]. We have begun to buy back our shares…and we have worked very hard to get our stores on common technology platforms. A lot of our stores are now on a common CRM, all of our stores are on common set of websites. If you pull it all together, we have gotten to the point that now as we start 2012 again, as a very different entity, for us it is really the first time that we are going to be able to go on the offensive…

So our balance sheet is in great shape. Our leverage is less than three times….We are sitting on excess cash, we just wrapped up a $900 million refinancing, had tremendous financial flexibility to pursue opportunities... We have got a new senior management team in place. …And we have also got a new operating structure in place at our stores. We do not a run at six platforms anymore. Those have all been eliminated. We run as a single enterprise today, common systems across all the stores.

…We have got standard processes, which is creating the groundwork for us to now start to move to shared services. Our strategy is, it’s really pretty straightforward. We want to continue to drive operational excellence. We feel like we are on a path to become a best-in-class operator. We are going to continue to work to maximize the returns on our portfolio [of dealers].

We feel very good about our portfolio, but it is a portfolio that we are constantly fine-tuning. I will tell you that just this past year, we sold a store that we felt we got an extremely good price for. About a year ago, we bought five stores in a package transaction that we are very thrilled with the improvement in performance that we have been able to bring to those stores. But we will deploy capital where we get the greatest returns and… that could be buying stores, but more recently most of our capital has been targeted to paying down debt, buying back leases and buying back stock. I would tell you that 2012 there will also be a heavy reinvestment in …a number of the stores that will we refurbished and we will continue with some of this technology [investment].”

After that 2012 quote, Monaghan continued to improve the operations of the company, allowing ABG to achieve some of the best cost efficiency metrics in many years.

Monaghan not only greatly improved the operations of the company, he also allocated capital intelligently. He was able to both reduce the share count by 1/3+ over his tenure, while also adding revenue via acquisition, and making intelligent lease buy-outs.

In 2018, David Hult (current CEO; was COO since 2014) took over for Monaghan. Hult seems to emphasize acquisitions more, and they are mainly larger, high-quality dealership groups. Hult’s pattern has been to do a large acquisition and then use most/all cash flow to deleverage the acquisition debt. Following this pattern, ABG recently completed the acquisition of Jim Koons Automotive Companies in December 2023. Jim Koons is the 9th largest private dealership groups in the U.S. and generates the 10th highest revenue per dealership in the U.S. Post-acquisition, ABG will do more of the same, using cash flow to deleverage.

In the murky post-COVID world of dealership margins, ABG has likely transformed their margin profile due to these high-quality acquisitions. ABG’s CFO commented on this during their 1Q22 call:

“And everyone keeps referring to 2019, and I brought this up a few times. I'll bring it up again. We will never see 2018 margins again in our company. We're a different company, not because of our size, but because of the accretive acquisitions that we've done. We sold off all of Mississippi, which was our lowest margin platform. And we've increased through Park Place, LHM and Stevenson, [acquisitions] all of them are accretive in margins to where we were in '19. We're also, from a productivity standpoint, under the legacy Asbury stores alone, it hasn't been integrated in any acquisitions yet. But from a productivity standpoint, from 2019, we've had a 50% increase on the variable side for production per employee for sales advisers.”

Similar to LAD, ABG has a 2025 growth plan. The plan (as shown below) has ABG growing from $8bn of revenue in 2020 to $32bn in 2025. While they have commented that the acquisition target is achievable, achieving the same store sales growth and Clicklane targets might be difficult in two years time. Clicklane is ABG’s online selling platform.

Again, similar to LAD, ABG issued $650mm+ in stock in late 2021 to help fuel this growth plan. The stock was issued at $182 per share, roughly 10% below where ABG trades today.

Overall, ABG is a very well run business that owns/acquires very high quality dealerships. In some ways, ABG can be viewed as a “cleaner” version of LAD - an aggressive acquirer but without all of LAD’s extra acquisition activity.

Sonic (SAH) - “The Chronic Underperformer”

Sonic has been the laggard of the public auto dealerships. SAH is controlled by the Smith family, with David Bruton Smith, acting as Chairman & CEO. The company has a two-class share structure with the Class B shares retaining 10-to-1 voting rights. Class B is held by a variety of Smith family members, thus the ability to control the vote.

Pre-COVID their earnings per share increased marginally from 2006-2019, hurt by stock issuances and weakening EBIT margins.

Outside of their new car dealerships, they also operate a used-only concept called EchoPark. EchoPark is now 52 stores and SAH’s end goal is to reach 90% coverage of U.S. population. In 3Q23, SAH suspended EchoPark operations at 50% of locations, helping them lower adjusted EBITDA losses from $32mm to $5mm. SAH said this partial shutdown allowed to them to better allocate inventory / better fill stores.

In recent years, they have shown more willingness to repurchase stock. However, as both capital allocators and operators, they still have a lot to prove.

8.) Summary

1. New car dealerships are a low-to-no growth businesses, most likely growing at population growth rates for the regions they serve.

2. Despite most profits being generated by car sales, dealership’s actual profits generated mainly by parts/service and finance/insurance business.

3. Defensive business model created by highly variable cost structure and gross margin mix that is ~50% derived from the resilient parts/service business.

4. Asset-light business model due to ability to floorplan inventory and limited receivables. Creates no net working capital need, allowing most profits to flow to shareholders. Does create some interest rate risk operating with variable rate floorplan - although some dealers choose to hedge out that risk.

5. Capital allocation in the industry has historically been strong. Since the early-2000’s auto dealership management teams have begun to understand the power of share repurchases when undervalued. Given that the industry is highly revenue cyclical and low-growth, can trade at oddly low valuations at times. With dealerships able to sustain profitability during recessions, this creates compelling moments to repurchase large amounts of stock.

Share

Disclosure: I/we might hold shares in any of the companies mentioned. I may buy more or sell my position at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Below are some of the more interesting excerpts from Warren Buffett’s chapter. Among the topics discussed are commodities, Henry Singleton, and his opinions on certain industries.

Share

On the ideal business:

“The few business that Buffett thinks are worth owning…often fall into the category he calls “gross profits royalty” companies, perhaps better called “gross revenues royalty” companies: TV stations, international advertising agencies, iron-ore landholding companies, newspapers. Benefitting directly from the large capital investments of the companies they service, they require little working capital to operate and, in fact, pour off cash to their owners. The unfortunate capital intensive producer-Chrysler , Monsanto, or International Harvester-can’t bring its wares to its customers’ notice without paying tribute to the “royalty holder”: The Wall Street Journal, J. Walter Thompson, the local TV station, or all three.

“Other valid franchises Buffett likes include the large insurance brokerage agencies and some specialized ad hoc situations such as Sperry and Hutchinson Green Stamps, but there aren’t many that have both a substantial and well-secured niche.”

On the qualities an investor needs to be successful:

“Buffett thinks to succeed as an investor you must have six qualities:

1- “You must be animated by controlled greed, and fascinated by the investment process.”

2- “You must have patience”

3- “You must think independently”

4- “You must have the security and self-confidence that comes from knowledge, without being rash or headstrong”

5- “Accept it when you don’t know something”

6- “Be flexible as to the types of businesses you buy, but never pay more than the business is worth” [He also adds…] “Calculate what the business is worth now and what it will be worth in due course. Then ask yourself, ‘How sure am I?’. Nine times out of ten you can’t be [sure]. Sometimes, though, the bell rings and you can almost hear the cash register.”

On valuation:

“Buffett won’t pay a high multiple of earnings. Specifically he feels the earnings yield should be as high as the prevailing bond yield.”

“Buffett has a theory that the Dow Jones [Index] is worth one times book value if you expect Treasury Bills to yield an average of 11% in the future, 1.3% if your expectation is that they will yield an average of 8.5% and close to twice book if you expect 5%.”

[Note: as the first quote mentioned, he’s effectively aligning the Dow Jones earnings yield to equal the Treasury Bill rate. This also follows with Buffett’s 1977 article he wrote for Fortune entitled "How Inflation Swindles the Equity Investor". In that article he mentions how American business has averaged a 12% return on equity over long periods of time. His math above seems to assume a 11% return on equity - close to the 12%.]

On how he thinks about managers:

“In discussing qualifications for business managers, Buffett grinned and recommended a one-line employment form: “Are you a fanatic?” A manager must care intensely about running a first-class operation; if his golf game is what he things about while shaving the business will show it. A good manager should be a demon on costs. He need not have fancy data processing equipment, or even a budget: he should know his costs, down to how many stamps he uses. Buffett mentioned Peter Kiewit, regarded as the leading businessman in Omaha, whose company may be the most successful construction firm in the world. There are no carpets in the executive offices, no consultants, and the bosses are there on Saturday.”

On Henry Singleton:

“Buffett considers that Henry Singleton of Teledyne has the best operating and capital deployment record in American business. When I asked if he did not consider Tom Murphy of Capital Cities to be equally outstanding, Buffett smiled and said, “Well, Murph plays a simpler game,” but added that part of great business ability is to get into simple games. Singleton’s return on assets, calculated in the way that Buffett likes to do it (inventory plus fixed assets), is unique. All four major industry groups in Teledyne are in fully competitive areas; none has a special protected niche; and yet all four earn 50% on assets. The company earns $250 million after tax, with very conservative accounting.”

“Singleton bought 130 business for ‘Chinese paper',’ as it used to be called, when his stock was riding high. Then when the market, and his stock, fell he reversed field and in the last eight years hadn’t acquired a single company; on the contrary, by buying his stock back he has shrunk his capital from 40 million shares to 12 million.”

“According to Buffett, if one took the top 100 business school graduates and made a composite of their triumphs, their record would not be as good as that of Singleton, who incidentally was trained as a scientist, not an MBA. The failure of business schools to study men like Singleton is a crime, he says. Instead they insist on holding up as models executives from a McKinsey & Company cookie cutter.”

On the Wall Street Journal as a business:

“Buffett considers the Wall Street Journal one of the most perfect business franchises, one you probably could not duplicate for a billion dollars. … The most profitable publication in the country, the [WSJ] offers a product for which many users would gladly pay double the price. Both advertisers and readers get a bargain, while required capital investment to support growth is minimal.

“Bernard Kilgore made the discovery that a newspapers is as good as its own city. The only problem was that all the cities were taken. So he created his own, the community of business readers, block by block. His city is a demographic dream, with no slums, and its readers have a vast buying capability.”

On advertising agencies as a royalty business:

“The perfect business is a royalty on the sales of a major company, as distinct from its net profits. One example is the big international advertising agencies, which net 1% or so after-tax on their client’s advertising expenditures, and often 5% or so on their own revenues. The clients, not the agencies, invest the capital to build those sales.”

“There are few big international agencies, and there will be fewer new ones, since it’s getting harder and harder to break into the club. At this point a J. Walter Thompson controls so much business that it can just buy an agency in a new territory that becomes interesting, such as Brazil or the Middle East. A smaller agency would have trouble making a competitive offer.”

“A local advertising agency is quite another matter. Buffett would not buy a share in a brain surgeon, but in the Mayo Clinic, yes, it’s become institutionalized.”

“Interpublic and Ogilvy & Mather, two of the top five or six agencies worldwide are to him the most interesting of them as investments. In 1974 Interpublic sold at less than two times pre-tax earnings per share, and half of the market price of its tangible assets, although this unique enterprise represents a well-earned royalty on the gross income of Exxon , Carnation, Buick, and Chevrolet . Small agencies at that time were being bought at perhaps three times that price. In a way, the situation was actually better than in 1932, since by 1974 it was quite clear that the companies themselves would not fall apart.”

On the television business:

“Broadcasting companies enjoy superb growth and provide cascades of cash. As a result they have maintained strong values in purchases by private buyers. (Buffett thinks it might be an interesting idea to buy a TV station in partnership form, so that one could duck the corporate tax.)”

“Their stock market values are another story. In 1974, Capital Cities was appraised by the stock market for $125 million but was worth at least three times that. Capital Cities’ only problem is the pleasant one of what to do with all its excess cash. Buffett felt it should buy its own stock.”

“Television stations are not entirely without risk as investments. In theory, the government can fail to renew a license, although in practice that almost never happens. Regulation and new technology could change the economics of broadcasting. But at present the arithmetic of television stations is astonishing: they often net 50% on sales, have no need for working capital, have only minor fixed assets, and no inventories except for a supply of movies, which can be bought on credit. Buffett bought a major television station in Dayton, Ohio for Grinnell College, of which he is a trustee. The purchase price in 1976 was $12.9 million; it’s probably worth more than double that now.”

On his failures investing in retailers:

“Buffett’s worst investments have been in retailing (including trading stamps), a field he says he never has really understood. In addition to investment losses on several retailing securities, his negotiated purchase of Hochschild Kohn, a Baltimore department store, has proved a dud. Figures and close observation are not enough: you need a special flair to understand what’s going on in that field. A store can report good figures year after year and then, as Buffett learned the hard way, suddenly go bankrupt.”

On commodities speculation:

“…[Buffett] says that one sometimes can analyze the long-term price outlook for a nonagricultural commodity, notably a metal. If the price gets way below production costs for an indispensable metal, it must eventually recover. But the prices of agricultural commodities are subject to weather and other vagaries of nature; investing in them becomes a matter of flair. Since he depends on analysis for success, Buffett will never invest in an agricultural commodity.”

“In twenty years he has engaged in two commodities transactions recently in copper and, some years ago, before the price was freed by the government, in silver futures. Every time President Johnson announced that the price of silver would never rise, Buffett went out and bought more. In his copper speculation he bought a large position at 56 cents per pound, since, though the above-ground stock of the metal was enormous, many mines were closing down and eventually the price would have to go up. …”

“He finds ownership of actual metal far safer than ownership of a mining company . A Kennecott, for example, spends hundreds of millions of dollars to dig a hole and sell copper. Then it reinvests much of its profits in more and more development and facilities. Eventually the consumers have gotten all the copper and Kennecott is left with the hole. In theory this can be profitable; in practice, lots goes wrong.”

Outside of the Buffett chapter, at the end of the book, John Train compares all the “master” investors profiled in the book. He said they all seem to have five traits in common:

“1- Realistic”

“2- Intelligent to the point of genius; or else [is…see #3]”

“3- Utterly dedicated to their craft”

“4- Disciplined and patient”

“5- A loner”

Disclosure: Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here.

Share

Combs’ intro is only 17 pages, but he gives a unique overview of his research process. Although it reinforces many ideas, his section is one of the more interesting things I’ve read regarding investment process.

Below are select quotes that were particularly interesting. I recommend buying the book and reading the section in its entirety - I do not do it full justice with just the quotes below.

Share

On the goal of an investor:
“When done well, investing involves learning how to process information in order to determine when the odds are in your favor; the goal is to make educated bets based on facts and not stories. In investing and in life for that matter, you can’t choose outcomes, but you can choose the decisions that may get you the outcomes you want.”

On how hard work is required to get to “simple”
“In attempting to value companies over my career, I’ve come to appreciate that the difference between a good analyst and a great one lies in the ability to keep things simple and determine what matters the most. People misinterpret this to mean that investors should keep things at the surface level. In fact, it paradoxically takes a great deal of depth to stay simple. The analyst’s job is to tear apart an investment in order to understand its essential elements. A great security analyst is willing to rip a company down to its studs and understand each part before they reassemble it. In the massive sea of information that an analyst is continuously digesting, there is always one piece that matters more than the others. Find that morsel is what keeping it simple means.”

On the three investment research buckets:
“Because finding simplicity can be complicated, I break down my process into three buckets - find a good business, with good management, at a good valuation. You don’t need or expect to find all three of these to the same degree in every investment; there can be a sliding scale with puts and takes. Nonetheless, all three must be present. Think of it as a multiplicative series where a zero in any of the cells will yield a zero overall regardless of how the other elements may rate.”

On determining business quality from quantitative factors:
“In determining if a business is great, I like to start on the quantitative side: I focus on the balance sheet, accounting practices, and unit economics, and then turn to cash flow generation. Meanwhile the qualitative side involves reference calls to assess the quality of management and channel checks to reveal how a company products are selling in real time.”

On starting with facts instead of opinions:
“In seeking to determine intrinsic values, I like to start with the concept of working inside out versus outside in. Start with facts not opinions. If you start with opinions, it’s easy to become wedded to them even when the facts run counter to the popular narrative. Start with SEC filings, annual reports, and trade magazine articles - not with management or colleagues’ narratives or sell-side reports. The biggest mistake an analyst can make in the initial state of their research is to start their assessment by looking at earnings (or even worse, management’s presentation f adjusted earnings). When you look at these reported numbers, keep in mind that you’re not looking at completely objective facts so much as a management’s team’s perception of them. The income statement is a snapshot of what has recently transpired, and this snapshot may well have been photoshopped. I want to focus on process rather than outcomes, so starting with the income statement is putting the cart before the horse.”

On aggressive accounting practices:
“I find it interesting to take two very similar companies and align their accounting practices. When I compare such factors as their expensing versus capitalizing of expenses, gain on sale accounting versus long-term holding of mortgage securities, acquisition accounting practices, and balance sheet variances, I’m often flabbergasted at the difference. The point is that earnings are a by-product of many assumptions and choices made by management. The treatment of reserves, choice of a discount rate on contingent valuations, assumed pension returns, and method of funding lead to a result that can be either significantly overrated or underrated. The number of games that can be played here is almost limitless.”

