Business

Porters sells workflow software for staffing firms and recruitment firms. While the company is ~20 years old, they have been working on a SaaS product since 2012. This is basically a CRM system that manages both labor/recruits and clients. While this would get lumped in with broader HR software, there is a more existential driver to adopting it, which is that a staffing or recruiting firm’s revenue is an outcome of how efficiently and productively they manage what is otherwise a HR department function more removed from the user paying their bills at the end of the day. There are additional business running aspects that make it a distinct vertical, such as contract management, invoicing, or summaries that get sent to a customer.

ARPU is JPY123k/yr (~$800) and 95% of revenue is recurring. The product is sold by a direct salesforce to ~2,000 companies and ~14,800 users. The company has a lot of white space given that potential customers are often not using modern SaaS products and workflows are increasingly digitized across Japan. Churn rate by number of IDs is negligible, while there is minor churn by number of companies – some companies fail to adopt the software, but those that do seem to remain and/or grow their usage.

A notable aspect of Porters, based on how they present their product and the specifics seen in reviews, is the customizable nature of the forms in the product. This is more important in the vertical than the horizontal aspect of HR software, because a recruitment or staffing business will be handling a wider range of clients, ever changing parameters, industries, and requirements in the normal course of business. This isn’t that unique, but it has enabled Porters to unlock the flywheel of being able to address the widest range of customer use cases, which fuels detailed case studies demanded by Japanese customers, which subsequently attracts more customers. Below is a more detailed description of what the software does from a case study. This is a better solution for an underserved industry, on premise incumbents are especially frustrating in this regard, and it is engrained into the daily workflow of customers.

Numbers

The entire job placement and staffing industry in Japan employs around 423k people per an industry report. The company considers this entire workforce to be their current TAM, which is potentially ambitious. AI tells me 70-80% of employees at staffing firms are focused on recruiting, implying 303-338k users. If the market for IDs is only half the industry workforce and Porters eventually achieves 50% market share, that implies 75-100k users, which would imply JPY9-12bn of potential revenue compared to 15k users and JPY1.9bn in revenue currently. The company launched a subsidiary in 2024, KIKAN, that will focus on back office software for the industry as well, so the TAM is conceivably everyone in the industry if you adopt a 5-10+ year time frame.

In an interview with the CFO on the recruitment page of the company, he says he is focused on the company being 10x larger, including international customers, so there is a strong growth orientation at the company. This isn’t explicitly stated in their investor communications. They don’t need capital and they are already profitable, so I am less inclined to dismiss the 10x comment as pure bluff, albeit it is still meant to influence talent acquisition.

The company has an abundance of growth opportunities in deepening its product suite to raise ARPU, winning market share against legacy players and excel heavy workflows, and expanding into ASEAN. The Japanese economy overall is not the most exciting due to demographic headwinds, but this has caused a big shift away from lifetime employment. Since workers are increasingly likely to move jobs, the recruitment market may experience a slower decline rate than the overall population.

Management

Management identified a large pool of unmet demand and has a logical growth strategy for making money out of it. Most of this assessment is based on them saying things that make sense and having a track record to substantiate that they are doing what they are saying they are doing. They do not have a scattershot approach. Porters has a massive growth opportunity, and the company has a demonstrated focus and forward looking strategy on pursuing it.

Reading between the lines, management demonstrates a strong understanding of how the internet is used to play the broader game. They have good reviews on Openwork.jp (4.07). They’re also a small firm looking to grow at high rates, so being able to convince candidates to join is especially important in a very tight labor market.

They also do well on ITreview.jp in terms of the number of reviews and their rating. Porters’ target customers are likely to do their own research around which product to buy, as customers are not that large and probably lack much in the way of an IT department, so this is an important element of acquiring customers. The gulf between them and peers seems too great to be purely gamesmanship, but even if it were then it is a realpolitik recognition of the reality of the market for both employees and customers (I’m half-cynical here).

Porters produces a magazine for the recruitment industry, which isn’t too notable but is a further indication that the management team is trying multiple ways to get in front of potential customers and build recognition. They claim annual circulation of 168,000. The contents are mostly interviews with people who work at recruiting firms. I suspect there is a Japanese subtext here around establishing contact and deepening relationships with potential customers, as cold calling is less common of a sales tactic in Japan. Japanese business relations require trust built up over time, and I suspect the magazine is a way of projecting a strong presence in the industry it serves.

Looking at competitors with similar marketing content attempts is a positive endorsement of Porters management. MatchingGood’s Dispa, which is online only SEO oriented content, contrasts to Porters’ interviews with industry people. UTS also has an “online magazine,” but it is mostly SEO slop, in addition to a long running magazine for which they charge JPY30,000/yr. Others approach this marketing channel with slightly less finesse - SEO slop is ultimately pointless, and charging for what is really marketing seems penny wise but pound foolish. The interviews are useful to the interviewee, potentially useful to the reader, and demonstrate some basic Cialdini Influence technique well (social proof).

Management is cultivating unique sales funnels into the recruiting and staffing industries of other countries. This piggybacks on Japanese companies having operations throughout the region, as well as Japan wanting to attract migrants to its domestic workforce. Porters is standing up or acquiring recruitment websites in Southeast Asian countries (Indonesia, Bangladesh, Thailand, Malaysia) to host job listings for jobs with Japanese companies and/or in Japan. These acqui-hires (Thailand, Bangladesh) and investments (Bangladesh, Indonesia) gain them a Japanese person who already understands the local market and a low cost capital light business that is already operating in the same industry as Porters. This is a self-aware bridge that allows management to gain expertise and relationships in the country in a digestible way, as they hope to use these to localize their core software product. These markets are poorly served by software, but simply offering software neglects how every country has different labor laws, practices, and customs that are better incorporated into the software before attempting to sell it. This dilutes margins in the short term but creates a lot of optionality at a low cost as these could be shut down without changing the core business in Japan. While I have not done a deep dive in the recruiting and staffing software available in these markets, I suspect that it is largely overlooked by the global players and looks closer to the Japanese market in terms of paper or legacy on premise software processes.

Competition

Competition comes primarily from MatchingGood and UTS. Both do not have a strong internet presence but have the most number of customers and users in terms of competing software in Japan. Porters has the lowest pricing, which I would interpret differently if they didn’t have the most SaaS customers. Based on what I have been able to find, Porters has the best combination of factors that should drive it from strength to strength.

Recruitment Systems

Staffing Systems

MatchingGood

MatchingGood sells a similar core system for recruitment and staffing companies. They are a subsidiary Brainlab, which is a subsidiary of ZigExgen, a serial acquirer of mostly job listing websites. Brainlab also operates CareerPlus, for recruitment agencies, but based on the limited information on the site, I believe they are essentially folded into MatchingGood. Pricing is JPY22,000/mo/seat with no implementation fee and no stated discount for a 10+ users. There is a 14 month payback on going with Porters over MatchingGood for one employee and less than three months if you have five, but price per seat drops to 7,500 after 10 employees for Porters, so even quicker for larger companies. They also rate poorly as an employer on openwork.jp with a 3.07 score.

MatchingGood claims 1,300 customers compared to 2,000 for Porters. They also have 60 employees compared to ~77 at Porters (Brainlab, the parent co, has 74 as of early 2024 , unclear where the delta occurs). They regularly put on seminars to advertise to customers, so they should be considered a credible and serious competitor. Other than the price difference and fewer customers, they’re also buried in a somewhat decentralized corporation whose focus is a little more spread out. An odd point is that the leading software review site, ITreview.jp, has basically no reviews of Brainlab/MatchingGood/CareerPlus products, especially compared to Porters.

Porters already has more customers. I suspect Porters wins out due to focus, an easily calculated better long term price structure, more visible online reviews and the people in charge able to get rich off success specifically in the staffing and recruitment software space. I would be far less confident in a leadership team that has already cashed out and is part of a broader capital allocation corporation that is less likely to fund reinvestment back in the business. Leadership is also unlikely to have an owner mindset, because they are no longer owners.