On understanding the unit economics of a business:
“Just as you can drop a dollar of revenue or cost through the cash flow statement and balance sheet, you can do the same in replicating unit economics of the company. For example, looking at the earnings for Costco is one thing, examining the balance sheet another, but understanding the unit economics of an individual store is far more powerful than either of those. While the company doesn’t overtly disclose store-by-store unit economics, in the case of Costco we can use company disclosures to triangulate into the average cost to build a store. Then by estimating the approximate time to get to run rate revenues and margins, we can approximate the individual store ROI.

…American Tower was a breakeven business when it had an average of two tenants per cellphone tower, but adding a third tenant led to extremely attractive unit economics per tower and a compelling overall ROI. Similarly, Walmart did not generate earnings or cash flow for over a decade while they were growing, but a look at the store unit economics led to the true story and foreshadowed what the picture would look like in the future.”

Disclosure: Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Share

Brief History
The uniqueness of TYBT is directly attributable to its independent-mind founder, Jeff Harp. Harp was the former President of Summit National Bank before being let go in 2001. As a 2003 Dallas Business Journal article states:

“…Harp got his walking papers after the bank's directors decided they preferred Summit Bancshares chairman Phil Norwood's growth strategy to Harp's ‘Warren Buffett mentality’ of concentrating on service over size.”

After his departure, Harp had no trouble finding investors after deciding to start his own bank in Fort Worth called Trinity Bank. As one original investor stated:

"Summit was probably the most profitable bank in Fort Worth [when Harp was President] … When you've been an investor in a commercial bank that routinely earned 2% on assets and 20% on equity, it's really, where do I get in line?"

He ultimately raised ~$11mm from 258 investors, at $10 per share, and started Trinity Bank in May 2003. As of May 2023, the stock last traded at ~$88 per share, with TYBT returning >$12 per share in dividends over the years. This 10x return over the last 20 years is tough to beat within the banking industry - especially, given the losses many/most banks experienced during the 2008-2009 Financial Crisis. Not only did TYBT stay profitable during the Financial Crisis, they also never suffered a single loan loss during ‘08-’09.

Harp and team combined three main factors to produce that unbelievable performance: (1) low risk lending, (2) high service to customers, and (3) high operational efficiency.

(1a) Low Risk Lending - Credit Risk
TYBT is a business lender. They mainly focus on providing working capital and equipment financing loans to small and medium sized businesses. Thus, the collateral on these loans is typically inventory, equipment, accounts receivable, etc. Examples of customers include brick distributors, plumbing suppliers, steel fabricators, and lumber companies.

TYBT also provides owner-occupied commercial real estate loans to business owners but mostly stay away from investor-owned (non owner-occupied) commercial real estate unless an opportunity arises. As Harp said in a 2014 interview, in his typical plain-spoken manner:

“If you compared us to other banks our size, our 57% in commercial and industrial loans are about three times what the average bank is, and it’s just because that’s what I used to do, and I know how to do, and that’s kind of what we focus on.”

And, on being opportunistic in non-owner occupied commercial real estate:

“We tend to do very little investor real estate except during periods when other banks [are retreating] and we have the ability to select good projects to do with experienced customers who have a proven track record of good performance.”

As mentioned, the bank not only remained highly profitable throughout the Financial Crisis (>1% ROA in ‘08-’09), TYBT did not experience its first non-performing loan until 3Q2010 - seven years after the bank began operations. But, as Harp states in many of his quarterly shareholder letters:

“…they key is not to have zero problem loans.  If that is the case, a bank is not taking any risk and is not serving its customers (and ultimately, will not prosper).  They key is how much of your money do you get back when you make a mistake.  We will make some mistakes, but we will protect the bank while working to help good people through bad times.”

On that front, TYBT has succeeded. As the table below shows, their net charge-off rate, in most quarters over the past 10 years, has been zero. Meaning they have not experienced any loan losses. Most banks at least have some losses each quarter, so this result is highly unusual. Equally unusual, is that in many quarters, the net charge-off rate has been negative, due to TYBT recovering some of an already charged-off loan.

(1b) Low Risk Lending - Interest Rate Risk
In TYBT’s 1Q2021 shareholder letter, Harp stated (and this would have been prior to inflation/high rates being the “themes of the moment” - making his commentary even more impressive):

“In a low interest rate environment like the one we find ourselves in currently, it is important to remain focused on the interest rate risk we are taking. During periods of low interest rates, customers prefer to fix their rates as long as they can to lock in the lowest cost of funds possible. While we have made several fixed rate loans recently, we have been able to add rate adjustments to those loans which allows the bank to adjust to a market rate periodically throughout the term of the loan. This greatly assists in limiting the amount of interest rate risk your bank takes, especially during times like these.”

Regarding TYBT’s securities portfolio, they incurred unrealized losses as rates rose just like most banks. However, their portfolio’s losses are lower than the many Texas peers (see chart below).

If you were to assume Trinity sold its entire securities portfolio today and incurred the hit to capital, TYBT would still have a Tier 1 Leverage ratio >10%. Still higher than most banks in the U.S., before adjusting for their own securities losses.

(2) High Service
TYBT, like many business-focused lenders, does not seek to generate deposits if a longer-term relationship is not involved. They do not offer brokered CD’s, or pay the highest CD rates necessarily, attracting short-term customers. As Harp says, they want “people that are going to have money here when times are good and times are bad, not the kind of people that will move a CD because of a quarter of a point”. However, TYBT does seek to pay competitive rates, aiming to pay the highest they can while still generating high profitability for shareholders.

TYBT believes one of the competitive advantages they offer is high service to their their lending customers. With only 25 full-time employees, TYBT is able (and seeks) to respond with extreme quickness to customers. They believe speed and quality of service are the few ways they can differentiate themselves.

Harp stated in an February 2020 interview:
“It seems to me, there is and has been a lot of irrational pricing competition. We typically don’t try to match those rates even if we have to lose some business. We try to find people that understand that price is a component of value and an important component of value. But it’s not the only component, and that’s why we try to be responsive, flexible and creative when we go after a piece of business. That approach appeals to some people. And some people just want the cheapest rate they can get. That’s usually not somebody we’re going to pursue very hard.”

Additionally, Harp tells the story in one of this shareholder letters that after rolling out a new technology product, TYBT’s operations guy visited many of the bank’s larger relationships to make sure they thoroughly understood how to use the new tech. That is a very high level of service that few banks can match.

(3) High Operational Efficiency
TYBT’s high operational efficiency creates a low cost structure. When I wrote last year about FFD Financial (FFDF), I mentioned how they have a local cost structure advantage because they have more deposits per branch than their local competitors. But I also mentioned that many more extreme examples exist of bank’s with high deposits/assets per branch.

TYBT is one of those extreme examples, operating only one branch with $400mm in deposits. Looking at employees, TYBT has $18mm of assets per full-time employee - ranking them #8 of 332, by that metric, against all Texas banks with <$2bn in assets (top ~3%). And, although not the perfect comparison, TYBT even exceeds most of the largest banks in the U.S. on assets per FTE ( ).

Besides not needing to spend money on additional branch infrastructure/employees, TYBT focuses on fewer, larger customers and therefore, provides fewer, larger loans. This means they need less lenders and loan administrative employees. The combination of less occupancy and employee expenses means TYBT’s overall overhead, as a percent of their assets, is much below their peers (as shown in the table below).

Ultimately, this cost advantage is so large it drives 100% of the differential in Return on Assets (“ROA”) that TYBT achieves versus peers (see below table). This ROA differential would be even more extreme if you included a “normalized” loan loss provision, since TYBT should experience much lower losses over a full economic cycle than peers.

Management
Between the statistical track record and highly rational mindset, it is easy to see that Jeff Harp and his management team are simply outstanding. TYBT’s quarterly shareholder letters are a tour de force in proper banking. The final quote I’ll include sums up management’s overall operational strategy (from 2Q2021 shareholder letter - again, well before rising rates occurred):

“There are only two ways (other than fraud) to mess up a bank –an interest rate mismatch (maybe 5% [of bank failures]) in a rising rate environment or loan losses (95%). We can’t predict interest rates so we just try to make sure that we avoid problems in a falling, flat, or rising rate environment. As far as loan losses are concerned, our track record is very good. We avoid concentrations. We focus on developing long-term relationships with quality people, not transactions. And we work with good people through bad times. We are not perfect, but we wouldn’t trade places with anyone. Finally, we spent nearly 14 years (57 quarters to be exact) with operating earnings increasing faster than operating expenses. We have spent the better part of three years building a base for future growth. We have added people, operating systems, and increased the size of our physical facility. Most of that investment is behind us. Going forward, we are in a position to grow operating income faster than operating expense. That is our main focus. We have begun to see good results and we are willing to be held accountable for that statistic.

Important to note that Harp is in his 70’s and is no longer CEO but remains an active Chairman. Outside of Harp, three additional people are in the management team. Matt Opitz took over as CEO at the end of 2019. Opitz is a former banker from Frost Bank, another strong Texas bank, and joined TYBT in 2018. Barney Wiley, with Trinity Bank since its 2003 founding, is now President. And Richard Burt, also at TYBT since the beginning, is Chief Operating Officer, overseeing IT, compliance, accounting, reporting, and security.

Overall, the management team seems very strong, with Opitz being of the “Jeff Harp mold”. In the past, Harp and team have quickly let go of lenders that did not meet Trinity’s standards. With Opitz not only lasting but being anointed CEO, I think that speaks volumes.

Valuation
***Note: Before discussing TYBT’s valuation, two items to note. One, given the declines in bank stock prices since March, TYBT is unlikely to be the best performing bank stock over the next five years (at least at current prices). Two, TYBT’s stock is highly illiquid. The last transaction in its stock was ~4 months ago in January. Despite those two factors, I think TYBT is worth watching. When markets go thru some future extreme stress, liquidity might “unlock” in TYBT’s stock as investors sell at much lower prices. If that environment occurs, both TYBT’s valuation and liquidity issues might be solved simultaneously.***

The two main factors for valuing any bank are future normalized return on assets and future asset growth.

With one exception, I would expect TYBT’s future normalized ROA to look fairly similar to its 1Q23 results (see “ROA Breakdown” table above). The exception being that over an economic cycle, I estimate loan losses likely average ~0.2% - if history serves as a rough guide. Adjusting for implies TYBT averaging an after-tax ~1.6% normalized ROA.

The second major valuation factor is asset growth. TYBT’s deposit growth was 8% annualized from 2007 to 2019 and 9% annualized from 2013-2019 (excluding COVID years since extreme, one-time deposit growth occurred). Since deposits fuel most of a bank’s assets, TYBT’s annualized growth equaled those 8-9% figures.

TYBT mainly benefitted (and still benefits) from operating in the highly attractive market of Fort Worth, Texas. No state taxes, high population growth, and overall good demographics fuels a very strong local economy and therefore bank deposit growth. TYBT has roughly maintained their deposit market share in Fort Worth over the past 10 years, meaning the overall market growth was also 8-9% annualized. Nationwide most banks grew assets at 4-5% per year.

Applying a 1.6% ROA to TYBT assets growing at a (wide) range of 4%-9% annualized over the next five years produces roughly $175-$215 per share (high-teens IRR). Those per share figures include the excess earnings available for distribution, meaning dividends (the other portion of earnings, “required capital”, will need to be retained to support TYBT’s asset growth). The valuation figures also assume, like other top-performing banks (due mainly to high ROEs and lower-risk models = lower cyclicality) TYBT should be valued at ~20x earnings. Of course, not many banks are highly valued today but, eventually the environment “normalizes”.

We’ll see if the future ever offers higher liquidity and an even larger expected return for this one-of-a-kind bank.

For reference, TYBT shareholder letters can be found here: https://www.trinitybk.com/about-us/investor-information/

Disclosure: Nothing stated in this article is investment advice. Do you your own due diligence. I/we may own shares of TYBT in the future. Note, again, that TYBT shares are highly illiquid and any investment should be viewed more as buying into a private company. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Share

As background, the Nifty Fifty was a group of ~50 U.S. stocks during the late-60’s/early-70’s. The group mainly consisted of large-cap, high-growth companies, with long records of dividend increases. They were often called “one decision stocks” as investors believed their prospects were so promising, you could buy and hold them forever.

Obviously with that investor mindset, things eventually were taken to an extreme. The valuations of the Nifty Fifty were ultimately pushed up to very high levels (~42x average P/E) and ultimately peaked in price around December 1972. Over the ensuing mid-70’s market declines, the Nifty Fifty declined dramatically along with the rest of the market. Many pointed to their decline as proving that the Nifty Fifty was just another bubble.

But Siegel argues there is more to the story. In his analysis (see table below), he shows the Nifty Fifty’s returns from their approximate peak in December 1972 to August 1998. Despite their much higher 41.9x average P/E at their peak, versus the S&P 500’s 18.9x, the Nifty Fifty’s stock performance roughly approximated that of the S&P 500’s (about 12-13% for each). The Nifty Fifty was able to achieve this mainly via higher earning growth over those 26 years (11% for average Nifty Fifty vs. 8% for S&P 500).

I think this stresses the importance of understanding two things in investment analysis: (1) the durability of a competitive advantage, and (2) the growth runway.

Using the Nifty Fifty list as an example, for most of those companies, assessing their competitive positions and growth runways over the next few decades would have been nearly impossible. To name a few, assessing IBM, Eli Lilly, or Xerox would have been tough in their high change industries. However, for a select few companies in lower change industries, it is conceivable that an investor could have achieved high confidence in the two stated categories.

I’d argue that three of the top five performers, Phillip Morris/Gillette/Coca-Cola, would be among the select few where confidence possibly could have been gained. All three had unbelievable brand power, leading to pricing power and an investor might have realized consumers were very likely to continue to smoke the same brand cigarette, shave with the same brand razor, and drink the same brand cola.

My final point is I’m not advocating paying 40x for every seemingly high quality business. Simply, value investors (myself included), tend to be leered in by statistical cheapness and are quick to disregard companies that are relatively highly valued on their current results. I would argue that investors need to pay just as much attention (if not more) to the durability and future growth potential of a business.

Just some quick thoughts on a Friday afternoon. And hopefully writing this continues to reinforce - in my value investor brain - the importance of business quality.

The first podcast series on 50x discusses TransDigm (NYSE: ) and founder Nick Howley who has produced a 37% IRR from 1993-2021 running TDG. Incredibly TDG has done 52 acquisitions and has lost money on zero of them. Even more incredibly, Howley believes TDG has achieved a private-equity like return (20%+ IRR) on all 52 of them.

TDG primarily designs and produces parts for airplanes. Specifically, Howley created a strategy where TDG has grown by acquiring (1) companies producing low cost / high value parts where they are “sole supplier” (monopoly) of that part, (2) they own the intellectual property for making the part, and (3) the part has a significant aftermarket (allows TDG to make money on high-margin replacement parts). This is a powerful combination where TDG is selling a monopoly part that might only cost a few thousand dollars but is incredibly important to both building and maintaining the airplane. Meaning, the buyer is less price sensitive creating lots of pricing power.

The podcast interviews TDG founder Nick Howley and he comes across as a practical, no-nonsense guy with a very clear, engineering-like mindset. He has a clear view on what TDG is looking for in an acquisition target and on how to operate the acquired assets. For example, he states, what might be obvious, that the only way to create value (increasing earnings) for TDG is to (1) increase prices, (2) decreases costs, or (3) find new business. He says if a TDG employee is not working on one of the above then they should not be employed with the company. An obvious statement but he has built this simple focus into the company culture very effectively. And with this very rational view TDG operates a very light headquarters with only 25-30 employees and therefore allow the subsidiaries an extreme amount of autonomy.

The other interviewee on the podcast is Rob Small, an investor from the private-equity firm Berkshire Partners and its affiliated hedge fund Stockbridge. He reinforces many things that Howley says but provides a different perspective on the company as well as some additional insights into how Howley operates. Not surprisingly, he stresses how disciplined and hard working Howley is. He also mentions how Howley has an unusual ability to focus on the controllable variables. They discuss hard economic times for the aerospace industry (9/11, Financial Crisis, COVID) and how quickly Howley was to cut costs when he realized a downturn was occurring.

The extremely good outcome at TDG seems to be what happens when you combine a GREAT sub-industry focus, with a GREAT operator, with GREAT capital allocation abilities. It is rare that a CEO could be rated among the best operators and capital allocators, and Howley seems to be one of the rare ones. He reminds me a lot of Hunter Harrison, who completely transformed the railroad industry with his precision-scheduled railroading strategy and also showed an amazing ability to allocate capital wisely.

The entire podcast is long, running about five hours. For those of you interested in the finer details, I’d recommend listening. But if you do not have the time, my notes are below with some of the finer details.

TDG notes from 50x podcast:

• 28^th anniversary of TDG in 2022

  • IRR 1993-2021 = 37% CAGR

    • First 13 years was owned by 3 PE investors – 37% IRR

    • Remainder 15 years, publicly owned – 37% IRR

      • Outperformed peer group by 9x

• Nick Howley, for most of his life, wanted to own a niche manufacturing company

  • Dad owned a manufacturing company

  • Throughout high school and college worked a variety of jobs – from top to bottom

  • Went to Drexel and played football

    • Engineering major

    • Then went to Harvard Business School

  • Worked for Raytheon and eventually a niche manufacturing business

  • Also did some not so successful entrepreneurial businesses

• Original transaction that effectively started TDG

  • EBITDA = $9-10mm on purchase price = $55mm (5-6x EBITDA multiple)

  • $25mm equity

  • Four small businesses in niche manufacturing

    • Commercial and defense businesses were down

      • Defense spending moved down due to post-Cold War era

  • Goals

    • Get costs in-line

    • Shut down unnecessary business lines

    • Wait for business to recover, then sell

  • Over next five years when Kelso (private equity firm) was owner

    • 5x growth in cash flow

  • Capital allocation

    • just did debt pay down during this period

    • And pure organic growth

• Result

  • Ended up selling at $450mm and 10-11x EBITDA multiple

  • Sold to Odyssey (private equity firm)

• After Odyssey Acquisition

  • Started to do acquisitions – buying 8-9 businesses over next 4-5 years

  • In the beginning Nick Howley would act as CEO, for new acquisitions, for the first 6 months or so

  • Marathon acquisition

    • Realized they misjudged the organic growth in this business

      • Admits that they made the mistake of not doing enough work on it to realize this

      • Due to the above, they stripped a significant amount of costs from business to get the returns, which made the transaction successful

  • Adams-Wright acquisition

    • Largest manufacturer of airplane faucets

    • Took 20% of the costs out in a 2-month period

      • Mostly people costs – many doing things that did not create value

      • Went thru all the products on pricing structure – had done a lot of work on this as part of their due diligence pre-acquisition

    • Increased prices in aftermarket

      • Margin increased from 12% to 28%

  • Champion acquisitions

    • Large buy at the time and had to lever up to do it

    • 9/11 hit just afterward

    • Replaced most of management in first 3 months

    • Took 20-25% costs out

    • Substantial adjustment in product prices

    • Removed half of new development costs that were unlikely to work

    • Corporate HQ = ~7 people during this second phase

  • Focused on buying:

    • Proprietary aerospace manufacturing businesses with significant aftermarket content

    • AND with clear PE-like returns likely to investors at purchase price

  • Sold to Warburg Pincus in 2003

• After selling to Warburg Pincus

  • Would find acquisition targets at 15-20% EBITDA margins, and TDG would increase them to 40%

  • Nick Howley moved to focus on capital allocation at this time period

  • Approach to M&A changed

    • Began to have sales approach to M&A to make sure they were seeing as many deals as possible

  • Required, as they did before, a clear path to a >20% IRR over a 5-year period

    • If something got too close to a modeled 20% IRR, they got nervous

      • Usually was in the 25,26,27% range

    • As they got bigger and acquisitions got bigger, the expected IRRs trended down to be closer to 20%

    • Modeling assumptions that TDG used/uses

      • Assumed same multiple (or less) – no multiple benefit

      • Assumed same capital structure – no additional debt benefit

        • Which was usually 50% equity / 50% debt

      • Assumed very little credit to new business, cause “its hard from the outside looking in” to accurately assess

  • Important questions when they considered an acquisition

    • Is product proprietary?

    • Does product have significant aftermarket content?

      • The target usually underestimated their own strength in aftermarket

      • Can we price the product higher?

  • Have detailed operational plan set once they decide to buy a company

• Acquisition record

  • Made 52 acquisitions and lost on 0

  • And Nick Howley thinks they actually got a PE-like return (20%+ IRR) on all of them too

• Hard Economic times

  • 9/11

    • Aerospace industry stopped for a few months

    • Took out company-wide, already lean, 20% of costs/people out of it

    • Picked up new business development

      • Developed cockpit security system – sold it across industry

  • Financial Crisis

    • Cut costs dramatically once they realized the recession was going to be probably deeper/longer

    • Interesting question on whether they were able to buy anything distressed

      • Nick Howley - “you don’t see a lot of distress in this industry.  We’re buying proprietary, sole-sourced parts aerospace businesses with a lot of aftermarket.  Unless you get yourself way over-levered, it’s hard to lose money [here].”

  • COVID

    • Commercial aftermarket is where all the money is so it hit you where it hurts the most

    • Thought volumes would go down by 1/3, so they decided to get out the same proportion of costs down to keep margins

• Decentralization

  • Decentralization is “almost a religious belief” within TDG – if you want people to act like owners need to treat them (autonomy) and pay them like owners

• Compensation

  • Wanted to underpay them in cash compensation but overpay in equity value when they increase IV

  • 25-35% quartile in cash pay

    • But then 3-4x in equity pay

      • Formula

        • Beginning period EBITDA x multiple = EV – debt = MC / diluted SO = Intrinsic equity value per share

        • THEN, the held multiple the same but allowed all the other numbers to change in order to calculate the change in intrinsic equity value per share

        • Equity awards do not vest with <10% increase in intrinsic value per share

          • and 20% growth to fully vest

            • Dropped this to 17.5% eventually and where it is today

        • Did this on a company-wide basis

      • Almost lose no employees on once they get on the equity plan

• Organic growth formula

  • 4-5% real growth per year

  • total 9-10% organic growth

• How to satisfy customers in the industry (ranked by Nick Howley)

  • (1) Product works

  • (2) Keep up with new tech, which mainly means extending life of product

  • (3) Delivery on time and be prompt on service

  • (4) Price

    • Price is not as important since “these are little things going into big things”

      • “Most important that you are not fouling up the big thing”

      • “Parts need to work and need to get them there on time”

• Current M&A runway

  • A few big ones are still around

  • But he said “I don’t know” on how big the runway

  • Will eventually need to expand either by:

    • (1) Start looking at non-proprietary products / no aftermarket

    • (2) Start looking at proprietary products with aftermarket in other industries

• Intrinsic Value Drivers – HAD EXTREME ENGINEERING FOCUS ON THIS that he spread throughout the organization/culture - focuses are:

  • (1) Product Price

    • Price not to cost but what do you think value is to customer

    • Value to customer based on what you are providing versus what are switching costs to customer

    • Usually trial and error to get to right price

    • Most niche manufacturers underprice their products

  • (2) Product Cost down

    • Don’t understand fixed vs. variable – too much “gaming” occurs in the planning process when you try to do this split

    • Simply trying to decrease costs each year (so, remove inflationary increase + get some additional cost savings)

  • (3) Generate new business

    • “Anything else is tertiary”

    • Focused on the controllables through the up/down markets

      • Have training programs on a variety of topics to reinforce culture

      • People overemphasize experience

    • Underweight people qualities of youth, and energy/drive

• Viewed excess equity capital as very expensive relative to debt and therefore have done multiple special dividends

• Returns

  • 58% IRR over 10 year hold to Kelso original $25mm investment in 1993

  • 42% IRR over 4 year – Oddysey

  • If held all the way thru IPO, from the start – 37% IRR

• Rob Small (Berkshire Partners & Stockbridge) take on TDG

  • People didn’t think TDG was well-positioned cause they sell the less complex parts, not the high-tech parts - “But that was the point”

  • TDG was the best business he saw in private equity

  • Everything centered around safety in aerospace and is also an incredibly complex product (600k parts)

  • Boeing uses their volume to negotiate pretty good prices from suppliers

  • Some parts never get replaced in 30yr lifetime

  • Aftermarket for TDG

    • Very strong margins in aftermarket

  • “Being paid for the intellectual property and the switching costs”

  • 2008-2009

    • OEM shrunk but only slightly

    • Aftermarket was still very strong

    • Berkshire Partners bought $150mm (5% position) during this time period

  • Berkshire Partners sold TDG a business and that is when he fully realized how good TDG is at acquisitions

    • TDG stripped out costs way more than Berkshire’s company could

    • Due to this, realized TDG should be able to pay the highest price of any rational bidder cause they run the business better than anyone else

    • Went SKU by SKU on pricing (in both directions) to maximize profits

  • TDG has always been at 15%+ IRR at least on a publicly-traded basis, according to Stockbridge’s math

• Ability to focus on what is important (price/cost/new biz) is unusual

• Nick Howley and the company don’t dwell on what happened – just keep moving forward

• Nick Howley very intense in his work but can still crack jokes

  • More serious about what he does then anyone he’s met

  • Very focused on the controllables

Disclosure: I might hold shares in any of the companies mentioned and I might buy or sell at any time. Please do your own due diligence before making any investment. None of my writings are investment advice.

Longer-Term Trends of U.S. Grocery Industry

To set the stage, first let’s walk through a few major long-term trends that impact the U.S. grocery industry.

(1) Americans are eating more food away from home and less food at home. This is a very long-term trend, presumably driven by the rise in U.S. disposable incomes. I think it is safe to assume if you looked at this chart for a developing country, that although the trend may be the same, restaurant spend (“food away from home”) would be substantially lower (as a percent of total food expenditures). Less food at home has obvious negative implications for the grocery industry, however, there are certain factors that somewhat dampen/negate this negative depending on your place in the industry.

You can look at the above figures through a different lens by calculating each category as a percentage of GDP. Not surprisingly, over the past few decades, “Food at Home” has grown less quickly than GDP, while restaurant spending has grown slightly quicker than GDP.

(2) Grocery sale consolidation continues to benefit the larger grocery chains. Another multi-decade trend that offsets, for the top grocery sellers at least, the increased propensity for Americans to consume food at restaurants. The grocery industry is a commoditized industry, where everyone is selling basically the same products. The lowest-price sellers will primarily “win” in this type of industry. And the main way to sell at a lower cost than your competitor in the grocery industry, is to have a scale advantage (discussed in more depth later), creating a lower unit cost structure. The scale advantage means the company can (1) utilize its large buying power to buy products at a lower unit cost than the competition, and (2) more sales per store mean your overhead costs as a percentage of your sales are less than the competition. The company can then price their products lower, giving some or all of the enhanced margin to their customers “in exchange” for higher sales.

Presumably this need for size, to be able to provide competitively-priced grocery’s, is the large driver behind the ever larger market share capture by the largest companies in the U.S. grocery industry. Scale matters in this industry tremendously.

(3) Changing industry structure away from from purely traditional grocers. Although grocery sales continue to consolidate among the largest national players, they are not all pure grocery companies. Broader retailer supercenters (e.g., Walmart ), wholesale clubs (e.g., Costco ), and dollar stores have gained increasingly relevance over time with U.S. consumers. Each offers its own additional advantage over the pure traditional grocer.

For example, a Walmart customer can choose to visit one of its supercenters for not only grocers but practically any consumer retail good they may need. This creates a huge convenience factor, combined with Walmart’s rock-bottom prices means U.S. consumers have flocked to it as their grocer of choice (see chart below - now largest grocery seller in U.S. at ~21% market share).

To summarize conclusions from these long-term trends:

1. Although grocery spend is increasing, it has been growing less quick than GDP as Americans allocate an increasing amount of their budget to restaurants or more generally, “food away from home”.

2. Consolidation among grocery sales is increasingly moving towards the largest competitors, likely due to their ability to offer the lowest prices.

3. Industry sales seem to be moving towards competitors that are not pure grocery stores.

What Grocery Customers Value

Before we discuss the industry in more detail, let’s discuss what may be obvious regarding what customers value.

1. Price

   1. Although no person wants to overpay for goods, the lower the income, the more price becomes important. These ultra price conscious customers are the consumers who will drive across town to get a slightly better deal.

   2. The warehouse clubs (e.g., Costco) benefit the more price conscious people act. These businesses can price lower than the competition due to their structural advantages.

      1. Dollar stores cater to the ultra price-conscious consumer by generally offering smaller item sizes (i.e., less of the item per unit) and then typically selling at a higher per unit/ounce/etc. than most. Many dollar store customers only want a specific/smaller amount, as their monthly budgets do not allow them to stock up on an item, like a Costco offers.

         

2. Selection (quality, number of products per food category, etc.)

   1. Most national grocery store chains offer, roughly, the same wide selection of grocery items. The major differing factor in selection, is in selling non-groceries or higher-quality groceries. Walmart fits the first category, selling a wide variety of general retail goods at their stores. While Whole Foods fit the second category, generally selling “higher-quality” grocery items that usually run 10-20% more expensive than the typical grocery store.

3. Convenience

   1. The traditional supermarket (e.g., Kroger , Publix, etc.) will typically sell groceries at a slightly higher price per unit/ounce than you might find at a Costco but will normally have more locations, which make them more convenient for most customers within a town. For the time-constrained consumer, who does not need to be as price-conscious, many will choose to visit their neighborhood grocery store and be fine with paying a small “premium” on their groceries to do so.

   2. The dollar stores also rely to some extent on this dynamic. For example, Dollar General’s core strategy is to locate their stores in rural areas where the closest Walmart is >40 miles away. This has allowed them to provide convenience to local consumers. However, as mentioned previously, even though their prices are lower than the mom-and-pop competitors they do not necessarily sell at the lowest per unit prices relative to the largest players.

      1. “We went where they [Walmart] ain’t,” - David Perdue, Dollar General’s chief executive from 2003-2007.

Industry Economics & Competitive Advantages

The grocery industry is a commoditized industry selling non-exclusive items. Combined this with very low switching costs and you get an industry that competes primarily on price (i.e., no pricing power) and therefore minimal margins.  However, the industry does have favorable asset turnover since groceries are bought frequently, which helps create low-to-no net working capital for some competitors. Let’s walk thru the economics of the industry in more detail.

• Gross Margins

  • Purchasing Power

    • The size advantage is all important for two reasons - one of which is purchasing power. Larger/national grocery stores can demand better per unit pricing from suppliers. These suppliers agree to lower per unit pricing in exchange for more volume from that grocer. The much smaller grocery chains, cannot offer the same volume and therefore the supplier will demand higher pricing.

    • I know someone who works for a private, small-sized but fairly well-known, candy company. This person mentioned that the largest buyers (think Walmart, Costco), with their huge size, can dictate their pricing and terms unlike the rest of the competition. And the only companies receiving a lower per unit price than these large players are “close-out” companies (such as Ollie’s Bargain Outlet ), which get the very limited supply of left-over candy.

    • Again, size = purchasing power = “theoretically” higher gross margins. I say theoretical, cause the higher margin is mostly passed on to the customer via lower prices. And low prices, ultimately draw in incremental customers, while helping to retain current customers.

  • Private Label Brands

    • Private label brands are products owned/produced by the store selling them (e.g. Costco = Kirkland brand). Since the grocer is not buying the product from a 3rd party, they effectively eliminate the margin from that 3rd party.

      • Here’s a simple example. Product A is sold by Company X, a consumer packaged goods company. Product A costs Company X $10.00 to manufacture and then they sell it to a grocer for $13.00. Then Grocer Z marks Product A by 20% to $15.60.

      • Under the private label scenario, Grocer Z produces Product A itself. It costs $10.00 to manufacture, and they mark the product up by a higher margin of 30% to $13.00. Both Grocer Z and the consumer benefit as a higher margin is earned and the consumer gets a very similar product at a lower price.

    • Certain grocers have focused their business around the private label concept. Aldi and Trader Joe’s are the extreme examples, selling a substantial amount of their goods purely via private label (Aldi = ~90% private label and Trader Joe’s = ~60%). Although these companies do not have all the cost efficiencies of the larger wholesale clubs, their use of private label allows them to offer very competitively priced items.

    • Private label adoption has grown and certain stats show that once people switch to a private label product, they are unlikely to switch back. This progression helps grocer’s gross margins, although competitive pressures may dampen this gain if mostly everyone is achieving these gains too.

  • Alternative Profit Sources

    • Membership Fees

      • Membership fees, such as at Costco, create both additional loyalty and high-margin profits. From a financial sense, it also creates the beneficial dynamic of being paid for a service that is yet to be provided.

    • Advertising

      • Kroger has discussed this recently. Approximately 85% of Kroger’s top 500 keyword searches are for unbranded items (e.g., “cereal” not “Cheerios”). Kroger is beginning to allow their suppliers to advertise directly to their customers, creating an additional high-margin revenue stream for Kroger.

      • I’m no expert in this area but as digital advertising seems to be moving towards more privacy (e.g., new 3rd party cookie restrictions), the value of new advertising routes could increase. Especially, with most large grocers having loyalty programs and apps, which effectively means they have massive amounts of detailed customer/location level data, useful to any supplier.

• Overhead (as % of revenue)

  • Scale

    • Not to beat this point into the ground but, again, scale matters also in terms of brining down overhead as a percentage of revenue. By selling more in your current infrastructure, a grocer creates additional margin by leveraging fixed costs that can be passed on to customers. This is simply done by generating increased sales in your current infrastructure or said another way, high sales per square foot and per employee. And what is the main way to generate a lot more sales than your grocery competitors? Low prices.

  • General Operational Efficiency

    • This goes without saying, if you can operate with less non-productive expenses your overhead will be lower, and thus margins higher. Some grocers structurally attempt to achieve this. Here’s some examples:

      • Aldi

        • Requires you to bag your own groceries, so they do not need to employ baggers.

        • Aldi’s cart policy requires customers to give them a quarter to “checkout” a cart, in order to ensure that the customer returns the cart. Again, this is so Aldi does not need to employ extra employees for cart returns.

      • Costco

        • “no-frills” warehouse style stores require less labor than the competition. Much of the merchandise is displayed on pallets and on racks above sales floor, which means no employees required to place/re-stock items neatly on a traditional grocery store shelf.

    • All these seemingly small structural cost efficiencies exist so that grocer/retailer can sell the goods at lower prices than the competition. As shown below, the warehouse clubs, with all their buying and operational efficiencies, allow them to price much lower than even Walmart, according to this Bank of America analysis.