UTS

UTS is the legacy on premise provider. UTS at points mentions 3,000 customers. While this is more customers than Porters, they are an on premise provider, which has negative implications for iterating improvements and cost efficiency. The product was first released on CD for Windows XP. They say they are the number one player in core systems for the human resources industry, although they seem to quote a 2018 survey for this. They also note negotiations with 250 staffing companies every year, which gives some insight into the growth opportunity.

They launched a cloud version in recent years. As of December 2021, the cloud product has 236 companies and 3,176 users (for dimensions, assume 40%/yr user growth and they could be at 8,714 users as of the end of 2024, still less than Porters). They have 40 designers on staff, which is slightly more than Porters, but their focus is divided and partially devoted to maintaining an on premise code base. They have a de minimis presence on openwork.jp and get a 2.99 rating, so I also suspect that they lack a workforce that is competitive and nimble enough for a SaaS world. It should be noted that they are not public, which also is a minor hindrance for attracting customers and employees.

Here is a picture of what their on premise StaffNavi looks like, as well as more information from an ERP system reseller, which also indicates StaffNavi is sold by SIers, an additional layer between the company and its end users that impacts the speed of feedback loops. While the website says it was released for Windows XP, these forms look like Windows 95 based on the blue ribbon headers.

UTS, which is somewhat worrisome as an incumbent with on premise experience, charges a lot more than Porters for their SaaS product. Their pricing is JPY20,000/mo for the first 10 licenses and then 10,000/mo for the 11^th and onwards, a 33% premium to Porters. The initial cost is also 150,000. There are add ons that can cost 5-10,000/mo as well. This doesn’t include hosting which costs another 250,000 install and 55,000/mo in maintenance, if I understand the pricing correctly (this may be for cloud hosting of their on premise system, which is distinct from the SaaS system).

Vincere

Vincere has a decent online presence, judged by itreview.jp presence, but their 5 case studies are abysmal single paragraphs each. This is a failure on Vincere’s part, because Japanese purchasing patterns typically begin with reading case studies and then reaching out to the company for more information. According to Linkedin, Vincere’s APAC offices are in Singapore and Australia, which would explain their poor localization efforts. Vincere’s Japanese pricing is not publicly available, but the internet shows £85/month/seat, which is ~JPY16,000. Vincere claims ~2,000 customers and ~22,000 users globally, which is nearly equal to Porters’ customer count in Japan alone, although slightly higher than Porters’ 14,800 users. Vincere competes globally, which I suspect makes Japan a strain on resources and a distraction rather than a real opportunity. They are a small part of The Access Group’s recruitment software business, since 2022, which implies an additional lack of focus.

Others

Lixas, a domestic SaaS competitor appears to also charge JPY1,500/mo/seat for 1-5 users, but has fewer reviews and it is unclear how they are positioned to serve larger customers. They also have an incredibly meager case study section and a generally less informative website. CastingOne has raised ~$6m, but only has 4 case studies on their website. They haven’t had a seminar since July 2024 and pricing is not available on their website. I suspect that these are startups that failed to gain traction and unlikely to threaten Porters in the future.

Risks

AI

“Find me candidates that meet these criteria using linkedin.” This is only part of the staffing and recruitment process and arguably the easiest part that is laborious anyway. Recruiting and staffing is a very human intensive process that involves interacting with job candidates to discuss matters that may be hard to make legible. Candidates need to be convinced on the merits of a job, recruiters need to sift through applicants to avoid wasting the time of customer with bad leads, and companies care more about the problem being solved than how exactly it is solved. Staffing firms similarly solve aggregation problems that will involve paperwork with candidates and labor law compliance. These are middlemen roles that job seekers and employers aren’t equipped to handle. None of this is to say AI won’t have an impact, but I believe that middlemen handling a complicated tasks are beneficiaries of technology rather than threatened by it. Porters with an aligned management team that has already demonstrated forward thinking abilities, existing customer relationships, and modern software product, seems in the best position to be the AI-enabled software provider in this vertical.

Governance

The CEO, age 62, owns ~57% of the shares (913,000 shares). The EVP, age 51, owns ~10% (164,000). This is an illiquid and tiny company. So far it looks like they are public to bolster their credibility with customers and for recruiting – they listed very close to the minimum number of shares to have a compliant float with the Tokyo Stock Exchange. They also just announced that they are going with a 5 person accounting firm instead of the KPMG affiliate they had been using previously, primarily on the basis of cost. This is basically a private company.

They seem to have not been getting enough attention from KPMG and didn’t like paying a Big 4 price. I can understand this feeling, but it is probably short sighted. Here is the precise wording (via google translate):

Although the current accounting auditor has a sufficient system in place to ensure that accounting audits are conducted appropriately and appropriately, the Company has come to the conclusion to change the accounting auditor after comprehensively considering the appropriateness of the audit response and audit fee level for the scale of the Group's business.

The company may fail to garner any investor interest because of the low float and lack of dividend. The valuation is low enough and shrinking where this is more of an opportunity cost issue if the company is hostile to shareholders. Hikari Tshushin showed up with a 20,000 share stake (~1.27%) in the H1 24 report, so the company is not entirely unknown. The company has barely been public for 3 years and reinvesting in growth, so there is still time for the company to announce plans on a dividend before one reaches a conclusion about their stance towards shareholders. The company is not reclusive, demonstrated by informative earnings presentations and hosting an earnings call.

Macro

The recruiting and staffing industry can flex its workforce during a downturn, which means that the software is potentially more volatile than a more binary ERP deployment or a pure theory VMS. The model of charging by the seat means that users can flex up and down depending on the economy. The demographics of Japan make it that there is probably a worker shortage even in a recession, but that may not hold true in the short term. The Kikan investment is encouraging because it should generate revenue more independently of seats. My general observation of staffing and recruiting firms in the US or Europe is that they prefer to hold on to staff for the upswing, which would also make sense with Japanese labor law that tend not to make layoffs too pleasant.

Competition

Existing companies may get their acting together. UTS has a cloud product that is an upgrade from their on premise solutions. MatchingGood may benefit from access to greater resources through their parent company. This is all worth monitoring but has yet to have a meaningful impact on Porters. Porters has already demonstrated they have an attractive product, so they will likely be able to capture a meaningfully greater market share than they currently have. Porters may also eventually pull from profit pools in broader ASEAN markets, which would be an advantage over UTS and MatchingGood. I also think that MatchingGood has a far less incentivized management team given that they don’t have direct equity in the company anymore. Zigexgen is also a capital allocation program, which means that MatchingGood is competing for capital with acquisition opportunities, which makes long term investments like Porters in Bangladesh, Indonesia, or Kikan not nearly as frictionless.

Global companies may try to enter the market. The recruiting and staffing industry is relatively homogenous in terms of workflows. Japan, which does have unique business practices, is probably not on the priority list for companies still focused on the US or Europe. More so than explicit localization of the product, a new entrant would also need to support a range of case studies and seminars with potential customers who may already be using a good enough (cloud SaaS) product. Porters already has thousands of customers, many of which are small, and serves them through a direct sales force, which also makes this market a slog to enter.

Valuation

For reasons discussed elsewhere, the out year power law distribution is more likely in Japan than observed elsewhere. This is not close to being reflected in the valuation of the company, which itself is very low relative to the already demonstrated high growth and margins. As previously covered, the management team seem high quality, a discernable competitive lead has been established, and the end market is underserved by modern software.

There are 1.68m fully diluted shares. The share price is 1,900. The market cap is JPY3.2bn. There is JPY800m of net cash, so the enterprise value is JPY2.4bn. This works out to an EV/ARR of 1.25x and a forward multiple of 1.06x using their estimates, or 1.68/1.43x without giving credit to the cash. I prefer the latter and it seems low.