      

• Asset/Capital Intensity

  • Many of the larger players operate with zero or even negative net working capital. Meaning, suppliers are effectively funding a part of the company. Any inflationary or real unit growth in net working capital does not need to consume additional equity or debt dollars.

    • If customers are paying an annual membership fee than that advance fee is funding the business as well. Lowering the equity/debt capital required even further.

  • The way the large players achieve this low capital intensity is since they sell mainly to consumers, as opposed to business, allow them to turn their accounts receivable quickly (mainly credit card receivables). Combined with high inventory turnover means an accounts payable period of only ~30 days will create minimal-to-no working capital. Which is the typical financial dynamic that exists.

  • Even better, combined with the ability to lease their locations, creates a much less asset intensive business model than one might guess.

• Resulting ROICs/ROAs/ROEs

  • The dual effect of generally lower margins and higher asset turnover, creates Return on Tangible Assets for the best players in the 7-10% range. Stable business models mean a decent amount of debt can be utilized and the low-to-no net working capital, means the equity required is small.

  • The end result is very acceptable Returns on Tangible Equity and Returns on Tangible Invested Capital. However, the trade-off is the industry is very mature in the U.S. with not much room to deploy capital at those high rates. This means a large portion of annual profits are deployed back to investors via dividends and share repurchases.

Industry Historical Financials

Below shows financials for a broad set of grocery stores plus multi-line retailers. This is mainly to provide the hard numbers behind the above qualitative discussion. Not completely apples-to-apples, since obviously some of the companies shown have a much greater mix of grocery sales (Kroger) than others (Target ) but it should provide a recent historical overview of the group’s financials.

Note on data tables: If fiscal year was not equal to calendar year then I grouped it into the closest calendar year. Also, 2022 for some is equal to last-twelve-months.

Future Risks/Changes to the Industry

The one risk or future change I’ll mention here is Amazon and e-commerce competitors. In 2018, Kroger announced a partnership with Ocado, for Ocado to build their robotic-filled grocery fulfillment centers for Kroger in the U.S. Kroger is using this to expand, via e-commerce, into regions they do not have a presence. They expect these Customer Fulfillment Centers (CFC’s) to be profitable by Year 3 and in the longer-term, provide better unit economics than their stores.

Kroger, very understandably, praises these facts. However, if these facts are true, it seems like they could create potential risks for the industry. I am no expert in this area, but if these CFCs are really just combining Ocado’s automated fulfillment centers with some logistics abilities, I do not see why Amazon cannot do better. As these are the skills Amazon currently uses, extremely effectively, in non-grocery retail. And with Amazon’s motto of “your margin, is my opportunity”, a higher-margin e-commerce grocery solution seems dangerous the industries economics in the long-run (as Amazon would presumably compete those higher margins downward, pushing store margins downward too).

Again, I am no expert in this area, and all these are just some random thoughts. You can also argue that this threat might be far away, if it exists at all. However, I do think it is a topic to be further examined.

Final Thoughts

• U.S. grocery industry is mature, slow/no growth industry, especially as U.S. consumers increasingly eat away from home.

• The large national grocers do benefit as consumers grocery spend has been increasingly consolidating among the largest competitors.

• Presumably, this spend consolidation, is because the largest competitors can offer the best prices. Scale matters in the grocery industry as it drives both increased buying power with suppliers and more sales per location - both acting to create a lower cost structure for the largest grocery competitors.

• The wholesale clubs (Costco, BJs, Sams Club) have the lowest cost structures (as shown in the overhead/revenue table) and therefore typically can offer the lowest per unit prices. Others operate in certain niches that take advantage of customers preferences outside of price (convenience, selection).

Disclosure: I/we might hold shares of any security mentioned. I/we may buy more or sell shares at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

1994 Annual Meeting

• In a world of 7% long-term government bonds, would use a 10% discount rate for valuation purposes

• Two yardsticks for judging management

  • How well they run the business (relative to competitors and the industry they exist in)

  • How well they treat shareholders versus how they treat themselves as management

  • WB has noticed that poor managers usually treat shareholders poorly as well and vice versa

• WB & CM value simplicity

  • WB - “You don’t have to do expectational things in the investment business to get exceptional results”

• WB and CM never have a short-term opinion on stocks

  • “You  may  have  trouble  believing  this,  but  Charlie  and  I  never  have  an  opinion about  the  market  because  it  wouldn’t  be  any  good  and  it  might  interfere  with  the  opinions  we have  that  are  good.  If we’re  right  about  a  business,  if  we  think  a  business  is  attractive,  it  would  be  very  foolish  for  us to  not  take  action  on  that  because  we  thought  something  about  what  the  market  was  going  to do,  or  anything  of  that  sort. Because  we  just  don’t  know.  And  to give  up  something  that  you  do  know  and  that  is  profitable for  something  that  you  don’t  know  and  won’t  know  because  of  that,  it  just  doesn’t  make  any sense  to  us,  and  it  doesn’t  really  make  any  difference  to  us.”

• Since Wesco was selling at a very high price and its intrinsic value is fairly easy to calculate within a reasonable range, Charlie decided to disclose the figure in the Wesco annual report

• Don’t hold cash just to hold cash from an investment perspective - WB would love to be fully invested

  • Actually, when they hold much excess cash they tend to stupid things

  • And, when they have held little cash and they had to sell an investment to invest in something else it tended to be a very intelligent decision - cause it raises the bar when you have to trade an investment you like for an investment you like even more

1995 Annual Meeting

• Charges subsidiaries to advance capital and credits them at same rate for withdrawing capital, which ties into the manager’s compensation plan

  • If business is seasonal, will only charge them LIBOR for seasonal capital but for any permanent capital will charge them a full cost of capital

  • [from later at annual meeting] If business does not employ a lot of capital, BRK does not charge them for capital

  • Interest rate range is between 14% and 20% on advanced capital

• Charlie mentions that when they are looking at investments they judge by past records

  • “If the company has a lousy past record but a bright future, we’re likely to miss the opportunity”

• When making new investments, WB and CM think in terms of opportunity costs

  • Will compare new investments to buying more of Coca-Cola - helps to screen-out a lot of things

• On their Wells Fargo investment, they were essentially betting that WFC’s CRE portfolio would perform much better than the average bank’s.  Charlie said that if the portfolio had performed like the average bank’s than WFC would have been wiped out by the CRE downturn

  • Mentioned they would not have been able to make the Wells Fargo investment based solely on the numbers.  Mentioned that they had some insight into how the CEO thought

• WB Delta Duck Club investment

  • Invested when it was earning $7k per share, with $20k per share in cash, and trading for $29k per share

  • Was a “long-lived” oil field

1996 Annual Meeting

• WB and CM don’t use different discount rates for different companies - they may require larger margins of safety but they want to make everything comparable

• WB has been thru “a half dozen times” (about every 7 years) where people didn’t think they won’t get a chance to buy securities at intelligent prices. But “it always changes”.

• WB loves to see management teams that are focused on just a few important things

  • this is why he doesn’t want GEICO to expand internationally right now cause there is such a large opportunity in the USA - wouldn’t want them to lose focus

• If someone were to offer WB $7bn for their insurance operations which have $7bn of float, he would easily pass. Reason being is he expects the $7bn in float to grow

• “When you find a good CEO running a good business, you want to bet very heavily”

1997 Annual Meeting

• It’s more important to be sure that the business is a wonderful business than that the price is a wonderful price

• Says they stay away from things they don’t have the ability to understand and continue to learn about things they do understand

• Says he could do his job each day in way less time but he enjoys it too much

• Opportunity cost is powerful concept that allows you to screen out other opportunities quickly and will result in a concentrated portfolio

1998 Annual Meeting

• Best reason to sell a stock is you found another investment that is even more attractive

• Would not base their investment decisions on the fact that current ROE’s / ROTE’s in the banking industry are sustainable

• Secret to success in life is weak competition

• Trying to think about two things – things that are IMPORTANT and KNOWABLE

• Would not give up their float for an equal amount of equity since the float creates profits for Berkshire

• Steps to evaluating investment decisions:

  • 1- figure out the key variables

  • 2- evaluate how predictable they are

• Silver commodity purchase explained by WB:

  • Silver aggregate demand per year, primarily photography/industrial/jewelry, is 800mm ounces

  • Silver aggregate production per year is 500mm per year (plus 150mm of “reclaimed sliver” per year – mostly from photography)

    • However, since most sliver is produced as a byproduct of mining gold/copper/lead zinc, silver production is not very responsive to changes in price

  • Creates a 150mm ounce per year excess demand over production, which has been filled by existing silver inventory over the last few years

    • This inventory, although exact number is not known, is now depleted significantly

  • Ultimately means price is not in equilibrium currently

    • Three ways to solve this: (1) reduced demand, (2) increased supply, or (3) a change in price

    • And since both supply and demand are pretty inelastic, they thought a change in price could be major

• CM said when investing is taught correctly it is taught from “cases where the investment decision was easy” – basically saying you should ingrain the easy investment decisions into your brains

  • Mentioned National Cash Register and its CEO as a cinch investment and a case study he would use

• Corporations/Boards don’t focus on post-mortems, but they should

  • like to spend a lot of time telling you how good an acquisition or a CapEx will be but don’t spend much time evaluating the actual results

• “Scuttlebutt” research is for after you already like an investment and need to fill-in the final 10-20% of info / trying to kill your idea

  • “like being a basketball coach and finding a 7 footer on the street – you’d then check to see if you could keep him in school, if he’s coordinated, etc”

  • WB doesn’t do much scuttlebutt now but used to talk to competitors, customers, suppliers, ex-employees, current employees, etc.

1999 Annual Meeting

• Both WB and CM said it is not easy to predict who will win/lose in internet retailing

• On internet jeweler retailing, WB hypothesized two firms that would have an advantage:

  • 1- Tiffany’s – “brand names are going to mean very, very much when you have thousands and thousands of choices.  … I think Tiffany has a name that people would trust”

  • 2- Borsheims – for price conscious people, the Borsheims brand could mean something

• WB thinks that the expected rate of return would fall off dramatically from working with $1mm to $10mm as an investor

  • “If you start with “A” and you go through and you look at everything, you’ll find securities in your area of competence and occasionally find little arbitrage situations or little wrinkles in the market”

• If WB and CM were designing option compensation they would:

  • (1) set the option price equal to the price the business could be sold at, since management has the choice to sell at anytime, and

  • (2) would incorporate a charge for the cost of capital, so that management wasn’t just getting the benefit of retaining earnings without intelligently deploying them

• Winners in the insurance industry will be franchises based on specialized talents:

  • terrific distribution systems (e.g. GEICO) (i.e. minimizing the expense ratio)

  • managerial expertise (i.e., minimizing the loss ratio)

  • ability to invest float effectively (i.e., maximizing investment returns)

• When WB ran his partnership, he would also evaluate how well his sale decisions were to his buy decisions

  • i.e., talking about when he was fully invested and sold one stock to buy another

• CM said that they have “learned more from the great business magazines than we do anywhere else.  It’s such an easy, shorthand way of getting a vast variety” of business experience

  • “And if you get the mental habit of relating what you’re reading to the basic structure of the underlying ideas being demonstrated, you gradually accumulate some wisdom about investing.”

2000 Annual Meeting

• CM talks about how some businesses will naturally die and there is no answer in how to prevent it – “except to wring the money out and go elsewhere”

• Berkshire float can be invested in anything (fixed-income equities, operating businesses)

  • Not all insurance companies can do that – BRK’s high capital levels, little debt, and diverse earnings streams allow this

  • BRK could have 100% invested in equities (and did in the past)

2001 Annual Meeting

• Hopes to make 2-3 acquisition per year on average

• Discusses important variables in analyzing an airline

  • Start with CASM (cost per average seat mile) and then use capacity utilization to calculate Cost per Occupied Seat Mile

  • Labor costs are the most important variable “in a relative sense”

• Don’t know if growth is good for the business or not until you know the economics of that growth (i.e., the incremental returns on capital)

• On capping insurance losses:

  • There’s a few things you can’t cap as a primary insurer: (1) workers compensation losses, and (2) Auto in the UK

  • In reinsurance they are almost always capping the potential losses

• Doesn’t worry about the dumbest competitor’s actions in a service-focused business – only in a price-focused business

2002 Annual Meeting

• BRK holds just under 10% of all U.S. float in the property casualty business

  • Thinks BRK float would have less natural run-off than the average P/C insurer

• After September 11th, 2001, insurers realized they either had exposures they weren’t charging for and so they now are either excluding those exposures or charging for them

• Most important characteristics of an investor are (1) realism and (2) discipline – WB/CM think these are their distinguishing characteristics as investors

  • Also need a good sense of probabilities

  • Same characteristics are important in underwriting insurance

  • Investing requires “extraordinary discipline” (from the 2004 meeting)

• For a two to three year period in the 60’s WB and CM hunted around for a bank before buying the Rockford bank

  • Found some “oddball banks they liked’ that were characterized by “very little risk on the asset side and very cheap money on the deposit side”

• Explained how they make quick decisions by focusing on the important variables using customer-framer Larson-Juhl as example

  • WB had never thought about the custom-frame business in his life before the phone call

  • 18,000 framers in the country so you aren’t dealing with buyer concentration power

  • Largely a service business – call on the framers 5-6 times per year and 85% of orders are delivered the next day

  • “I know that you can’t crack our custom picture frame business. I mean, you cannot figure out a way to call on those 18,000 people that are in that business and figure out a way to divert their business to you when you can’t offer a frame as good as ours and you can’t offer service remotely like ours. So it’s a good business.”

• Most business that are difficult to understand, you’ll never be able to fully understand no matter how much research you do

  • Mentions trying to figure out which auto manufacturer will be the best 10 years from now – “it would be impossible”

  • CM – “if you have endless due diligence and no horse sense, you just described a corporate hell”

• On understanding failure in investing:

  • “If you study the people who die financially, you know, with high IQs and say why do they die, you know, you’ll see certain overwhelming characteristics that are present in most of the cases.”

  • “And you’ve just got to make sure that either you don’t possess them, or if you do possess them, that you can get rid of them or control them in some manner.”

• On avoiding thinking incorrectly

  • “There’s no question, the human mind — what the human being is best at doing is interpreting all new information so that their prior conclusions remain intact. I mean, that is a talent everyone seems to have mastered.”

  • “I would say a partner, who is not subservient, and who himself is extremely logical, you know, is probably the best mechanism you can have.”

• On the bottling business

  • Capital intensive – spend 5-6% of revenue on maintenance capex

  • Says with the bottling industry making 15% EBITD, that maintenance capex is a large number (~1/3)

• Option plans

  • Stock options are for most employees would just be a “lottery ticket and also a royalty on the passage of time”

  • Says the future BRK CEO could have an option plan since he is in charge of capital allocation, but would need a cost of capital built-in so they didn’t get paid just to retain dollars

    • Says most normal employees shouldn’t be paid via options since their aren’t allocating capital / making corporate investments – their incentives structure should be more specific

  • Should not grant options below intrinsic value, just because stock price is below intrinsic value or vice versa

• WB says his expected rate of return on bonds is equal to whatever bond market is saying – even if prices are “swinging around a lot”

• Post-bubble periods produce fallout that is tough to predict

  • Cites as an example, Japan and their stagnation despite running huge deficits

• CM - Black-Scholes model is good for pricing very short term options (mentions 90 days as an example at the 2003 meeting)

2003

• Intrinsic value is a range, not a specific number

  • Looking to buy at a clear discount to the lower levels of intrinsic value

• Thinking about low probability events all the time and how they effect BRK

• Clayton Homes purchase

  • When he bought Clayton Homes he had never met the people - Read Jim Clayton book and their 10K’s

    • “I knew every company in the industry.  I look at competitors”

  • Not interested in talking to management since they’ll just tell you what you want to hear

    • Interested in management’s track record though and that can be gleaned from public docs

• CM – “The more basic knowledge you have, I think the less new knowledge you have to get”

• “But, you know, I’ve always said that the way to get a reputation for being a good businessman is to buy a good business. It’s much easier than taking a lousy business, you know, and showing how wonderful you are at it, because I haven’t seen that done very often

• CM – Mostly Berkshire has bought stocks that practically couldn’t fail.  But occasionally BRK makes a gamble when there is a chance of failure but enough chance of success that the gamble is worth taking

2004 Annual Meeting

• “We think the best way to minimize risk is to think”

• “People tend to underestimate low-probability events when they haven’t happened recently and overestimate them when they have happened recently”

• National Indemnity had a record unlike any other when WB bought them despite having nothing special that distinguished it, EXCEPT for exceptional underwriting discipline

• PetroChina investment

  • Bought because it was cheap in relation to earnings, reserves, daily oil production, and refining capacity – “whatever metric you wanted to use, it was far cheaper than Exxon, BP, or Shell, etc.”

  • Factored in the fact they are 90% controlled by China but such a wide discount to other oil majors should not have existed, even after considering that fact

  • Thought about other reasons why you might lose in the investment outside of low oil prices, such as if US-China relations deteriorated and something occurred because of that

• Told story about how scientists studied world-class chess players and the way their mind works is by almost instantly dismissing 99.9% of all moves first and then they naturally focus on the sensible moves – very similar to investing in that you should dismiss the bad/mediocre ideas very quickly

2005 Annual Meeting

• Can learn a lot about the durability of a business’ economics by observing pricing behavior by companies

  • Meaning what happens when they raise/lower prices

• Pick management that has a demonstrated track record of success (“looking for people that have batted 0.400 historically”)

  • Would not have any special ability at picking managers with no track record

2006 Annual Meeting

• Compensation managers based on the variables they control

  • At GEICO – (1) unit growth, and (2) profitability of seasoned business

  • For an oil company would be based on finding & development costs

• WB made interesting comment about adjustable rate mortgages

  • “And if you look at the 10-Qs that are getting filed for the first quarter of some lending institutions, and 10-Ks that were last year, and you look at the balances increasing on loans for interest that’s accrued but was not paid because people had adjustable mortgages, but they’re only adjustable so far, but the lending institutions are taking in the income as if it were paid, you’ll see some very interesting statistics.”