Envelope math. It is not unthinkable for Porters to be doing 10bn of revenue in 10 years (15% topline CAGR) with mature operating margins of 30-40%, which works out to 2.1-2.8bn of net income. A 4x in revenues would be from a 4x in IDs, currently 14.88k. This implies 59k IDs in 2035, even though there are potentially 400k IDs in the staffing and recruiting market.

If Porters can reach ~100k IDs in the next decade. That would imply a 7x in revenue, or ~13.3bn of ARR, which translates into 3.2bn of net income at 35% ebit margins. If they hit 200k IDs, that is 6.4bn of net income. This also assumes flat ARPU. Cool cool cool.

The Present

If you want to obsess over a single year of earnings, you can. Earnings are understated due to startup costs for their Bangladesh operation. Applying the ~25% EBIT margin achieved in 2024 (technically 26.2%), excluding startup costs, to Q4 ARR of 1.9bn implies current earnings power 475m of EBIT, or 320m of net income. That is how I arrive at the core earnings power.

Applying a core business ebit margin of 25% of the 2.24bn revenue forecast for 2025 (the start up business isn’t charging fees yet) implies 560m of ebit and 390m of net income. The growth investments look obvious, moat deepening, and growth runway expanding. The margin normalization helps give us a grounded sense of paying an undemanding price, which sets up great potential over the next 10 years as the growth investments bear fruit.

The company’s free cash flow in 2024 was hampered by capitalizing intangibles. This is genuinely for a business that does not currently generate any revenue, Kikan, which will in essence be core software for the staffing industry. I am comfortable with this because the core business that I am valuing on an ongoing basis is distinct from this – e.g. this is very explicitly a growth investment that could be turned off tomorrow and not impair the prospects of the existing business. They historically have not capitalized intangibles either, so historical operating margins are reflective of cash margins. The risk that the Porters capitalized software is a dud is mitigated by a couple of factors – the product development being capitalized can easily be cross sold to existing customers given the industry expertise of the direct sales force the company already employs and have relationships with potential customers, and the competing tool is very likely paper or excel based and takes up needless time spent on nonrevenue generating tasks at the customer.

To further emphasize the point – the targeted growth in 2025 of seats and a small uptick in ARPU will not be because of Bangladesh or Kikan. There is still a core business that is highly profitable and growing independent of the expensed or capitalized investments. They do appear to be spending a little more on growth of the core business in 2025, so depending on how thinly you want to slice things you can ding the core operating margins from 25% to 20% or whatever.

Conclusion

Porters has 14.8k customers that they already profitably serve. They could have 1-2-300k customers at some point in the future, as early evidence points to them having the most focused strategy of offering modern workflow software to the Japanese staffing and recruitment industry. Competition is presently weak, a situation unlikely to change given the IT ecosystem dynamics in Japan. Porters could eventually have even more customers if nascent efforts to enter Southeast Asia yield success. High inside ownership supports confidence in the long term execution of the company’s strategy, while governance unknowns should be balanced with the recent step change in Japanese corporate governance norms.

Maaku out.

Serverworks sells a dominant, essential, and recurring product in an underpenetrated market – Amazon Web Services in Japan. Serverworks is in the top tier of the AWS partner program and a top rated employer in Japan, which likely solidifies their position reselling AWS in Japan for many years to come. Growth spending that is part of a Strategic Collaboration Agreement with Amazon is compressing margins, which are likely to start expanding again in 2025 and revert to their prior 6%+ already achieved in prior years. The company trades at 15x trailing normalized earnings and ~12x NTM normalized earnings while the top line grows at 30%+ without requiring capital. The CEO is incentivized (~33% owner) and demonstrably long term oriented.

Investment Setup

The company has a JPY20bn market cap and JPY9bn enterprise value after backing out cash and investments. They are on track to do JPY35.6bn of revenue in FY2/25 at depressed margins, with forecasted EBIT of 994m, a 2.8% EBIT margin. At normalized margins of 6%, they would be generating JPY1.3bn of net income for a valuation of 15x normalized earnings.

In the next few years, it is possible for Serverworks to generate a >6% EBIT margin on JPY75bn of revenue, which would translate into ~JPY3bn of net income. This implies 21% topline growth over 4 years, which is below the current trend for the industry and the company. The company has abundant growth opportunities up to and beyond 2030, which could justify a high multiple on the earnings as well as patience with lower profits in the short term. While a 6% target seems prudent, there is the potential for the company to earn higher margins, which presents some additional upside optionality.

This is not an excel fantasy invited by promotional management. The company has demonstrated its ability to earn higher margins and a fundamentally proven distribution business model for a dominant rapidly growing product. AWS is the leading cloud provider (~32% share, 50% bigger than the next largest competitor) in Japan. Japan is several years behind cloud adoption from the US, which itself has still maintained a high growth rate in cloud spending. Even a transition to a multicloud approach isn’t an issue for Serverworks, as they have a GCP business that is quickly growing at 56% YoY and accounts for ~20% of consolidated revenue (Serverworks owns 50% of the company, which operates as G-gen).

There is no uniquely Japanese equivalent where AWS’s market position and economic proposition can be circumvented, which is visible in cloud market share data. In a specific example, there are 5 approved government cloud providers for public agencies in Japan, as of October 2024 1,452 out of 1,497 systems are using AWS. It’s also worth noting that of the 5, the only provider yet to be used is the only Japanese company on the list, which has $400m of assets on its balance sheet and is also pursuing an AI data center business. As of January 2025, Sakura has only met 11 out of 119 requirements set by the Digital Agency, which also highlights the advantage AWS has as an already established and standard setting player. NTT, Fujitsu, and Softbank round out the top 6 in Japan cloud market share but are ultimately not challenging AWS for the top spot.

Serverworks is spending in advance of additional growth, which has high visibility and is being done in a business model with high recurring revenue that does not expose the company to sudden air pockets in demand. AWS is likely to continue growing in Japan overall and Serverworks still has a lot of customers very early in their adoption cycle. As existing customers continue to ramp up spending, the relative cost of a growth orientation (sales force, onboarding/migration support) should decrease. A direct AWS reseller competitor, Classmethod, already has 8.5% EBIT margins on 77bn of revenue, further indicating a 6% margin is not a stretch. Serverworks does not have to come close to that high of a margin for the shares to be undervalued.

A very crude model that sees them compound the topline 15%/yr until FY35 would see cash build of ~JPY38bn (100% FCF conversion, no net tangible assets) and a market value of JPY73bn if exiting at a 12x earnings multiple on 6% EBIT margins. This combined value of JPY111bn compares favorably to the current JPY20bn market cap.

Business

Serverworks helps Japanese companies run their software on the cloud as a reseller of Amazon Web Services, and Google Cloud Products to a lesser extent. They layer on additional services as well, such as being a managed services provider (MSP), which is a higher margin business line. Reseller is an understatement, as Serverworks takes on a lot of responsibility for a company’s IT, as many Japanese companies lack a full IT department and there is an acute shortage of AWS savvy engineers. Serverworks is as much an intermediary for AWS to end users as it is from end users to AWS, from a technical and cultural perspective, as their explanation of the business makes clear:

What distinguishes us is "resale." Customers may think, "Why not just buy Amazon's cloud directly from Amazon?" However, if customers actually want to buy cloud directly from Amazon, they have to prepare a corporate credit card and pay in dollars, which is a fairly high hurdle.

If you have this done through our company, you can pay in Japanese yen by invoice. Also, some customers have requests for separate invoices for each department, which are complex operations unique to Japanese companies.

Amazon will not accommodate such requests at all, but by going through a reseller like ours, we can properly adjust to such specific corporate needs, so from the customer's perspective it is better to go through our resale service.

In fact, there are two other services besides billing services. One is insurance. Although we have never actually applied this to our company in the past, we have insurance that will compensate customers for damages if a major accident occurs with AWS.

We are also developing another SaaS called "Cloud Automator" in-house, which can be used to automate the operation of "AWS."

For customers, signing up for "AWS" through our company provides various added value and helps you to meet your needs. That's why we have made it possible for you to sign up through Serverworks. This is the second reason.

The third of our main services is the world of maintenance and operation. Because we need to operate 24 hours a day, 365 days a year, we have created an affiliated company called Sky365, a joint venture with TerraSky. This company is located in Sapporo and operates on a 24-hour shift basis. In this way, we provide specialized services to Japanese companies when they want to use "AWS."

The company’s revenue is 90%+ recurring and tied to the value of cloud computing customers use. The remaining ~10% is cloud integration work that increases future recurring revenue. While the large Systems Integrators (SIers) in Japan have AWS engineers and sell the service as well, they also have internal data centers they may prefer to have customers use, which creates potential conflict. Serverworks isn’t constrained by these considerations. Serverworks’ “Cloud Automator” which helps customers track and manage their cloud usage is also unlikely to be pleasant for an SIer to offer. Serverworks show strong customer centricity in this regard.

Competitive Landscape

Serverworks is one of two major AWS resellers that is not affiliated with a large corporation. There was an independent reseller, Iret, that was purchased by KDDI to help KDDI. The other independent competitor is Classmethod, which is focused more on mobile companies, according to Serverworks. The remaining AWS partner level resellers in Japan are all SIers.

The company has a JV that intelligently leverages Fujifilm’s large sales network to reach SMB’s more effectively. This market is not well served by the larger SIers. Serverworks emphasizes clearly that they are investing to grow revenue ahead of profits. The still early nature of DX means that this is a large white space opportunity for the company.

The second topic is that on March 1st, we established a joint venture, Fujifilm Cloud, with Fujifilm Business Innovation. Fujifilm Business Innovation has a very large business in multifunction printers, and has built a very powerful sales network across the country to support the sales and support of multifunction printers.

We will bring cloud-related ideas and businesses to this sales network, thereby enabling us to deliver the power of the cloud to small and medium-sized businesses across the country, known as SMBs.

As I have said, there are reasons for the decline in profits, and above all, we are investing costs that we are confident will result in medium- to long-term returns. We are very positive not only about sales, but also about future profit growth.

All of this is to say that Serverworks has a stronger position in the long tail of Japanese companies. This should be a long term advantage because smaller companies are structurally understaffed in IT departments, if they even have one, and economically disadvantaged in supporting their own IT function in the future given staff shortages. This gives Serverworks a strong advantage in the AWS ecosystem because they are essential to both Amazon and their customers in equal measures. It’s also likely that displacing Serverworks competitively is not cost effective for anyone to attempt since every individual account is not that significant.

Serverworks has seen breakneck growth throughout its entire history. They have ~3,600 accounts across ~2,000 customers, many of which are still in the multiyear growth phase of cloud adoption. Integrating a customer into AWS secures a revenue stream for many years. They’ve had a negligible number of customer losses in their history.

Culture

The company has a very high employee rating on openwork, 4.56, which supports that they are a high quality organization (this is 9^th overall out of every company reviewed on the Glassdoor of Japan). This is important because there are ~25x as many AWS job openings as there are people with the skills to fill them. The two major pure-ish play AWS reseller competitors, Classmethod and Iret, have a 4.01 and 3.59 ratings on Openwork.jp, which is also inline with competitors like TIS, KDDI (of which Iret is a subsidiary), etc. (since I started researching Serverworks, the ratings on Classmethod and Iret have increase 0.2-0.3, so maybe it is starting to get gamified). While Classmethod and Iret are private, it is notable that Serverworks management is very vocal about being a high quality employer. This is indicative of a Magic Bakery ™ - everyone has the same recipes, but not everyone cares as much holistically and if you know you know.

The company is aware of how happy employees help to recruit and retain talent, which feeds a flywheel of strong execution for customers that attract additional customers that require additional talent to fully serve. The current labor market in Japan sees a tension between employees traditionally being very loyal and labor shortages driving wages higher to encourage job switching. Serverworks is in a sweet spot where they can obtain employee loyalty and access to the most in demand talent pools. This is a long term benefit for the business as the company can accrue expertise and experience that will continue to help it solve customer problems. An employee driven advantage being prominent in software resale reminds me of CDW, and supports higher than average confidence in the persistence of the future growth rate.

They are explicit about their recruitment philosophy and very explicit this is done with the expectation of getting an economic return:

“As you all know, there is a lot of competition for engineers these days. By recruiting properly now, we believe that it is possible to fully recover the investment in the future, and we can also expect to see long-term employment of high-value-added personnel and a decrease in turnover rates in terms of labor costs.”

Here is the CEO discussing a high profile hire for their GCP reselling subsidiary. It ends with a clear nod to growing rapidly and then focusing on profits once maturity is reached. It demonstrates they know what they are doing, doing so clearly, and doing so with the goal of profits.

Moderator : "I saw the recent release and learned that someone named Yoshikazu Kurosu, who used to work at Google Cloud Japan, has joined G-gen. What specifically will be his role?"

Ooishi : We invited Mr. Kurosu, a former partner of Google Cloud Japan, to be G-gen's CRO (Chief Revenue Officer). He has already taken up his post in October.

Mr. Kurosu is the founder of the Japanese community for Google Cloud, Jagu'e'r, and is quite well-known within the community.

The fact that such a person would be coming to G-gen was a hot topic on social media. I heard that when it was decided that Mr. Kurosu would be participating, his Twitter account (now called "X") got over 1,000 likes. I think that shows how much attention he attracted.

We didn't hire such a high-profile person just to attract attention. We've known him since he was with the company three years ago, and we've always been good friends.

During our various conversations, I also mentioned that G-gen is growing very rapidly. Of course, if you are part of Google, you will understand that G-gen is growing very rapidly.

This growth is solid and substantial. I believe he decided to join us as CRO because he saw that we have great members, a system in place where shareholders are fully supporting us, and a company that is destined to grow.

His role is related to sales, as the name CRO suggests. In particular, G-gen is expected to grow its top line in the same way as Serverworks for a while.

We believe that by expanding our top line, when the market reaches a certain limit and further growth is no longer expected, we can increase the absolute amount of profits by making some changes to our operations and establishing a profit-making structure.

Growth

AWS launched in 2006. AWS Japan opened in 2009. The Tokyo region went live in 2011. There is probably some type of “dog years” conversion factor for AWS Japan to show that it isn’t just 3-5 years behind US or European levels of adoption, as proliferation of cloud applications really took off during the pandemic.

Growth should continue mechanically because they are still increasing the numbers of accounts and accounts steadily increase their spending over time. Given the high growth rate, only 25% of accounts have been with the company for more than 5 years and 50% of accounts of the customers have only been with the company for 2.5 years. Serverworks’ customers currently spend ~$6,500/mo on AWS, which is on the low end of conceivable spending over time (their presentations show ARPU as AWS usage free for the quarter divided by the number of clients for that quarter, page 21 Q3 FY25 presentation referenced here – I divide this figure by 3 for a monthly spend). Given that they focus on smaller customers than the major SIers, Serverworks could also sustain faster growth as they are dealing with low cloud maturity in their customer base compared to large corporates – e.g. double dipping the low penetration nationally and within their market segment.

Using some broader figures around AWS usage indicates the dimensions of the growth potential. This Flexerra survey indicates ~20% of customer use under $50,000/yr (Flexera surveyed over 750 IT professionals and executive leaders on a global basis in late 2023. The majority of respondents were employed by companies with 1,000 to 100,000 employees with 62 percent of respondents headquartered in the U.S). Amongst SMBs Flexerra surveyed, 43% of SMB AWS customers spend under $50,000/mo (the lowest rung of responses possible, which probably tracks closer to the typical Serverworks’ customer). There are many differences, known and unknown to me, that don’t make this apples to apples, but it is broadly indicative of how much higher the spend in Japan could rise, even with just existing customers and now further customer acquisition.