• Were a $250bn insured loss to happen (about 4x Katrina, which was $60bn), BRK would pay about 4% of that or $10bn

• At that time in 2006, $10bn was the amount of cash WB wanted on-hand at all times

2007

• Doesn’t think BRK has ever had a permanent loss in marketable securities of 1% of net worth (mentioned maybe 0.5% of net worth though)

  • Dexter Shoe acquisition cost BRK more than 1% of net worth when WB bought entire business

• Management should create annual reports so the relevant figures are discussed

  • Annual letters, or lack thereof, are an indication of management’s feelings towards shareholders

• WB has still bought extremely good businesses where they did not like management

• Rail Industry developments

  • Lot of progress on labor front

  • Competitive position versus trucking goes up as oil goes up

  • Reregulation threats temper pricing power

• Don’t want to buy into a business that has both a high labor component and can be shipped easily from abroad (e.g., Dexter Shoe)

• People’s habits don’t change immediately even when new, obviously better product or service arises

2008

• Would be happy to buy common stocks with an expectation of 10% total returns, and might settle for a little less than that

• Many business WB wouldn’t buy even if it had the best management team, if they were in the wrong business

  • The business and industry economics are what counts

• Noted how the Board has four names for who will manage Berkshire’s investments after WB is gone

  • Up to future CEO and Board if they hire all four, just one, etc.

• Multiple times over the past 50 years where WB or CM would have had 75% of their net worth in one position

  • Uses the example of in 1974, Cap Cities was (1) trading at a third or fourth of what their properties were worth, (2) you had the best manager in the world running it in Tom Murphy, and (3) it was in one of the best businesses even if the manager wasn’t that good

  • Coca Cola before or around the time BRK bought it, you could put 100% of net worth in and not worry

• On the over-under of world production of oil per day being up or down 25 years from now (~2033), both WB and CM bet down

• WB and CM said they have never made an investment mistake that would have been avoided by traditional due diligence

  • Said yes to the Mars deal with no Materia Adverse Change clause or financing contingency

2009

• After Ajit Jain is gone, his successor will not have the broad authority to write reinsurance as Ajit does now

  • Only gave Ajit that authority after seeing that he deserved it over a long period of time

• GEICO business saw improvement during financial crisis due to their price advantage

• CM/WB both agree that Financial Crisis stimulus money should use Great Depression stimulus investments as a model (e.g., Tennessee Valley Authority, Hoover Dam, etc.)

• Update on reasonable worst case insurance loss scenario - If a $100bn loss occurred for the insurance industry, 3-4% of that for Berkshire

  • In Katrina, which was around $60bn, they were 4-5% of the industry’s loss

  • Absolute worst case that WB can come up with would be in highly inflationary environment where people in auto insurance especially became outraged at the price increases, and so the government chose to nationalize the industry

2010

• WB believes close to absolute worst case insurance event at $250bn

  • If BRK accounts for 4% or $10bn, so would still be profitable that year, while most other insurers were wiped out

2011

• Insurance industry $50bn insurance loss from major Asian catastrophes

  • BRK portion of the loss will be 3-5% of that

• Always thinks about ease of entry into an industry when evaluating a business

  • In 1972 before buying See’s he asked himself if he had $100mm could he take on See’s

    • If the answer had been yes, he wouldn’t have bought it

  • Asked this of Lubrizol CEO before making an offer

    • Answer was it’s not impossible for people to enter the industry BUT (1) the overall market was small (only $10bn) and the product sold is relatively low cost, so hard to undercut them

    • Also Lubrizol is deeply connected with customers and work with customers when new engines come along to develop the right type of additives

    • Also have patents

• WB thought Berkshire’s normalized earning power = ~$12bn

• “But I think, generally, we have followed the right government policies [during the 2008 financial crisis]. I think they’re less important than most people think they are. I think if you did the wrong policies it would really screw things up. But I … I think the natural resuscitative powers of capitalism are — will be the biggest factor in taking us out [of the 2008-2009 recession].”

• To evaluate a business want to looks at Return on Tangible Assets

  • Used Lubrizol as an example and said BRK is paying $9bn for $1bn of pre-tax earnings – BRK should be judged on that $9bn figure (meaning inclusive of goodwill) but to evaluate the Lubrizol CEO’s managerial performance, should judge based on the $2.5bn of TANGIBLE equity in the business)

• CM says that getting 10% on invested assets isn’t bad if the funding source is 0% float

• CM said he would teach investing based on a hundred-ish companies that did something very right or wrong

  • Would have Value Line type figures showing entire history of a company and would detail out why the changes in the data/business occurred

    • Example he would use - Costco – intensity on accumulating and passing on cost advantages to customers – which created huge customer loyalty

    • Example he would use - GM – heavy unions, tough competition from Asia, hubris based on past success

• All the 2008 investments had different interest rates on the preferred since WB was assessing changing opportunity costs

  • Each investment was made at a different time – also, some of the terms are different as well

• PetroChina investment

  • Liked Petrochina since it was cheap relative to reserves / refining capacity / cash flow / “pretty much any metric”

  • Also liked that they said they were going to payout 45% of earnings as dividends

2012 Annual Meeting

• WB estimates 80% of utilities do not pay federal taxes and therefore cannot reap the full benefit of tax credits for renewable energy

  • Most utilities are not federal tax payers because they get bonus depreciation at 100% of cost - which wipes most of their income

• “Charlie and I probably think about worst cases more than any two managers you’ll ever find, and we are never going to expose ourselves to a worst case”

• Capital in BRK’s life insurance companies is worth less to BRK than its P&C companies cause they are more restricted in what they can do with that capital

  • Best place to have the cash is at the HoldCo where there are no restrictions – have $10bn currently

  • Berkshire P&C biz has so much more capital in relation to insurance premiums than competitors

    • It also has assets like BNSF in that capital which makes the company so much stronger/durable

  • Regulators wouldn’t let Berkshire do things like BNSF if they weren’t so strong

• WB says they are happy if they can earn 12% on equity going forward, particularly when some of the capital consumed by capital-hungry businesses is from insurance float (since the float costs them nothing)

  • Float could shrink due mainly to the natural run-off of retroactive contracts

• “If you really think a business is declining, most of the time you should avoid it”

  • WB said they tried a lot of these whether it was textiles, department stores, trading stamp companies, US made shoes (Dexter)

  • (MJS) subsequent to this meeting, BRK bought up a bunch of declining newspapers at “cheap” prices which turned out to be a mistake (although immaterial to the scale of BRK) -> just reinforces this principle on avoiding declining businesses

• Railroads are three times more fuel efficient than trucking

  • “probably why the railroads move 42% of all inter-city traffic”

• MidAmerican may have the opportunity in the next 10-15 years to invest $100bn

2013 Annual Meeting

• Each new GEICO policy probably adds $1,500 of intrinsic value

• WB believes most of their edge lies in that they do not get caught up with what other people are doing

2014 Annual Meeting

• Coca Cola excess compensation discussion (as outlined by WB)

  • KO plan involved 500mm shares to be issued over approximately 4 years

  • KO currently trades at $40 per share, so if stock at $60 when exercised that represents a $10bn transfer of value ($20/share excess value x 500mm shares)

  • BUT, the company gets a tax deduction at 35% or $3.5bn in this scenario, so nets to $6.5bn in value transferred via options compensation plan

  • Then WB walks thru Treasury Method

    • $20bn of proceeds from options exercised + $3.5bn of tax savings = $23.5bn of total proceeds to KO

    • If they all buyback stock at $60/share then would be able to buy 391,666,666

    • This means the net issuance is ~108mm shares (on a base of 4.4bn shares, equating to ~2.5% dilution)

      • (MJS) could also do the calculation by saying that there will be $6.5bn of value transferred away from shareholders in four years when the stock is valued at $264bn ($60/share * 4.4bn shares outstanding), equating to the same ~2.5% dilution figure

• WB says in Annual Report he explicitly stated his belief that GEICO, which is carried at ~1bn over tangible assets, is probably worth ~$20bn over tangible assets – and wouldn’t be surprised if this number increased a lot in the future

• Cost of capital = next best idea (i.e., opportunity cost)

• Paid somewhere between 11-13x (implies 8-9% earnings yield) after-tax earnings for Nebraska Furniture Mart in 1983

  • LT interest rates were around 11% on average in 1983

• Wife’s inheritance will be in 10% ST bonds / 90% S&P500 index fund

• Rail versus pipeline

  • Rail is about 2x as fast as pipelines

  • Allows for more flexibility in which refineries you can take the oil to

• Economics of oil sands usually only works if (1) oil price is high and (2) spread between oil and natural gas is unusually high, since a lot of natural gas is used to produce the heavy oil from the oil sands

• CM stated there is a lot to learn from scrambling out of mistakes (in the football sense)

  • “Imagine Berkshire, a textile mill sure to go broke because power costs in New England were about twice as high as they were in TVA country, a sure-to-fail department store, and a trading stamp company sure to be forced out of business by change... Out of that comes Berkshire Hathaway. Talk about scrambling out of mistakes, I think of what we might have done if we’d had a better start.”

  • CM on change:

    • “I think we’ve adapted pretty well to changes in our circumstances [at BRK]. And that, again, is part of life. I mean, since change is inevitable, how well you adapt to it is terribly important. And I would say the changes that many of you have watched in Berkshire over the years have been very much in our interest, and then there may be future changes that are just as desirable.”

• CM on success:

  • “What I needed to get ahead was to compete against idiots.”

• WB/CM says the largest deterrent from people copying BRK’s methods is that it’s a slow way to get rich

• In Iowa, BHE has significantly lower rates than their competitors (both stock-owned and municipal-owned)

  • Thinks that’s important for them since regulators are the ones that guarantee the returns they get on capital

  • Greg Abel says across they regions BHE operates, they are either the low-cost provider or in the lowest quartile

  • Tech companies building data centers in Iowa due to BRK’s low costs and since they also want to receive electricity from a renewable energy source, which BRK provides

    • Just did first rate increase in Iowa since 1998

  • Cited example they did in 2013 of 1k MW projection that will cost $1.9bn but will earn 11.6% percent

  • WB says generally, maintenance capex = depreciation BUT their utilities business also earn a return on that maintenance capex

2015

• CM says he watched both WB and Henry Singleton invest, and WB a better investor than Henry Singleton cause he put more work in

  • “Henry was thinking about inertial guidance, and Warren was thinking about securities. And the extra work enabled Warren to get by with his horrible deficit of IQ, compared to Henry.”

  • CM said Teledyne’s incentives were too strong and caused them to get in trouble with defense department a few times

    • (MJS) Similar to incentive problems with WFC

    • WB mentioned story of Jack Ringwalt’s Head of Claims hiding claims since he didn’t want to be berated by Jack (his point was, you need to be careful of hidden incentives especially when you are CEO and setting a tone)

• Berkshire’s “float is very close to permanent”.  “It can decline a couple percent in a year, but it can also increase a few percent”

• “…all Berkshire does is copy the right people.”

• “[On WB’s early success]…I had a great teacher, I had exceptional focus, and I had the right sort of emotional qualities that would help me as an investor.  [And] I enjoyed the game.”

2016

• Repeats goal is to increase normalized earnings every year

• Says he would rank Mark Donegan as “one of a kind” even versus all the managers they’ve seen over the years

  • No limits on the acquisitions PCP can do – “canvas has been broadened” with the acquisition by Berkshire

    • CM thinks they’ve gotten “almost as good at picking superior managers as were in the old days at picking the no-brainer businesses”

• Precision Castparts has good attributes besides management

  • (from 2017 and 2018 meetings) Reliability is important in terms of quality and delivery time

  • Quality is important – so customers don’t just take the low bid

  • Contracts extend over time

  • Customers depend heavily on them

• Sold Swiss Re and Munich Re since he thinks reinsurance biz will be tougher in next 10 years than previous 10 years

  • (1) In part due to interest rates being low, so low return on float

    • Also other reinsurance companies are limited in what they can do with float, vs. BRK, since (1) they do not have the capital in relation to underwriting that BRK has, and (2) they do not have the earnings from unrelated businesses

  • (2) A lot of new capacity in reinsurance, which has resulted in heavy competition

• Matt Rose (BNSF CEO, at the time) thinks that railroad mergers will eventually occur as the population continues to grow and “transportation becomes more scarce and the railroads will need to do more”

  • Thinks great efficiencies will be created for shippers and communities due to these mergers

• On aircraft leasing business

  • Offered various aircraft businesses over the years but regard it as a “scary business” that does not interest WB “in the least”

    • ST money financing LT assets with big residual risks – “not for us”

    • Only likes leasing business where it’s not purely a financial transaction – needs to be something else like a servicing aspect

• “Recognizing reality is … important.  You do not want to try and fix something that’s unfixable”

• “cash flow [for Berkshire is]… net income plus increase in float”

  • Says the ~$17bn of operating earnings + increase in float is the “net new available cash”

• WB says they have done well by simply avoiding self-destructive behavior

  • CM says it was because they had the appropriate balance between patience and opportunism

• Van Tuyl auto dealer acquisition

  • Paid $4.1bn but purchase included about $1bn of securities earnings 0.25%

    • (MJS) net paid ~$3bn and Van Tuyl had ~$8bn in 2013 revenue (0.375x revenue)

      • (MJS) probably $10bn in “peak” revenue, so, 0.30x “peak” revenue

2017

• Driverless technology would hurt both GEICO and BNSF

• When evaluating business they simply want to know:

  • (1) if a competitive advantage will exist 5,10,20 years in the future, (2) if they have a management team they like, and (3) if the price is sensible

    • See’s Candy purchase – Knew manager was competent, so simply needed to ask the question would people still want to both eat and give away See’s in preference to other candies?  Meaning, would people still be willing to pay up for See’s

      • Figured it would be a yes, 10-20 years down the road -> couldn’t see further but didn’t necessarily need to

• Discussion of AIG retroactive reinsurance deal with BRK covering $20bn of exposure for $10bn premium

  • AIG has to pay first $25bn, then next $25bn BRK pays 80% (meaning, up to $20bn)

  • Applied to their losses in many different products written before 12/31/15

  • AIG did transaction since many thought they were under-reserved

  • Berkshire was only insurance company in the world willing/able to write that contract

  • Could extend out 50 years for final dollar of payouts

• CM quote:

  • “The first rule of fishing is to fish where the fish are. And the second rule of fishing is to never forget the first rule. And we’ve gotten good at fishing where the fish are”

• Airline purchase

  • Thinks the industry is still tough but a few favorable things going for it now

  • Did say that even if the market caps are the same size as they are today, the price per share will be much higher since the companies are doing significant buybacks at cheap multiples – so, they “don’t need heroics to do OK”

• AAPL purchase vs. IBM purchase

  • Thinks they understand consumer behavior better than the dynamics impacting IBM’s future

• CM says a lot of other investors are trying to be brilliant and they’re simply trying to stay rational

  • Said this is a advantage for them

• Said his wife will do fine after he dies holding the 90%/10% index fund/cash

  • Only reason for cash is in case the stock exchange closes down for some period of time, she doesn’t feel she’s in a cash crunch

• A good test for management on whether they have a good “money mind” (good capital allocator), is whether they repurchase stock when their stock is cheap or just have sound opinions on the subject

  • WB says the math is so clear for repurchases when a stock is cheap that if management teams give odd opinions on this it probably indicates they don’t have a great money mind

    • WB says that this doesn’t mean they aren’t a great business operator, just that their lacking in understanding capital allocation

      • BRK does not want a manager that does not have a “money mind”

• WB said there were 12 or so people throughout his life that he would have predicted generating market-beating returns

  • WB said he would have also predicted that probably none of them would have beat the market with >$100bn

• On Berkshire’s ability to handle stresses

  • CM: “In every way, Berkshire is structured to handle stresses”

  • WB: “It’s the kind of thing we think about all the time. We’ve thought about it ever since we started. But I really don’t know any company that can take more general adversity or even some specific adversities”

2018 Annual Meeting

• Normalized earnings power per share is close to 1Q18 performance of $5.25bn

  • Said (1) they do have a lot of cash earning 0% that should be considered “untapped firepower”, (2) insurance is seasonally stronger in Q1 but other biz weaker in Q1

  • Then said, $21bn normalized (1Q18 annualized) + $xbn retained earnings of equities (since only dividends reflected in the $21bn)

    • (MJS) maybe 30% payout ratio (was 31% for top 10 investments in 2019 according to Letter to Shareholders) on $1bn of dividends in Q1, so another $2bn pre-tax or $1.5bn AT for Q1

    • (MJS) implies $7bn for Q1 or $28bn for year // at 20x = $550bn on 1.6mm shares or $350k per share (traded around $290k at time of meeting)

• Breaks down how he thinks of cash coming into BRK (Net income +/- CapEx over Depreciation +/- float)