AWS continues to roll out additional application products that run on top of the infrastructure, as well as work on their own AI chips that will likely further expand the scope of their offering. Serverworks can grow from expanding at existing customers, acquiring new customers as cloud adoption expands in Japan, and from the continuing expansion of the AWS product offering. There are many avenues for growth.

Serverworks is a valued AWS partner and from 2023-25 both are investing in advance of expectations of faster growth in coming years. The Strategic Collaboration Agreement (SCA) that they signed in 2023 underpinning these investments has put downward pressure on Serverworks’ operating margins. These largely consist of hiring in advance of cloud demand, since the chicken-and-egg issue at the moment is there isn’t the supply of talent for demand to be activated. This likely starts paying off via sustained high growth and expanding margins in the coming years. It also validates Serverworks as a key partner for AWS even though it is a ~$130m market cap company with $230m of revenue, which is small compared to other companies announcing SCA’s with AWS (Fujitsu, NEC, NTT Data, SCSK, etc.).

Something tells me there is likely to be a multiyear period of increasing cloud usage in Japan as the country plays catch up. At the start of 2024, AWS announced another JPY2.26trn (~$15bn) of investment in Japan through the end of 2027. By contrast, they spent JPY1.51trn (~$10bn) in Japan from 2011-2022. Microsoft announced their own $2.9bn cloud investment in Japan in April 2024. Oracle has committed $8bn over the next 10 years, validating the attractiveness of the Japanese market going forward and AWS’s likelihood of continuing to comfortably retain its relative scale advantage that sustains its competitive position. At the end of 2024, Fujitsu signed a collaboration agreement with AWS and plans to double the number of orders by the end of 2027, a ~24% annual growth rate. NTT Data is investing JPY1.5trn over 4 years from 2023-27 in data centers.

Industry reports on Japan further support the growth opportunity:

IDC Japan predicts that IT spending on IaaS will increase by 21.5% in 2025, while Gartner Japan predicts an increase of 26.3%. Regarding IaaS spending, IDC Japan's Jin Ichimura, Senior Research Manager, believes that small and medium-sized enterprises will continue to feel the limitations of their existing on-premise systems and will continue to move to lift and shift to the cloud. Large companies will accelerate efforts to promote DX (digital transformation), such as adding data integration platforms to the IaaS they are already using. Gartner Japan's Rika Narusawa, Principal Researcher, points out that "many companies are positioning IaaS investment as infrastructure development in anticipation of the use of generative AI (artificial intelligence)."

Total AWS growth for Amazon from 2018-2023 was 28%/yr. While the growth rate declined in 2022 and 2023 from the COVID peak, growth was 19% in 2024. Even though the pandemic accelerated Japanese tech investment, the penetration of IT spend on cloud still dramatically lags Europe and the US, even as cloud adoption still increased in those markets. Gartner estimates that from 2023-28, the number of workloads on the cloud will go from 25% to 70%, which is a global figure.

Over the long term, further growth can be unlocked from expanding the products offered. Serverworks will be in a strong position as they are involved with customers at the infrastructure level. The employee-centric culture gives me confidence that vendors will view Serverworks as a priority relationship. For context, Crayon, while they are primarily a Microsoft reseller, has distribution relationships with Google, AWS, IBM, SAP, Adobe, Red Hat, Symantec, Citrix, etc.

Will this dumb gaijin ever make a buck?

Will the share price ever reflect the underlying value of the business, assuming it realizes some semblance of the potential discussed? There is evidence that the CEO is a dynamic and entrepreneurial leader focused on long term business drivers and not short term accolades or avoidance of inconveniences.

The company has yet to announce a plan related to shareholders, but this isn’t unexpected given the growth orientation. There is still time for this to be released as pressure continues to build for better Japanese corporate governance and the company is likely to be more profitable in the coming years. The company will release a medium term plan in April 2025, which will likely point to the margin expansion discussed and potentially at shareholder returns.

Here is the CEO’s response to a question about the cash rich balance sheet, in January 2025:

Moderator : The question is, "Your cash and deposits have piled up to 7.4 billion yen. Are you considering measures to address the stock price or return value to shareholders?"

Ooishi : The majority of our current cash and deposits are funds raised for business investments, including M&A and recruiting. In other words, the cash is intended to be used for medium- to long-term business growth.

Of course, we are not neglecting returns to shareholders and investors or measures to improve our stock price. We will also work hard on this, but first we will invest heavily in business growth and increase our medium- to long-term corporate value. With this, we hope to reward our shareholders properly, so we hope you will understand.

Is it possible to think about management more broadly? To briefly be an armchair psychologist, a position I am eminently unqualified for because I don’t own an armchair, I believe the CEO is commercial even by American standards. Serverworks began as a business in 2000 and was running a system to share university admission decisions on decision day. This only needed to work for 15 minutes on one day in February with 100% uptime. They had invested in servers, but they weren’t being used most of the year. The CEO stumbled into AWS as a solution to this business problem in 2006/7 and realized it would be impactful and so they pivoted into selling AWS when it was introduced to Japan in 2009. I recount this story because it seems to point to the CEO being observant, in the action itself and as well as awareness of sharing this with shareholders, and forward thinking rather than conservative and preferring to stick to tradition. It is still possible I may be conflating a more ethereal Japanese artisanal instinct to pursue impactful work that will benefit society with a desire to make money by pursuing a money making business.

To provide a more recent example that is strong evidence of a commercial mindset, the collaboration agreement with AWS in 2023 that currently sees margins depressed supports my belief. This requires Serverworks to invest money upfront through its SG&A, which hurts profits in the short term in order to secure long term growth. It is the obvious and simple thing because the easiest and maybe only time to gain new AWS customers is when they initially adopt the cloud. There is a mountain of evidence that customers are sticky and increase spending over time. Because of this decision, lower profitability demoted Serverworks from the Prime section of the Tokyo Stock Exchange to the Standard section. This is less prestigious, and Japanese investors don’t seem fond of it. I suspect that a more traditional management team would view this tradeoff differently – a desire to remain on the Prime section, a desire to report consistent results – and would be wrong for doing so. Below is the full exchange when the CEO is questioned about this and his response is far more direct and properly oriented than the vast majority of American management teams are capable of giving.

Moderator : "This collaboration with AWS is big news and I am very excited about it. On the other hand, I am a little disappointed that we are moving to the standard market. Can we understand that the move to the standard market will mean that there will be more challenges in the future?"

Ooishi: We are not taking on this challenge in order to move to the standard market. Our basic stance will not change - we will continue to take on challenges aimed at achieving sustainable growth in both the prime and standard markets.

However, in response to the question of whether there will be more challenges like SCA, there are not many such large-scale initiatives on this scale. This initiative was reached after close discussions with AWS for nearly a year. I understand that there are not many initiatives of this scale.

However, rather than managing our business while worrying about the standards of the prime market, we have decided that since we are currently clearing the standards of the standard market by a large margin, by stepping firmly on the gas without worrying about the standards, we will be able to aim for greater growth in three or four years' time than if we remained in the prime market as we are now.

Therefore, even after transitioning to the standard market, we intend to continue working to improve our corporate value and further strengthen the trust of our shareholders and investors.

…

If we had not entered into this strategic collaboration, we may have been able to aim for a higher operating profit target for this fiscal year. However, as I have said, the AWS market is still growing, and we have no intention of settling down at a small scale at this time.

Our business model is like that of a SaaS company, but without development. Therefore, we don't take on development risks, so it's a business model that combines the best of SaaS companies.