  • “to make it very simple, in the first quarter we earned five and — from operations we earned a little over $5 billion. Now, we only spent about our depreciation. Normally we would spend somewhat more than that. But that’s 5-and-a-fraction billion. Two billion came, in net, from float. So that’s $7 billion that — basically in the first quarter — that would have been added to our cash if we hadn’t done something with it”

• Likes Apple since it’s “an exceptional product with a strong ecosystem [that creates a very sticky customer]”

• TTI (electronics distributor)

  • Billion dollar sales business with average product cost of $0.05

  • Great growth business with not much competition

    • ticker ARW is a public competitor

  • CM says it’s a bit of the “dead horse business” – not too many people want to get into this business

  • TTI holds more inventory than competitors which makes them more valuable to customers

    • WB said business is all about having the right millions of the right products and quickly getting those electronic parts to customers worldwide

• When evaluating a consumer product want to see how consumer behavior changes on it in a lot of different environments

  • Says they would not have been able to invest in Coca-Cola when it was first started [and no track record]

• WB said you then want to do scuttlebutt research, to see if you can get more in-depth insights on the products (“some you can, some you can’t”)

2019

• Says his estimate of intrinsic value is a range with a probably 10% band

• Property insurance and reinsurance are bad standalone businesses, since if you truly hold enough capital to withstand worst-case scenarios, you would hold too much capital to make the business attractive

  • However, since BRK holds a lot of capital in other businesses, that are importantly, not very correlated with natural disasters, they are able to deploy this extra required capital in a efficient way

  • Mentioned that in last 30 years, all three large reinsurers have been on the brink of BK, even though it’s been a pretty good last 30 years with Katrina as the worst disaster

• Wouldn’t sell BRK insurance business for float value

• Thinks 10 or 20 years from now people will look back at the record of BHE and see that no other energy company comes close to achieving the record that it achieved

  • Competitive advantages:

    • they retain 100% of capital whereas most utilities payout 100% of earnings

    • there are three owners, one of which is the CEO – aligns incentives

    • BRK is able to use excess renewable tax benefits to offset income in other parts of its business [whereas, many other utilities are unable to use renewable tax credit since 100% bonus depreciation wipes out taxable income - as stated at 2012 meeting]

  • Rates in Iowa are half of their largest competitor

• Says the finer details on most of BRK’s subsidiaries are not important

  • [WB on what is important in evaluating businesses is how the future capital will be deployed] “Wouldn’t have mattered in 1965 if you knew what percentage of [Berkshire] linings went towards this or that – what was important was what would be done with the capital going forward”

  • Wouldn’t have mattered in the 1980s to know more about the See’s Candy expansion eastward that failed – again, what mattered was what was done with the capital generated

Disclosure: I/we might hold shares of any security mentioned. I/we may buy more or sell shares at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

FFD Financial (ticker: FFDF / OTC-listed) is the holding company of First Federal Community Bank, a small ~$670mm asset bank located in Central Ohio.  The bank was profitable throughout the financial crisis with very minimal losses in their loan portfolio.  The same CEO is running the bank today and has created a strong business model that generates returns well above most of its local peers.  This outperformance is driven by two factors: (1) “scaled” branches with ~35% more deposits at each than local peers, and (2) intelligent expense control.  This creates a lower cost structure for FFDF, and thus higher profitability.

In addition, FFDF stands to benefit from two potential additional positive factors: (1) FFDF continuing to lower their expense structure as they have done successfully over the past decade, and (2) higher interest rates, widening the spread they make between loans and deposits.

FFDF is likely overlooked due to its illiquid and OTC-listed existence, offering investors a strong community bank at a cheap valuation.

Share

Strong Business Model

As mentioned above, FFDF succeeds by doing more with less. Specifically they have ~35% more deposits per branch than local peers, only trailing their much larger regional peers in this category.  Why does this matter?  If a bank is able to generate more deposits than peers per branch, each dollar of deposits effectively costs less. 

Take this simple example:  Bank A has one branch with $100mm in total deposits and Bank B has two branches with $100mm in total deposits.  Each bank has the same amount of total deposits but Bank B required a second branch to generate those additional deposits.  And that additional branch creates additional expenses, mainly in the form of additional occupancy (rent, maintenance, etc.) and employee costs.  The end result is that even if both example banks generate the same amount of loans, at the exact same interest rate (meaning they have the same amount of loan income), the higher cost structure of Bank B means it will produce much less in net income.  FFDF succeeds by acting like Bank A.  Much more extreme examples of “Bank A” exist (online-only banks) but FFDF also has many strengths that those others do not, such as dominance in its local communities (more on that in next section).

Also this “do more, with less” strategy benefits other stakeholders besides shareholders.  Although FFDF has less employees they pay each above market rates on average ($86k vs. $73k for peers) which allows them to hire and retain the best talent.  FFDF earned the “Great Place to Work” certification since 2019.

Despite FFDF’s net interest margin being average among peers, their expense control and scaled branches allow it to generate strong returns on assets. As of 3Q22, FFDF generates nearly the same pre-tax pre-provision income on its assets as much larger peer Huntington (see below).

Market Dominance

FFDF’s share of deposits in the markets they operate can best be defined as dominant.  If you combine the deposits in the six cities that FFDF operates and consider that one market, FFDF would be #1 in deposit market share, out-ranking even the large banks that operate in its markets such as JPMorgan.  Even more incredible is that FFDF has 65%+ more in deposits than the competitor that ranks #2 (see table below). 

Although top positions in deposit market share are nice, it is really the direction over time that matters.  Meaning, is FFDF gaining or losing market share relative to its competitors?  On this metric FFDF succeeds as well – in all six cities they operate, FFDF has gained deposit market share compared to five years ago.  In the New Philadelphia-Dover, OH metropolitan area, where six of their eight branches are located, FFDF has grown deposit market share consistently over the last decade (see below table). This is even true in their most mature market, the city of Dover, where they held 39% of the city’s deposits at the end of 2015.  By 2022, FFDF held 49%.

Risks

The largest risk a bank faces is large loan losses or “underwriting risk”.  However, the problem often times is the difficulty differentiating between a bank taking on a lot of risk and one that is not.  Normally, it is only when a recession hits do you really know how well the bank has underwritten their loan portfolio - which is too late to find out.

The way to “find hints” on the loan underwriting strength of a bank is to find a management team that has shown no signs of doing anything dumb in the loan and securities portfolio over very long periods of time. With FFDF, they came through the financial crisis with extremely minimal losses on their loans.  For 2007-2012, the average commercial bank experienced ~1.7% of losses on their loans per year, whereas FFDF over that same time period only experienced ~0.2%.

The lack of loan issues has continued after the financial crisis with FFDF continuing to experience extremely minimal loan losses and delinquencies.  It also helps put you at ease when the top executives/directors own ~13% of the company and all other employees own another ~10% via their ESOP.  They are incentivized to act properly and not put the bank, and their large investment, at risk.

Currently, FFDF has loans that are delinquent much below peer levels (0.10% of loan portfolio versus 0.68% for peers). And when the loan portfolio is reviewed by each individual loan category, FFDF has only one category that exceeds peer level delinquent rates. 

Also, based on some anecdotal evidence (so take it with a big grain of salt), FFDF seems to be lending to better quality customers at above average rates. FFDF’s website posts interest rates on some of their loan products, including their single-family mortgage (largest segment of FFDF’s loan portfolio). Over the past two years that I have owned the stock, I have looked at this page every few weeks (link). For mortgages, they quote a rate for a 30-year fixed rate loan, with 25% down payment, and customer FICO of 740. Until very recently, this quoted rate was usually around ~50bps above the national average, despite the down payment level and required FICO score also being above typical national averages. The mortgage rate recently is closer to the national average.

But assuming FFDF is sticking to these quoted rates, the implication is that they are lending mortgages primarily at better rates, to better customers, with better collateral coverage. Local customers are likely taking the higher rate given that FFDF seems to have such a prominence in their local community and many people look to their bank for loans first and many times last. Another reason why FFDF’s market dominance is important.

The final point I’ll make centers around FFDF’s pre-tax provision income. On an annualized basis, FFDF currently generates ~$13mm of income before taxes and provisioning for loan losses. An investor can think of this pre-tax provision income as FFDF’s loss absorbing capacity, prior to eating into its capital.

During the financial crisis, the average bank experienced a ~2.4% loss rate, in the worst year, on their single-family mortgage and commercial real estate loans (data at FRED website). As an overly simplified exercise, if you assume FFDF’s entire loan portfolio experiences this 2.4% loss rate (on $525mm of loans), you get ~$13mm of loan losses. Meaning, FFDF’s current pre-tax pre-provision income roughly offsets loss levels of the average bank during the financial crisis. Again, the analysis is overly simplified as the next “crisis” will be different with different causes and magnitudes of losses. But, the Financial Crisis was a large banking industry downturn and, as stated previously, FFDF’s loan portfolio is likely better underwritten than the average bank.

All that being said, it does give some comfort knowing that their business model, generating strong returns on assets, can absorb quite a bit prior to any impact to underlying capital levels.

Valuation

FFDF currently generates ~2.00% pre-tax pre-provision income / assets. Due to their clean loan portfolio, FFDF has averaged a loan loss provision / assets of ~0.15% over the past ten years. This means that FFDF is currently generating ~1.85% pre-tax income / assets, and after an 18% tax rate (lower due to muni bond portfolio), ~1.5% after-tax income / assets.

Over the next five years their return on assets is likely to increase. First, their noninterest expense to average assets has declined nearly 100bps over the past decade (2.7% to 1.8%), as FFDF’s branches continued to grow deposits mostly within their existing branch network. Although growth will likely slow from the high single digit growth rate of the past decade, FFDF should still experience adequate deposit growth to help push down noninterest expense below 1.8% of assets. Combine this with the potential for higher future rates, allowing FFDF’s adjustable-rate and floating rate portfolio to continue to increase, likely increasing FFDF’s net interest margin further.

All of these factors combined means FFDF should generate anywhere from 1.6% to 2.0% in after-tax income to assets. The next question then is what are assets five years from now. Most asset growth is driven by deposit growth. FFDF has grown deposits in the high single-digits as it continued to increasingly dominate its markets. Even if it grows deposits in the mid-to-low single digits means, they are likely near $830mm in deposits five years from now.

A 1.6%-2.0% return on assets on $830mm of deposits implies net income of $13mm - $17mm (or $4.35 - $5.65 per share). With the typical high-quality bank valued at 15x earnings, this implies roughly $65-$85 per share, before excess cash generation is accounted for (i.e., dividends). FFDF’s growth of $160mm in assets (from $670mm to $830mm), will likely require it retains 10% in equity capital against that asset growth. Roughly, $16mm of net income will be required to be held at the bank to fund this growth. If FFDF generates ~$60mm in cumulative net income over the next five years, then ~$45mm will be available to investors, likely in the form of dividends. This $45mm equates to $15 per share. Add that to the $65-$85 per share range, and the total value in five years is likely $80-$100 a share. At a current stock price of $33/share, this implies a 5-year IRR of 20%+ at the midpoint.

A more than adequate return for this high quality bank, likely overlooked due to its small size and OTC-listed existence.

Share

Disclosure: I currently hold shares of FFD Financial. I may buy more or sell my position at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Group 1 Automotive (ticker: ) is one of the largest new car auto dealers in the United States and also owns new car franchises in the United Kingdom.  GPI operates in many states throughout the U.S. with a concentration in both the demographically favorable Sunbelt region (southern part of U.S., coast to coast), and the upper Northeast.  GPI is the largest auto dealership in Texas, which has seen some of the highest population growth over the last decade.

As a new car dealership, GPI operates in an industry with a highly variable cost structure and its largest profit segment (parts and service) has limited cyclicality.  The combination of these two factors allow dealerships to remain profitable even during deep recessions.

GPI has a simple capital allocation strategy of repurchasing stock at attractive valuations and acquiring additional dealerships.  They have repurchased ~40% of their stock since 2013 and ~14% of their stock over the most recent prior three quarters, ending 2Q22.  The new car dealership industry is highly fragmented with the public new car dealers only representing ~10% of new car sales.  A long runway exists to continue to consolidate the industry, as has been occurring over the past few decades.

GPI currently trades at ~7-8x my estimate of normalized earnings and ~3.5x their current temporarily heightened earnings (driven by new car shortages).  GPI’s elevated current earnings provide the extra benefit of additional excess cash to accelerate growth in value per share through either additional acquisitions or share repurchases.  Even if you assume those heightened earnings go away tomorrow and only normalized earnings exist going forward, GPI’s stock could increase 2-3x over the next five years as additional cash generation occurs and the current undervaluation is corrected.

Operating in a durable and defensive industry, with minimal risks, and a cheap current valuation, GPI has great investment potential over the next few years.

Industry Overview

New car dealers are protected by strong franchise and state laws that effectively limit competition and in some cases operate as local monopolies of their brand.  In many cases, these laws limit the manufacturers from opening a dealership of the same brand within a certain distance of an existing dealership. This dynamic is not all bad for the auto manufacturers, as it allows the dealers to more easily make the investments asked of them. More sales through a limited number of dealerships creates a stronger, more financially secure, dealership network, which benefits both parties.

New car dealers have four business lines: (1) new cars, (2) used cars, (3) parts and service, and (4) finance and insurance.  To fully understand GPI, let’s walk through how the new car auto dealer industry works.

In normal economic environments, selling new cars is a low margin business, where dealers make a ~5-6% gross margin on the sale.  However, those margins are worse – after considering indirect costs required to sell those new cars but not directly attributable to each individual new car sale (such as certain personnel and property costs) the margin is close to 0%.

Why sell a product that you make little to no money on?  For the same reason Gillette sells it razors at no profit:  large margins on the subsequent sales of razor blades from your now “built-in” customer base.  New car dealers work with a similar business model, making money from new car sales in a variety of ways.  First, when a new car is sold, a very high percentage of them are financed, either via a loan or a lease.  When the dealer arranges the loan/lease for a customer, they are paid a commission by the finance company for the referral.  Because there are no expenses attached to the commission it is a 100% margin business line for the auto dealer. Dealers also earn commissions when they sell products for insurance companies such as gap insurance.

Next, and most importantly, is the parts and service business where dealers average 50%+ margins.  After a new car is sold it is typically on warranty with the manufacturer for three years.  Meaning, that if any repair is required, and is covered by a warranty, the car’s manufacturer will pay their associated dealer for the cost of the repair.  Once that new car is off warranty (or when they sell a used car), customers always have the option to service their car at an independent repair shop instead of a dealership.  A certain percentage of customers will choose to go the non-dealership route, but certain customers will always feel more comfortable with a dealership servicing their vehicle versus the independent shop.  Also, even when a customer chooses to service their vehicle from an independent repair shop, they still need parts to perform the repairs.  Local auto dealers act as a supplier to many independent repair and collision shops, selling them the parts they need to complete their service work.

Better yet, the service business also has limited cyclicality, with consumer demand for vehicle servicing remaining fairly stable in all economic environments.  Due to this, when new car sales decline dramatically in a recession, a dealership’s service business still generates lots of cash.  The service business is one of the main reasons why the public auto dealers did not lose money even during the deep recession of 2008-2009. 

The service business represents a disproportionate large amount of a dealer’s profits.  Although each service transaction is a much smaller dollar amount than a car sale, since the margin on that service transaction can sometimes be 10x as profitable, it requires far fewer transaction to generate the same profits.  To put that in numbers, in 2019 (using a non-COVID effected year), parts/service represented 13% of GPI’s revenues, but 45% of gross profits. Whereas, new car sales represented 52% of revenue but only 17% of gross profit. These facts really put into context the importance of the parts and service business, the largest contributor to an auto dealer’s gross profits.

Finally, each new car dealer operates a used car business at each dealership.  Since the lowest-cost method to source used cars is from the consumer, new car dealers are especially well positioned to collect used vehicles in a variety of ways others cannot.  The used car business is also less cyclical than new car sales.  Industry-wide U.S. new car unit sales declined 40%+ in the Financial Crisis (from peak-to-trough), whereas used car unit sales only declined ~16%.

Variable Cost Business Model

Auto dealers, unlike auto manufacturers, operate with a highly variable cost business model.  Compensation expense is by far the largest expense item in its cost structure, followed by advertising.  Much of this compensation is paid to the dealer’s sales people, which comes in the form of small base compensation plus larger potential commissions.  When sales decline, commissions automatically decline (less sales = less commissions).  Dealer’s can also cut staff during a recession as they obviously need less sales people if they have less customers.

This dynamic combined with the ability to cut advertising expenses creates a the predominantly variable cost structure.  For example, during the Financial Crisis, GPI’s revenues declined ~30% from 2007-2009.  Despite this decline, operating margins only declined from 3.1% in 2007 to 2.8% in 2009.  So, although revenues and profits both fell substantially during a very deep recession, GPI (and the other public dealers) still remained profitable.  Profitability was only possible due to (1) the less cyclical service business being a large portion of a dealer’s profits, and (2) the ability to quickly/”automatically” pull costs out of the business once a recession begins. 

Capital Allocation Strategy

After all this lead-in you are probably thinking, “that’s all great but why GPI over other public auto dealers then?”  Although I think many of the U.S. new public auto dealers are priced for high returns, the answer really is due to GPI’s capital allocation strategy, and relative valuation (discussed later in Valuation section below).

GPI operates with what seems to be the simplest capital allocation strategy of all the public dealers.  GPI’s capital allocation strategy is simply (1) buy other new car dealers, (2) repurchase stock (bought back ~40% of company since 2013), and (3) pay a small dividend.  Pre-COVID, this was the same strategy as many of the other public dealers.  However, many are now seeking to buy more dealers and in a quicker timeframe, start standalone used car sites, start/buy their own captive finance companies, and are beginning to talk about venturing into selling products outside of cars such as RV’s and agricultural vehicles. 

Nothing is necessarily wrong with any of these strategies, but they are all new strategies with no track record behind them. Also, outside of one or two of the public dealerships, most do not have a highly successful track record of success in simply acquiring other dealerships, which makes you question the potential success of their new ventures.

However, like any good operator, GPI has evaluated many of these ventures that the other public dealers are choosing to take on.  On starting their own captive finance company, GPI noted on their 22Q2 earnings call, they are not interested – believe they have supportive finance partners currently and don’t want to add fixed costs to their business model.  On standalone used car sites, mentioned as far back as 2015 how hard it is to make that model work, while discussing how three of the other public dealers failed in their attempts at starting standalone used-car sites.

GPI has intelligently realized that there is an opportunity in the used car space but they think they can utilize their existing infrastructure.  In 2018, GPI introduced “Val-U-Line” used car offering which is just GPI retaining more of 6-10 year old cars instead of sending those to auction. First, this allows them to capture the margin they previously gave-up on those sales when offloading these types of cars in bulk to auctions.  Also, GPI could not get the math to work on standalone used car stores so this was their version of it, allowing them to sell additional cars without additional fixed costs / infrastructure (along with their online selling portal discussed in next section).  GPI believes this can also help increase the number of people coming to the dealership for service.  They have stated they are not necessarily looking to sell cars to people far outside of their current markets.  They want to retain their customers and gain future, higher margin, service work from them as well.

Final point on GPI’s capital allocation – they have shown the rare willingness to shrink their business when it makes sense.  GPI purchased a Brazilian auto dealership group in 2013.  Although they attempted to grow in Brazil, GPI ran into two main issues.  One, they could not make additional acquisitions in Brazil it if they did not accept existing liabilities in deals related to tax/employees, and (2) the exchange rate kept deteriorating.  Due to these factors, GPI divested their Brazilian operations in July 2022 for slightly less than $100mm (4-5% of current market cap) and can now re-deploy that capital towards better uses.

To sum it up, GPI is simple but focused.  Although they have not been anywhere near as successful at making acquisitions as some of the other public dealers, they have repurchased ~40% of their stock since 2013 at attractive valuations.  GPI’s simplicity and focus in capital allocation are very appealing, in addition to not pursuing a “conquer the world” strategy like others.

New Car Dealers Advantage in Used Car Business

GPI has coupled their Val-U-Line strategy selling older used cars with their recent online car selling website named AcceleRide in 2019.  The other large public dealers are all introducing online sales, as they compete with Carvana and certain consumers desire to complete their car purchases online.  Although Carvana has grown quickly (despite their recent struggles), the new car dealers do have certain advantages in the used car business over the online-only used dealers.

The four main ways dealers source used vehicles are from: (1) trade-ins, (2) off-lease returns, (3) direct consumer transactions, and (4) auctions.  Options #1, #3, and #4 are available to used car lots and the Carvana-type online only used retailers but new vehicle dealers have two main competitive advantages in the used car business.  First, off-lease returns are only available to new car dealers providing an additional source of used inventory that is less expensive than buying from an auction (and paying the associated auction and transportation fees).  Second, whenever a customer buys a new car and trades in their used vehicle during the transaction, the new car dealership’s used vehicle inventory will increase.  Used car lots and online used car dealers do not have this benefit.  In a typical used-for-used transaction, the dealer’s inventory levels do not change.  But, if a customer is buying a used car with no trade-in (e.g., first time car buyer), then their used inventory declines.  By offering new cars, new car dealers benefit from customers exchanging their new car for a used car, which grows the dealer’s used vehicle inventory.  Effectively you can think of this dynamic as a ratio or percentage all dealers have, indicating the replacement rate of their used car inventory.  Since new car dealers have additional sources of used vehicles, their “replacement ratio” (my made-up term) should be higher than used-only competitors, which means they must go to the more costly auctions less often.

Carvana, and its peers, lack other advantages that new car dealers have.  The second being new car dealers can make additional money, at high margins, from used car customers by servicing those vehicles post-sale, while also providing a “free” marketing opportunity for the dealer.  And finally, and maybe most importantly, the dealers are selling these incremental online cars out of existing infrastructure.  Slack capacity in both their service business and on their lots means new car dealers only incremental expense will be to build out the technology to sell online, which really just leverages their existing websites.

To sum it all up, versus the online start-ups such as Carvana (and even CarMax ), new car dealers have advantages.  They will be able to offer customers the same used vehicles, at better prices due to their lower sourcing costs, while also being able to make money from customers future servicing needs (which also provides a free marketing interaction with the dealership).  Although Carvana may find a permanent spot among the used car dealers, large new car dealers with effective online portals, should be able to compete effectively against them. 

Main Risks

New Management

Earl Hesterberg has served as GPI’s CEO since 2005.  The Board recently announced that Hesterberg will retire at the end of 2022 and their current President of U.S. Operations, Daryl Kenningham, will become the new CEO.  With any CEO change, the question is always how both the operational strategy and capital allocation strategy of a company change.  With Kenningham as President of U.S. Operations since 2017, drastic operational changes seem unlikely.

The larger question is will Kenningham change GPI’s relatively “simple” capital allocation strategy and attempt a more aggressive approach that others in the industry are currently pursuing.  With Hesterberg, who holds $43.5mm worth of GPI shares or 1.6% of the company, you knew his interests were strongly aligned with shareholders.  He showed this by allocating capital to repurchasing shares at intelligent prices, while also not pursuing ventures that others in the industry were, noting many times that the “math did not work” on a specific venture, despite his peers eagerly pursuing these ventures.  Kenningham currently owns $9mm or 0.3% of GPI, although that fiture will likely grow once CEO. 

Kenningham’s career path is fairly similar to Hesterberg’s in that they have been in the automotive industry their entire careers and came up mainly in sales/marketing/operational roles.  Despite this, Hesterberg has shown an ability to understand capital allocation mainly via the large share repurchases at intelligent valuation that have occurred over the past decade.  Kenningham has been close witness of this but, of course, we’ll need to see what Kenningham does to truly understand how he will manage capital.

GPI does have a logical management incentive structure in-place that presumably will carry over to Kenningham.  Both the short-term and long-term bonus/awards are increasingly focused on financial goals and are increasingly performance-vesting (as opposed to time-vesting).  Long-term performance awards are based on ROIC and total shareholder return versus peers.  With this incentive structure in-place, and the Compensation Committee of the Board trending toward more financial/performance focused awards, Kenningham should be properly incentivized to continue to manage the company in a shareholder-friendly manner.

Electric Vehicle Impact on Parts & Service Business

Electric vehicle’s (“EV’s”) engines contain less parts than the traditional internal combustion engine.  Because of this, less parts fail or need service.  This dynamic means auto dealer’s parts and service business will likely be negatively affected as EV’s are increasingly adopted.  The size and timing of the impact will depend on many factors.  On size of the impact, many in the industry have noted that although current EV’s require less service appointments, when they do enter a dealership for service, the amount of money spent by the customer is more than the traditional car. So there may be somewhat of a netting effect that occurs, with less transactions but higher transaction sizes. 

On timing of the transition to EV’s, Mike Jackson, the former long-time CEO of AutoNation, said about a year ago that he expects by 2030 for ~20% of cars sold to be EV’s and ~7% of cars on the road to be EV’s.  Obviously this could be drastically wrong, but it is also pretty accepted that the current U.S. electric infrastructure could not handle a full switch to EV’s today.  Gradual consumer adoption combined with gradual U.S. infrastructure changes should mean this trend will not occur over night.

Also, outside of the potential EV shift, vehicles are becoming more complex.  Each car is integrating more technology in the form of sensors, internal chips/computer, software, etc.  Each of these make it more difficult for the do-it-yourself consumer looking to maintain/repair their own vehicle.  At the same time, many small independent repair shops might not be able to make the required investment to provide service work on many of these advancing technologies, including EV’s.  These factors are tailwinds towards increasing service work finding its way to the new car dealership, whose technicians are highly trained, and are larger companies with the financial resources to make the required investments for these new technologies.

Valuation

GPI’s valuation comes down to understanding normalized revenue and margins.  Although this is true when valuing any company, the “normalized” piece is even more important given that auto dealer’s are currently earning outsized profits, driven by ongoing new car supply shortages.  GPI has also acquired large dealerships since COVID began, divested their lower-margin Brazil operations, likely lowered their cost structure, and repurchased a large chunk of their shares. This creates a murky picture of future earnings and is probably the main reason why this opportunity exists.

Just want to note that by “normalized” I mean the profit potential GPI should make in an average year.  Not a recessionary year, not a booming economy year, and definitely not a new car shortage year like 2022. 

Let’s start with normalized revenue. A back-of-the-envelope way to estimate their normalized revenue is by looking at GPI’s historical fixed asset turnover.  Essentially, how much revenue each dollar of fixed assets (e.g., property) generates.  In the immediate years before the pandemic, GPI generated roughly $7.5 to $9 of revenue per dollar of net fixed assets.  GPI’s current net fixed assets are around $2.0bn.  Applying the $7.5-$9 range to $2bn implies $15bn-$18bn of normalized revenue, as compared to the ~$16bn of revenue GPI should generate in 2022.  If at least some new and used car price inflation sticks around permanently, then the upper-end of the range is more likely.

The next piece is determining normalized margins.  GPI operated around a 15% gross margin over the past decade.  Auto dealers have experienced increasing penetration rates on their finance products over the years.  Meaning, not only are auto dealers receiving commissions due to more customers financing or leasing their vehicle, but dealers are also receiving commissions from the increasing amount of additional service and insurance products being sold simultaneously.  Due to higher penetration of these finance products, this means each car sold is generating more finance commission dollars (which are 100% gross margin sales).

Also, the pandemic likely caused a permanent shift in the way new cars are sold.  Pre-2020, auto dealers dealt with near-permanently bloated inventory levels by discounting cars, with much of the discounting incentivized by the auto manufacturers.  Sell a certain number of cars in a month and the manufacturers would pay the dealers a small “bonus” per car, if the dealer achieved those targets.  This dynamic caused new car margins to decline over the past 10+ years.  But once COVID shutdowns arrived in 2020, and the economy quickly re-opened thereafter, the auto dealers depleted their existing inventory as demand bounced back quickly.  The auto manufacturers were not able to supply as many cars as pre-COVID due to the microchip shortage, driven mainly by consumers buying electronics for their new work-from-home lifestyle and inability to spend money on services (e.g., travel, lodging, etc.).  A new car shortage resulted, lifting margins on new cars from ~5% pre-COVID, to 9-10% currently.  The auto dealers obviously benefited by being able to sell closer to MSRP, while the auto manufacturers also realized that producing less supply, meant more pricing power.  The auto manufacturers have mentioned they will seek to keep this dynamic in-place, in some respect, going forward and obviously the dealers agree.

The point of all this is that new car margins are likely to be higher in the future than they were for much of the past decade.  These higher new car margins combined with the increased finance product penetration, means that normalized gross margins are probably higher than GPI’s historical 15%.

Then the question is what is GPI’s cost structure in terms of SG&A.  Historically, GPI has had one of the more inefficient cost structures in the industry, operating at 73-75% SG&A as a percentage of gross profit.  However, this figure included their now divested (as of July 2022) Brazilian unit which operated at ~90% SG&A/gross profit.  Plus, management believes similar to coming out of the Financial Crisis, that they and others have figured out ways to be productive with less.  With compensation expense being a dealer’s largest expense, lowering a dealer’s cost structure mainly means figuring out ways for each employee to be more productive.  GPI management has mentioned they believe they permanently removed at least 400bps from SG&A/GP, implying a 69-71% range.

Finally, if auto dealers and manufacturers can keep inventory levels down versus pre-COVID, dealers will pay less in interest to hold their inventory and lowering their interest rate risk (more on the next section). 

To end the long-winded explanation, this all sums up to a 2%-3% pre-tax margin, compared to the average ~2.4% pre-tax margin GPI managed from 2009-2020.  Given all the potential positives to the margin structure of GPI, a 2-3% estimate for pre-tax margins is not outrageous. This implies ~$15-$25 per share of normalized earnings.

Final item to note is on the next five years of earnings. Even if these deployed earnings only generate dollar-for-dollar of additional market value, and the shortage-driven, $700mm+ of heightened earnings revert to normalized tomorrow, it is difficult to derive a scenario where a positive return for the investor does not occur at today’s ~$155 per share stock price.

Other Factors to Consider

Interest Rate Hedges

GPI management has also displayed their intelligence via the use of interest rate hedges on their floating rate debt. Auto dealers use floorplan financing to finance most of their inventory.  Floorplan financing is typically floating rate debt, which means that utilizing the debt means less investor equity is required to be invested in inventory, but it does expose auto dealer’s to some interest rate risk.  GPI’s management has realized this and has a unique feature the other auto dealers do not.  GPI has interest rate swaps that have swapped a large portion of their debt from floating rates to fixed rates.  As of June 30, 76% of GPI’s $2.8 billion in floorplan and other debt was fixed.  Although the swaps expire on average around 2028, they do provide a large buffer against rising rates over the next few years.

Operational Strategy Focused on Parts & Service & Favorable Demographics

GPI, more than the other public dealers, seems to stress their operational focus on the parts and service business.  They understand the importance of that segment, and the large profits it generates.  Although not many unique operational strategies can be used in the service business, they have implemented a four-day workweek for their technicians.  This allows the dealer to operate longer hours at each service bay and it allows technicians to have more consecutive days off (in exchange for longer hours each day).  The expansion of open-hours, expands capacity for GPI’s service business, and it offers a wider variety of time availability to potential service customers, helping GPI better compete with the independents.

As noted previously, GPI is the largest auto dealer in Texas.  Texas was third in population growth rate from 2010-2020 (+16% growth), and first in total population growth (+29.1mm residents).  With no personal or corporate state income tax, along with its warm climate, Texas is attracting many additional residents and businesses.  This means more people and cars on the road, which benefits every segment of GPI’s business, including their highly-important parts/service business.

Disclosure: I currently hold shares of Group 1 Automotive. I may buy more or sell my position at any time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.

Motorpoint is the UK’s largest independent used car dealer.  Motorpoint’s business model centers around offering unbeatable prices (95% of customers say their prices cannot be beaten).  Because they offer the lowest prices, Motorpoint sells high volumes per site, creating major economies of scale, spreading their fixed costs over more units sold. Their high-volume strategy, coupled with shrewd operational excellence, pushes down their operating expenses as a percentage of revenue to industry-leading levels.  The low cost structure means they can price their cars lower than competitors and still make a decent profit.

To sum it up, Motorpoint’s main advantages create a self-reinforcing cycle:  offer low prices -> achieve higher volumes per store and per employee -> higher volumes lowers unit cost structure -> lower unit cost structure allows them to price below competition.  This powerful competitive advantage, combined with Motorpoint’s asset-light operating strategy, allows them to achieve 50%+ returns on equity, while using no corporate-level debt.

Better yet, Motorpoint’s growth runway is long.  Despite being the UK’s largest used dealer, they only hold a ~3% market share in their niche (0-4 year old cars).  The industry is highly fragmented, with many smaller competitors.  Management announced a plan in July 2021 to double their FY20 revenue and profits over the next three to four years, mainly by opening additional stores.  Management has also stated that they can achieve in the long-term mid-teens market share.

Finally, the valuation is cheap.  Even with their strong competitive advantages, high returns on capital, and long growth runway, Motorpoint currently trades at ~10x current earnings.  And they trade at only ~4-5x management implied earnings at the end of their plan in FY24 (or even lower if you include excess cash generation over that time period).  Although certain risks exist, Motorpoint seems to be significantly undervalued, especially given their highly-profitable future growth potential.

Used Car Industry Dynamics Summary

The used car industry is comprised of a few main types of sellers: small-to-mid sized independent used-only retailers, franchised new car dealers that also sells used vehicles, and large used-car “supermarkets” (e.g., Motorpoint).  Each used car seller competes primarily based on (1) price, (2) location, (3) service, and (4) selection.

Factor #1: Price

Price matters but how does a used car get priced?  As Motorpoint’s CEO has stated, they basically operate in a spread business, applying a margin to their all-in cost to acquire the vehicle.  The cost of a used car primarily consists of: (1) the cost to buy, (2) cost to get the vehicle to the right location and recondition it, (3) “held depreciation”, and (4) indirect overhead costs that are semi-fixed such as marketing, employee costs, and building lease costs.

Buying Costs

Dealers primarily source their cars from consumers, fleets (corporations or leasing companies), and auctions.  Auctions are a costly option as auction fees need to be paid, purchased cars need to be transported to the appropriate site, all while facing price competition from other dealers on every auctioned vehicle. 

Buying from fleets and consumers (or receiving trade-ins) can be much cheaper.  Motorpoint’s pre-pandemic focus was selling 0-2 year old cars purchased mainly from fleets.  Since Motorpoint is the largest used car retailer in the UK, they could provide an easy solution to fleets looking to sell to one buyer, in one simple transaction.  Even better, auto manufacturers typically sell cars to fleets at a discount.  The combination of this discount (that was then passed along in some form when fleets determine a car’s sales price) and Motorpoint’s large buying power allowed them to historically acquire large amounts of cheap inventory.