By capturing the market, we are able to adjust our operating profit margins later, so as long as the market is growing, we should continue to capture it, which we believe will ultimately lead to increased corporate value and returns to shareholders and investors.

We fully anticipated that we would receive some harsh criticism in the short term, but I am confident that three or four years from now, people will look back and say, "It was a good thing we did this at that time.

Lastly, treating employees well is the epitome of simple but not easy things that a business should obviously do. It requires intentional effort and discipline to instill in a company and is not immediately gratifying. While not a guarantee, it increases the odds that the people pursuing this goal do everything else in this fashion as well, which we already see in the willingness to have lower margins in the short term to secure a much larger pool of future business. This dynamic creates the potential for further pleasant surprises over the long term.

Valuation & Earnings Power

There’s a shade under 8m fully diluted shares and the current price is JPY2,500 for a market cap of JPY20bn. Cash and investments of JPY11bn brings the enterprise value down to JPY9bn.

I believe it is reasonable to think about the valuation in terms of normalized earnings power – e.g. how profits would look today if they weren’t investing for growth in both the AWS and GCP business, as well as what margins will look like over 2-5-10 years as the company returns the business to higher margins it already demonstrated prior to investing for growth. In the fullness of time, I assume AWS and GCP reselling have similar margins.

Choose your own adventure with target margins and multiples. My vague guess is Serverworks earns JPY2.2-2.5bn in the next 3-4 years, based on ~6% EBIT margins on JPY57-68bn of revenue after another ~20%/yr revenue growth, which gives room for a deceleration given the near term industry estimate of 21.5-26.3% and the company’s current 32% growth rate. If they grow 30%/yr in the next 2 years, they will already be at the low end of this range. Depending on the growth rate and how much one cares about the cash balance, the enterprise value will approach zero in 4-5 years.

While the revenue growth assumptions are high in a vacuum, they do not seem aggressive relative to the trajectory of AWS, Japan catching up to US cloud spend, or general cloud adoption. In 2019, 2020, and 2021, Serverworks earned a 7.5%, 6.1%, and 5.8% operating margin, respectively, so this isn’t just number plucking irrespective of what margin this business can generate. Note I also cut the net income output by 10%, which implies that the 50% owned GCP cloud business grows to be 20% of the consolidated normalized earnings.

Sanity Check

Classmethod, a strategic AWS partner in Japan, has 8.5% EBIT margins per their own disclosure. They have a broader product offering – Cloudflare, Snowflake, Alteryx, etc – in addition to AWS and GCP, which is possibly an indication that their service handles a more complicated range of tasks and subsequently deserve a higher margin. They have higher revenue, JPY77bn in FY2024, as well. Serverworks describes them as having a greater focus on mobile companies.

Further afield, we can see there are resellers like Crayon, based in Norway, or CDW that print >8% margins. Even Insight Enterprises, which has much larger customers, prints a >5.5% EBITA margin. It is too opaque to confidently plug 8% ebit margins into a model for Serverworks, but it would represent further upside to which I would say, “itadakimasu,” if served.

A specific factor that should mechanically increase margins over time is that the company generates 2x rev per employee for the AWS business compared to its GCP business. This is a visible area where costs are coming in ahead of potential revenues, as the GCP business is younger. G-Gen also merged with a separate Serverworks JV, Topgen, in order to combine Topgen’s cloud integration capabilities with G-Gen’s reseller capabilities, which the company believes will generate cost synergies. Incremental GCP growth is likely to have high incremental margins, as the GCP segment is currently at break even with ~JPY6.5bn in quickly growing annual revenue.

It is also worth pointing out that this is not a capital intensive business. Excluding cash and investments, the company has negative tangible equity. JPY7.4bn of receivables and prepaid expenses are offset by JPY7.3bn of payables, there is no inventory, and little PP&E (Q3 FY25). The company should continue to generate a lot of cash as it grows and depending on your estimates the market cap could be entirely covered by cash in 3-7 years. Net income should convert 100% into free cash flow.

Risks

As goes AWS, so goes Serverworks. Given the early stages of the growth opportunity, channel conflict is unlikely to become the main focus of either party in the next ~5 years, but it is worth being aware of. There is a strong incentive for AWS to pay fairly for the product needs to be sold by a well qualified technical salesforce. This is quite visibly acknowledged by AWS reseller commissions being lower for poached customer than new customers. Serverworks and AWS are still pursuing infrastructure growth in Japan, but eventually the focus will shift more towards cloud applications built on the infrastructure. This should be yet another growth leg for the company that will likely drive focus on continued penetration rather than poaching customers or squeezing resellers. Serverworks is also a leader of the pack of AWS resellers and unlikely to be on the losing end of Amazon seeking to consolidate its distribution.

Numbers will begin to be challenging. Serverworks is one of 2.5 major independent AWS resellers and there are several more within the major Japanese SIers. It’s hard to totally grasp what the true TAM is for them. Crayon, a primarily Scandinavian Microsoft reseller “only” has ~$650m in revenue overall and ~$250m of that in the Nordics. If Serverworks compounds the top line at 15% for the next 10 years, they will be around ~$1,050m in revenue (JPY160bn). The Nordics have a combined population of 28m people, which is ~20% of Japan’s. If mature per capita IT penetration looks similar, it wouldn’t be crazy for Serverworks to hit $1,250m of revenue (e.g. 5x Crayon’s Nordic revenue). This is a very crude calculation of a Microsoft-centric reseller to a pure AWS reseller, although Serverworks still has time to diversify if software offering.

Looking out into the future is difficult. All sorts of technological shifts may alter the cloud market. For the investment to be attractive, one must anticipate a lot of growth. This growth may not come. The growth looks clear for the next ~3 years, but then it’s anyone’s guess. AWS does have a strong market position that they continue to build on, so the momentum of the underlying business that Serverworks resells is still increasing.

Wading into a Japanese microcap has inherent risk. There appears to be a justifiable reward, but this may be taken away in a takeover or other unforeseen changes. NTT is a Serverworks partner and 6% shareholder of the company and may decide to bring the company under its fold well before the full growth potential is realized. TerraSky, a partner and 12% shareholder in Serverworks, also has business partnerships with NTT. Serverworks’ CEO owns 33% of the company, but there may be some cultural nuances that elude a Western interpretation of aligned incentives leading to a takeunder by NTT (prestige of working at a large company, reluctance to take long term risk of wealth tied to the stock market fluctuations, etc). Iret, a formerly independent AWS reseller, was taken over by KDDI, although there may have been other circumstances. All in all, there are factors that are beyond our control, although the CEO has gone the independent route long enough that he likely wants to build a company on his own terms.

Serverworks went public in 2019 and peaked during the pandemic at JPY10,000 from which the shares are now down 75%. Growth has been high and the revenue multiple has dramatically compressed. The market seems uninterested in the investing for growth story and so this remains a mostly revenue driven valuation. The staying power and growth opportunities of AWS are highly visible, which reduces my concern that the growth or profits never materialize. This could still turn out to be the wrong set of assumptions and the market never regains an interest in Serverworks.

Conclusion

Serverworks is an AWS in Japan derivative with an encouraging management team and culture. There is credible evidence the company is investing for growth and the normalized margins are much higher than currently reported. Taking a longer term view points to higher margins on much higher revenue, which should translate into higher EPS.

Maaku out.

Opportunity

Call me Maaku Renaado マーク レナード the way I’m about to shill software from a capital allocation perspective (that’s “Mark Leonard” put in a Japanese name converter). The core bet is that we are still early and valuations don’t reflect it. IT spending remains low in Japan relative to other countries and the penetration of cloud spending as a percent of IT budgets lags dramatically - ~18% in US, 12% in Europe, and ~4% in Japan (this stat may be ~2 years old, which is a long time given high growth rates, but the US has continued to grow cloud spend double digits over this period). The explosive growth seen during the pandemic has moderated, but the long term trend still points to double digit growth for a long period of time.

The Japanese people are wealthy and not stupid. There are 124 million of them. Even with a declining population, Japan will remain a large addressable market with the economic structure, budget, infrastructure, and digital literacy in place to upgrade its software stack.

The necessity of increased investment in and adoption of cloud based software is on the new side of a punctuated equilibrium post-covid. This contrasts to the American experience which has experienced SaaS and cloud computing as a steady evolution over the last 25 years. Most importantly the Japanese themselves recognize this out of self-interest across all levels of society - individual, SME, corporate, and government – as both a financial and existential issue.

Japan did not suddenly identify the need for Digital Transformation (DX), but the present moment sees DX already underway compared even to 2019. The government is proactively pushing more digitalization. Since 2018, METI has been discussing the 2025 Digital Cliff, their name for the rapid falloff in the ability to maintain legacy on premise complex black box customized software, 60% of which are now over 20 years old. About 80% of IT budgets go towards maintaining existing systems, many of which are increasingly outdated. The cost of maintaining outdated systems was pegged at JPY 12trn, about $80bn/yr, which is ~2% of GDP. This exerts a massive cost on the Japanese economy, which creates abundant opportunity for overhauling its digital infrastructure. The budget for IT investment already exists but is being poorly allocated into an increasingly inefficient burden.

An important subtext to black box systems that are difficult to maintain is that increasing geopolitical tensions and cybersecurity risks make them a major vulnerability. This risk can be partially mitigated through the cloud (e.g. on prem system could be totally bricked without off site redundancies, older systems are the most likely to have easily exploited vulnerabilities). This is a further incentive for the government to take seriously and prioritize DX, as these concerns likely become more pressing over time. National security risks give DX initiatives salience to more conservative leaders that may otherwise have no particular interest in giving their support.

METI is walking the walk. For example, 500-1,000 employees are using a project management software, Backlog (1.4m users in Japan), to reduce paperwork and time spent keeping track of tasks. This is a good example of the white paper writers no longer just writing white papers. METI also has a dedicated website to promoting DX at SMEs, as well as another dedicated website walking SMEs through the various subsidies available to them, including an IT implementation subsidy.

At a more granular level, at the start of 2024, only 10% of companies were considered “DX-promoting” by the IPA, which is Japan’s Information-technology Promotion Agency (table created in March 2024 – can read for more). While likely not all encompassing, it is directionally supportive of the idea that the post pandemic growth is very far from over. While this may not have the heft of the Tokyo Stock Exchange Name & Shame on capital allocation, it is a good proxy for how underinvested Japanese companies are. METI also collaborates with the IPA and TSE to highlight noteworthy and platinum DX companies, so the IPA rankings tie into social incentives in capital markets.

“Analysis”

There is a strong element of a supply and demand imbalance in Japanese software that has some very attractive capital cycle dynamics. This is favorable for investment opportunities in a way that electric vehicles or AI lack. Many software companies can achieve power law outcomes and face little competition. The risk/reward is very attractive given these circumstances.

Supply

There are not enough software engineers to build products, case studies to demonstrate their efficacy to customers requiring a lot of up front information for vetting, and few international suppliers prioritizing localization of their software and business cultures. This should favor the first companies to solidify their presence in the market with a credible product since SaaS adoption is happening on a compressed timeline. Time is a physical fabric of the universe bottleneck. Bottlenecks in tech talent and tech savvy workforces reciprocally amplify the tension in the time bottleneck.

Competitors would have to develop a comparable offering at the same time as the adoption curve is compressed, but with what surplus technical talent and bottomless entrepreneurial risk taking appetite? There are 15 times as many IT engineer job openings as there are people looking to change jobs and this gap is 3x larger than when METI first warned of the 2025 Digital Cliff in 2018, a function of increased demand and a shrinking workforce.

The VC ecosystem and start up culture is much smaller in absolute and relative terms (report on VC in Japan and Internationally and post on the state of VC in Japan for the curious). It also seems that foreign VC is not a major player at the earlier stages – both because there are existing Japanese sources of capital and foreign players have more limited value to add to an investee besides cash if they have not operated in the market for a long time. This further constrains the supply of new entrants relative to the US. This positions already established companies with modern solutions to capture the majority of growth going forward. This will be more pronounced in niche markets or those with increasing returns to scale, which is often an inherent factor of many software applications.

In a country with a consensus oriented business culture and where the nail that stands up gets hammered down, I expect there to be far more consolidation around the existing players who sell cloud software. In one example, there are 5 approved government cloud providers for public agencies in Japan, including Microsoft and Google, but as of October 2024 1,452 out of 1,497 systems are using Amazon Web Services. I do not believe this will be an exception given the positive flywheel that a SaaS business model can unlock.

Vendor consolidation is reciprocal to supply constraints in IT labor markets. Japanese companies do not have large IT departments. Purchasing decisions often defer to the actions of the industry leaders who may have larger IT departments, such that companies who sell to the leaders have already done most of the heavy lifting and need to manage their onboarding resources to work their way through the market. This is particularly true in Japan, which is consensus driven. Here is a CEO for a company that sells software to a highly regulated and large customer base that is underinvested in software as an industry and especially underinvested in this specific application being sold:

In fact, when we tell our customers that "other companies do it this way," we show them a list of our customers. Then, they respond by saying, "If Company A and Company B are using it, we'd like to hear more about it."

So we set up a meeting between the three companies, and they explain, "This department and that department have never communicated with each other before, but this is how we communicate.

Then, they will say, "Oh, so that's how it's done," and once they understand the practice, they will be able to visualize it and make a purchase. We focus on getting existing customers to support us during the sales process.

When many best practices emerge, when customers get together, they discuss things like, "How will you respond to this request?", "We use their product, and this is how we do it now," and "So we use their product after all." This can lead to increased sales speed.

In order to shorten the lead time, if you focus on improving the product for existing customers, you can create success stories. Once you have a success story, that company can tell other customers, and they will say, "So that's how you set up the operations," and the lead time will be shortened.

Rather than increasing our in-house staff, we believe that the more we can increase customer satisfaction at our existing business partners and become the de facto standard among industry companies, the less resources we will need.

Separately, here is a story about how one the largest used auto retailers is implementing DX. They have a $750m market cap. The key point is that they are creating an entirely different subsidiary, which will have different pay scales and work rules. This company stands out as being very proactive in addressing their IT needs, but it also highlights how most companies are not well staffed with IT talent.

IDOM plans to "promote in-house system development" (President Hatori) and will also strengthen its recruitment of IT talent. In May 2024, it established a DX subsidiary, IDOM Digital Drive, to recruit IT engineers, and began full-scale operations in September of the same year.

What is unique about IDOM Digital Drive is that employees hired are immediately seconded to the parent company, IDOM, and work in IDOM's IT department. This is clearly different from the "subcontractor position" often seen in Japanese system subsidiaries. In recent years, this type of structure has been called a "receptacle-type system subsidiary."

IDOM has not disclosed the salary levels at the new company, but systems subsidiaries that serve as a base for recruiting generally offer salaries higher than those of the parent company to make it easier to recruit IT engineers, and most also offer remote work and flexible working arrangements.

In fact, IDOM Digital Drive's job postings include annual salaries of over 10 million yen. "Nearly 90% of the employees who were originally working in IDOM's IT department have already been transferred to the new company," said President Hatori. IDOM Digital Drive has not yet decided on its hiring plans.

IDOM has embarked on a large-scale investment, invited a reform leader from outside, and established a new company to steer the company toward digital transformation. However, the shortage of IT engineers in Japan remains serious. The key to the company's success in digital transformation seems to be how well it can provide an attractive environment for IT engineers and gather talented colleagues.