In the post-pandemic world of shortages, fleets are no longer selling many cars.  Due to this, Motorpoint expanded its ability to buy from consumers, now allowing people to sell their car to Motorpoint, even if they are not buying from Motorpoint.  In FY22, they sourced 18% of their retail units sold from consumers (up from 6% in prior year).  Motorpoint has also adjusted to the lack of inventory by beginning to sell 3-4 year old cars, as opposed to their former 0-2 year old niche.  Previously they would dispose of any car older than two years via Motorpoint’s auction business, Auction4Cars.  Now they retain these vehicles, allowing them to sell them at higher retail prices.

Depreciation Costs

The second component of a used car’s unit cost is “held depreciation”, which represents the amount of depreciation occurring prior to sale.  Motorpoint exceeds the competition here as well by achieving some of the highest inventory turns in the industry.  Historically, they turned over their inventory ~9x per year, with most years leading their UK used car supermarket peers in this metric.  They are also still competitive on inventory turns compared to new car franchised dealers, despite franchised dealers sourcing more of their vehicles on-site via lease returns and new car buyer’s trade-ins. 

Since Motorpoint holds their inventory for minimal time they also incur minimal depreciation.  This performance is driven by management’s efficiency at funneling purchased cars to the right location and then employees are equally effective at selling these cars.  To oversimplify, it’s doing all the little things correctly and efficiently, each and every day. Obviously, it also helps move cars when you are the price-leader of the industry (… with the most satisfied workforce in the industry - discussed later).

However, during the recent supply shortages, holding used cars for longer has recently been a good action for dealers, as prices appreciated instead of depreciated.  But, this dynamic has recently changed.  Motorpoint’s CEO stated in mid-May 2022: “Sure, prices are around 30% higher than they were a year ago but prices have plateaued and are beginning to ease off. Additionally, for the first time since COVID, we’re seeing normal levels of depreciation returning, with stock typically losing between 1.5% and 2% of its value per month.”

Indirect Overhead Costs

The final component of unit cost, indirect overhead is really Motorpoint’s “secret sauce”.  Since Motorpoint does such volume per site they can spread their fixed and semi-fixed costs over many units sold, lowering their unit cost structure.  The indirect overhead of operating a used car retailer contains three main semi-fixed costs: (1) site lease/ownership costs, (2) employee compensation, and (3) marketing. 

Besides employee commissions, none of these other costs increase proportionally as sales increase.  For example, just because sales double, does not mean lease costs double.  Motorpoint achieves revenue per location of £85mm+ (mature stores are likely much higher).  Whereas the average public UK franchised dealer generates £30mm+ per site (this includes their service and new car sales as well), and the largest UK used car supermarkets generate a similar amount to Motorpoint in revenue per site.  Also, franchised dealers need to abide by auto manufacturers requirements, which usually means locating their dealerships in higher cost locations and updating/renovating their sites when requested. Overall, this means Motorpoint, and the other large used-car supermarkets, are able to leverage their occupancy costs with more revenue per site, while also operating less expensive sites in less expensive areas than franchised dealers.

Employee costs also do not increase directly proportionally with sales.  A dealer may need more employees if sales increase, but most employees are not working at 100% capacity - they can always take on additional customers per day.  This leveraging of employee expenses is where Motorpoint really exceeds peers.  Despite paying the same average amount per employee as their competitors, Motorpoint has significantly lower compensation expenses as a percentage of their revenue.  On this metric, Motorpoint has averaged ~3% of revenue historically, whereas both UK franchised dealers and UK used car supermarkets average 6-7%.  According to management, this is achieved via their higher inventory turnover and from their highly-productive employees.  Motorpoint’s operational efficiency is truly amazing.

To sum it all up, Motorpoint has lower unit costs than the competition by being well-positioned to buy from the cheapest sources, incurring low depreciation per unit, and with very low per unit indirect overhead costs.  These lower unit cost advantages, show up in Motorpoint’s financials with its industry-leading operating expenses as a percentage of revenue (5-6% for Motorpoint versus 8-10% for competitors).   This allows them to price below the competition, operating at gross margins levels not profitable for many competitors.

Factor #2: Location

Currently Motorpoint operates 17 locations throughout the U.K.  Pre-pandemic Motorpoint was very conservative with their new store strategy, targeting one new store per year.  However, in July 2021, they announced a plan to significantly increase the number of stores over the following 3-4 years.  Management’s plan is to open 12 new stores that will be smaller than their existing sites, serving mainly as sales and collection centers. 

Management’s thinking is simply that location matters significantly.  According to Motorpoint’s FY22 call, their market share to customers greater than 30 minutes away from a store is <1%.  But, their market share with customers less than 30 minutes away is 7.7%.  This dynamic is reinforced by an analysis by the U.K.’s CarWow in 2017 revealing two main facts: 

1. average car customer from London or Northwest England, travels 32-33 miles to purchase their car.  In Northeast England this figure increases to 62 miles and for Scotland it increases to 151 miles, and 

2. as the price of the car decreases, a customer’s willingness to travel also decreases, and vice versa

With (1) Motorpoint selling mainly cars on the cheaper end of the scale, and (2) most of the U.K. population, in the London or Northwest England area, Motorpoint’s need to place branches close to customers is crucial.

More importantly, this dynamic also reveals that the threat of Motorpoint cannibalizing their current store’s sales with new stores, is not much of a threat at all.  The lack of almost any market share in markets greater than 30 minutes away, means if Motorpoint continues to open stores at the appropriate distances from existing sites, nearly all incremental sales should come from new customers.

Growth potential for Motorpoint is large via both store count growth and additional market share growth at their younger stores.  Management has stated previously that they can eventually achieve mid-teens market share.  With their pre-2013 opened store cohort operating at ~10% market share, even these stores have significant room to grow if management’s targets are correct.

Factor #3: Service

Badly reconditioned cars or overly pushy salesman using less than ethical sales tactics can easily turn-off a customer from making a purchase at a specific dealer in the future (or recommending that dealer).  Fortunately, Motorpoint exceeds on service and the data proves it.  They have a net promoter score of 84.  This ranks above the net promoter score of many top global brands and more importantly, it is about double the average score of the automotive industry.  For an industry not known for its loving customers, this score is remarkable.

Motorpoint’s happy employees undoubtedly help increase customer satisfaction.  After all, happy employees are more likely to delight the customer than a disgruntled or uninterested employee.  While every company aims to please their employees, Motorpoint seems truly focused on achieving this goal.  Motorpoint is ranked as #1 within the automotive sector, in the UK’s Sunday Times Best Large Company to Work survey.

Factor #4: Selection/Choice

Most UK consumers begin their car buying journey by first visiting AutoTrader’s website.  AutoTrader has 90% prompted brand awareness among consumers and is the dominant car buying research platform in the UK.  Among all car buying websites, UK consumers spend 75% of their car research minutes on the site.  This compares to 9-10% of “minutes share” for their #2 competitor.  Simply put, UK consumers value AutoTrader as the first and potentially final research point for finding the vehicles they will either buy or visit.

Motorpoint and most other dealers pay a monthly subscription to AutoTrader to list cars on their website.  The importance of this is AutoTrader’s platform has effectively created the ultimate large UK “dealership” with great breadth and depth of car variety.  Consumers know they can visit the website and find all types of cars and compare prices in the process.  Motorpoint, as the largest UK used car dealer, will obviously be able to list a much larger inventory than almost all other competitors.  But better yet, due to Motorpoint’s unbeatable prices, UK consumer comparison shopping on AutoTrader is to Motorpoint’s benefit.  Even AutoTrader stated in a recent a May 2022 AutoTrader presentation that: “Motorpoint has consistently more 'well priced' stock compared to the marketplace, and this trend is growing.”

It should also be noted on “Selection/Choice”, that people always have the choice of buying a new vehicle instead of used.  In historical recessions, used car sales usually decline much less than new car sales.  For example, during the 2008-2009 Financial Crisis, Motorpoint’s revenue declined less than 8%, from highest point to lowest point, showing the resilience even with the UK unemployment rate reaching ~8% (compared to -18% decline in new car volumes in the UK).  When times get tough, people (1) buy less, (2) buy cheaper, and/or (3) are more concerned with buying better “value”.  Although people may choose to buy less in a recession, with Motorpoint being the low-cost UK used car dealer, Motorpoint will excel when people choose to buy cheaper and are looking to get the most value for their money.

Valuation

Motorpoint made ~£17mm in earnings during FY22 (year end March 2022).  During the year, they opened three new sites, two of which opened in the final two months of the fiscal year.  Which means Motorpoint incurred operating expenses to open these sites, but only received one or two months of revenue.  And the revenue of Motorpoint’s stores ramp significantly in subsequent years.  Motorpoint also spent marketing dollars of ~£19mm in FY22, versus ~£7mm in prior years.  The point of all this is that Motorpoint’s earnings include heightened investment expenses as they execute on the FY24 growth plans. Without adjusting earnings for any of the previously mentioned items, Motorpoint trades at ~10x earnings on their ~£170mm market valuation.

And frankly, the current earnings multiple is a bit irrelevant, due to the amount of growth Motorpoint should experience in the next few years.  Let’s focus on management’s FY24 projections (see graphic below).  If Motorpoint achieves their targeted ~£2bn of revenue at a midpoint 2.5% pre-tax margin, then that implies after-tax earnings of ~£37.5mm (meaning, they trade at 4.5x earnings).  But, Motorpoint should also generate distributable free cash flow of £10-£15mm per year until the end of management’s FY24 plan, implying they are trading for ~4x FY24 estimated earnings, when including excess cash generation.

The obvious question then is can management achieve their projections on revenue and margins?  With the 12 new stores, Motorpoint will operate 26 total stores by the end of the plan.  Last year Motorpoint generated £85mm per store on their average store count.  Mature stores likely generate £100mm+ in revenue currently, however the newer stores are a smaller format and will likely generate smaller volumes.  Even if you assume no additional increase in revenue per store and assume that the 26 sites each generate £85mm, that implies £2.2bn of total revenue.

As stated previously, the business is essentially a spread business where a margin is applied to the cost of the vehicle, creating stable margins.  Motorpoint has operated at ~8% gross margins historically and overhead plus interest expenses have been in the 5.5%-6.5% range.  Using these figures, implies 1.5%-2.5% pre-tax margins, which is a slightly lower range than management’s forecast.  On £2.2bn of revenue, these levels of margins would generate after-tax earnings of ~£25mm-£40mm.  On Motorpoint’s current ~£170mm valuation (~£195p per share), these earnings imply a 4x-7x multiple, before including excess free cash flow generated.

However, there is reason to believe that a fully mature Motorpoint operates at the lower end of the 5.5%-6.5% overhead+interest expense range.  The only year on record where Motorpoint did not open a new store was FY19.  In that year, overhead+interest was ~5.4% of revenue.  Yet, FY19 still included the dampened results of non-mature stores prior years, just not the opening costs of a new store.  So, the expense leverage could be even greater than FY19 displayed. 

You can run the analysis out further to, say, five years, with assumptions of 30 stores, and with existing sites continue to mature up the mid-teens market share management has cited as achievable.  These numbers are almost absurdly attractive compared to the current valuation and are not required to generate a more than adequate return.  Whether they end up trading at 15x earnings or 20x in five years, Motorpoint should increase multiples above its current valuation, assuming it can navigate a few risks.

Risks

The largest risk to Motorpoint is a competitor manages to steal volume from them, which would “un-wind” some of the high-volume operating leverage that is so important to Motorpoint’s business.  I view this as unlikely mainly due to: (1) historically difficult industry, (2) very fragmented UK used car market and (3) recent changes in valuation and strategy of Motorpoint’s aggressive online competitors.

The ability to achieve a lower cost structure depends on utilizing a high-volume strategy.  And this high-volume does not appear overnight.  As shown in the market share graphic above, market share grows slowly year-by-year by delighting customers and running an efficient operation.  This is no easy task – just look at the U.S. used car market.  There is a reason why the only real large, profitable, used car dealer is Carmax.  It is an industry with a large graveyard full of many failures.  Operating on slim margins requires incredible operational discipline, heavily aided by a superior CEO (more on that below).

Second, the UK used car market is extremely fragmented, filled with many smaller, less-efficient operators.  This is not a situation where Motorpoint holds 50% market share and a competitor’s growth only comes at the expense of Motorpoint’s share.  If anything, more efficient operators should steal share away from the smaller, less-efficient operators that cannot offer the same low prices.  As long as AutoTrader continues to be the website most UK car consumers use to find their next car, then Motorpoint and the other efficient operators should have a place in the UK’s used car market.

To continue that last point, the one large risk is if AutoTrader is displaced as the “go to” site by a competitor’s website.  This is effectively what online competitors Cazoo and Cinch were attempting to do before recent events slowed them down significantly.  If UK consumers suddenly switch to thinking “Cazoo” instead of “AutoTrader” when they want to search for a used car, then Motorpoint will be left out, since Cazoo only sells Cazoo vehicles.  This obviously assumes that Cazoo/Cinch achieve such a size that they can offer the same breadth and depth of used cars as AutoTrader provides, otherwise AutoTrader will always be more useful to consumers.  This is no easy task and has become even more difficult for them. 

As interest rates began to rise this year, shareholders and bondholders of Cazoo/Cinch (and Carvana in the U.S.), became unwilling to tolerate never-ending losses for the sake of rapid growth.  Due to this, Cazoo/Cinch recently changed strategies from a very aggressive growth stance to seeking slower, profitable growth.  They are spending less on marketing their brand, while also presumably being forced to price their inventory more rationally to achieve future profitability.  This means they are forced to grow slower if they want to survive, which means the chance of one of them displacing AutoTrader has becoming an even smaller probability now.  Nothing is guaranteed, but I like Motorpoint’s odds of succeeding, especially given the low expectations implied by their current valuation.

Other Factors for Consideration

Management

The CEO, Mark Carpenter, owns 10% of the company.  Carpenter was the former CFO at Sytner, the largest U.K. auto dealership.  He brings an analytical, data-driven approach, which shines through in their publicly-released financials, showing various important metrics that other companies might not bother to measure.  The company has historically operated very conservatively, considering they have not carried any company-level debt, and, pre-pandemic, opened only one new store per year.

Carpenter receives a salary of £350k and was paid £978k in total for FY22.  Much of his non-salary compensation is paid in stock or is cash incentive pay.  Unlike most CEOs, his salary is dwarfed by the ~£17mm of stock he owns in Motorpoint.  He is highly-aligned with shareholders given this level of stock ownership and his current incentive pay structure (focused on broad mix of growth, profits, customer/employee satisfaction).  Given his shareholder-alignment, it is no surprise that Motorpoint has shown the ability to return cash to shareholders.  Before the pandemic, they paid a dividend and repurchased nearly 10% of their stock from 2018 to 2020 at intelligent prices.  And, at their recent Annual Meeting, shareholders approved a stock repurchase plan for another 10% of shares outstanding.  Given the compelling economics of this business, capital returns should restart soon.

Business Economics

Despite operating on small margins, Motorpoint’s high inventory turnover and asset-light real estate strategy mean they still achieve a return on average assets of 8-9% in a typical year.  Unlike many car dealers, Motorpoint seeks to lease all their properties, conducting a sale-leaseback shortly after opening each store.  According to Motorpoint’s management, the leases have been structured in an inflation-friendly manner, with price increases capped at 1-3%.

Leasing real estate reduces the capital intensity of the business and allows Motorpoint to redeploy that capital into building new stores.  Due to the minimal investment required for their floor-planned inventory, leased fixed assets, and small receivables, the resulting returns on average equity are 50%+. 

Due to the high ROE’s, the business economics to shareholders are very compelling.  Even with Motorpoint investing ~£2mm of equity per store, in a year where they build three new stores for ~£6mm total, they will still have ample free cash flow to distribute to shareholders.  Thus, the earlier mentioned conservative target that they should be able to return £10-£15mm of free cash flow annually over the next few years.  Over the course of the next five years, distributable free cash flow should ramp significantly, as they complete their new store growth plan.

Auction4Cars

Motorpoint also operates an auction site for cars it does not plan to retail.  Due to Motorpoint’s strict pre-pandemic criteria of 0-2 year old cars and <15k miles, many trade-ins did not fit their desired profile.  Instead of paying someone else to auction the cars for them, Motorpoint built Auction4Cars to dispose of these vehicles. 

Motorpoint decided to change the business model to now allow third-party sellers.  They have also decided to utilize their low-price retail strategy within this auction business.  According to Auction4Cars, competitor’s auction fees can be 800%+ higher than Motorpoint. 

When I asked management how they were able to achieve the lower fees, they confirmed that it was a combination of a lower cost structure and the competition pricing unusually high historically.  Although they seem to not want to disclose too information on Auction4Cars advantages, based on Motorpoint’s current valuation, you are essentially paying nothing for the future growth potential of their auction business.  Given management’s remarkable operating ability, I would not put it past them to turn the auction business into a much larger profit engine over time.

Disclosure: I might hold shares of any security mentioned in this article and may buy or sell at any future time. Please do your own due diligence before making any investment. None of my posts are investment advice. For full disclaimer, please click here. Feel free to contact me - I can be reached on this site or via my firm’s website here.