An alternative delivery mechanism for software is through Systems Integrators (SIers), which do in effect control a lot of IT departments to the point of being the de facto IT department. SIer solutions often lack the agility of dedicated SaaS providers and are competitively disadvantaged as time goes on, as they have more constrained addressable markets. Corporations are generally aligned with specific SIers, majors such as NTT Data, TIS, SCSK, Fujitsu, such that the concept of a best of breed solution proliferating out of an SIer faces the obstacle of divergent incentives (certain SIers have industry specialties such as Fujitsu in hospital EHR software). SIers want to drive customers towards solutions that may be more beneficial to the supplier than the customer. They often get paid on a per person per hour basis, which further highlights divergent incentives. Corporate IT departments are often referred to as “order takers,” as in other departments ask for features or changes, which are then relayed to SIers to actually implement. This is not conducive to innovation or best practice implementation. SIers will continue to exist and pose some competitive threat to pure play SaaS companies but are mostly notable for soaking up IT talent to create structurally worse products in a way that limits competitive supply being broadly available.

Demand

What is happening on the demand side of Japan’s tech infrastructure is at the point of existential, far beyond the concerns of the 2025 Digital Cliff. There aren’t enough people to perform the existing jobs in the economy, so Japan will have to improve productivity if it is to maintain its standard of living. SaaS often replaces paper and excel based workflows that are time consuming. This can help address productivity issues very broadly. There has been the “2024 Problem” where labor laws initiated more oversight on overtime, further reducing aggregate workhours, further incentivizing productivity enhancements. The 2024 Problem is in more manual labor such as construction or logistics, but it is emblematic of broader demographic forces pushing for a rethink of processes.

There are also more general IT labor constraints as seen in other countries, such as with COBOL engineers retiring, that encourage a shift to software systems that can be more easily maintained. More unique to Japan is that some IT staff are closer to being one-of-one when it comes to understanding the customized systems built up over decades.

There is a broad endeavor by the Japanese government to introduce legal requirements that foster adoption of digital systems, which adds systemic pressure for additional digital uptake. For example, My Number Card, brings every Japanese person into a digitally legible system that will ease access to a variety of government programs, which will also have to be managed in a digitally legible way. This is occurring in invoicing and social insurance coverage, where modern digital systems are required to comply with the laws. These visibly force adoption of software, but beneath the surface they also highlight further the pain point of continuing to adapt dead end on premise customized solutions. This should act as a procyclical force that encourages further adoption of software solutions when thinking about how the market will evolve over the next 5-10 years.

An underappreciated aspect of self interest in DX driving demand is at the microeconomic level. It is a massive improvement in job quality right as the market for employees is becoming even tighter. The existence of much more efficient and better staffed companies is an economic threat to businesses that are inefficient and poorly staffed. This was not an intense dynamic in earlier stages of SaaS in the US, as the concept was still being proven and the competing products in 2012 were mostly not traditional paper processes or software products custom designed in 1992 (for an American equivalent 2025 Digital Cliff, 60% being 20 years or older), and unemployment was higher.

There is more power in the hands of employees due to the number of job openings in Japan, which strongly suggests that the companies that have the least burdensome processes are in a better position to attract or retain revenue generating employees, as well as pay competitive salaries. The rate of midcareer job transitions is increasing from a low level in Japan, which should further encourage companies to update their processes to have the fewest unnecessary burdens that discourages their staff. This is doubly true for IT professionals, who have very in demand skills and typically receive low pay at traditional companies. The movement of talent out of these roles to more efficient and modern software players further exacerbates the difficulty of maintaining internally developed customized black boxes. Some examples of these forces at play:

Today, however, talented younger workers are far more willing to take a chance on a new firm than their parents were. Four decades ago, 70 to 80 percent of people in their late 20s or early 30s who had worked for one employer for ten to 15 years stayed at that employer for at least another ten to 15 years. By the early 2000s, that rate had dropped to 50 to 65 percent, and now statistics indicate that less than half of young workers stay at the same firm for so long. The shift is also apparent in the hiring of people in the middle of their careers. Back in 1994, only 35 percent of companies hired anyone in their 30s and 40s away from another firm; now, 70 percent do so, and those that do are more profitable as a result. In the lifetime employment system, workers tended to develop company‑specific skills. Given today’s rapidly changing and uncertain conditions, firms benefit from incorporating new skill sets and perspectives through hiring midcareer workers.

A virtuous cycle has begun. Workers have greater leverage in the current tight labor market, and now, with established firms more willing to make midcareer hires, they feel emboldened to take risks. Newer companies have been able to recruit both veterans from more established firms and recent college graduates. Take the recruitment firm Visional, founded in 2009, which matches companies, new and old, with potential candidates. By 2023, it had found jobs at 20,000 companies for 2.3 million well-paid employees seeking better opportunities, and in 2021, its founder became Japan’s newest billionaire. Visional is now just one of many such recruitment agencies.

Newer firms have also been able to take advantage of a pervasive problem in employment practices among traditional firms: the lack of equal pay and promotion opportunities for women. I recently spoke to two female executives at Askul, a distributor of office supplies. They had left household-name companies to join Askul in its early days (it now has sales in the billions of dollars), lured not only by better opportunities for advancement but also by the adventure of building something from the ground up. The newer companies do not yet have sufficient weight to reduce the national gender gap in pay and promotion, but the more talented women they recruit, the more pressure traditional firms will feel to close the divide.

Technological advances are also increasing the market power of startups. In the past, new firms had difficulty reaching customers because they had to use a distribution system for products that was largely controlled by big legacy companies. E-commerce has changed that. Take Rakuten, Japan’s flagship Internet mall. In 2023, some 57,000 small and medium enterprises sold more than $40 billion worth of products to over 100 million customers through the site, which functions much like Amazon. One of Rakuten’s merchants is Tansu No Gen, a former furniture maker and now a seller whose founder was wary of e-commerce and preferred using traditional retail stores. When he retired in 2002, his children joined Rakuten’s network, and they saw sales explode from less than $1 million per year in 2002 to $175 million today.

Digitization is putting enormous pressure on Japan’s more staid companies to look in new directions. In a ranking done by IMD Business School of 64 countries in “digital agility”—how much a company increases sales and profits for every dollar it invests in digital equipment and software—Japan came in dead last. That struggle to master digitization is one of the reasons Japanese giants have had trouble competing in world markets. As a result, some traditional companies now feel compelled to work with digitally adept newcomers. In 2018, for the first time, the number of software vendors exceeded traditional parts makers among the top 5,000 suppliers to the automaker Toyota. Few of the software companies wanted to join Toyota’s corporate group and be treated as subordinates rather than partners. They cherished their independence, including the freedom to collaborate with anyone, even Toyota’s competitors. Toyota’s need for outside technological expertise for all the sophisticated electronic software and hardware in vehicles these days forced it to abandon its long-standing reluctance to allow its vendors to work with the competition. In order to innovate, it has accepted conditions that it had previously disdained.

Is there money to be made?

Many of the opportunities I find most compelling are tiny companies with controlling shareholders – 40-70% floats on $10-200m companies aren’t inviting a lot of scrutiny from individual or institutional investors. The Japanese microcap retail investor is one of the least fundamentally driven in the world. Some other factors include Japanese markets not being interested in EV/ARR valuations, even if the company has 70%+ gross margins, no SBC, huge white space, and very compelling LTV/CAC ratios. Mature margins aren’t just a promise 2-5 years out at this point. Companies with intermittent and low profitability are also not eligible for Prime listings on the Tokyo Stock Exchange, which further dampens interest in the short term.

The growth rates for a lot of software companies in 2020 and 2021 were very high, but from a low base – 50%+ YoY. Price charts show a company IPOing, entering a down 75-90% freefall as growth rates and hyperinterest couldn’t be sustained, and then remaining relatively flat for the last 2-3 years. Revenue multiples for the broader SaaS industry in Japan have collapsed from 20x to ~5-6x, with many companies trading below 2x revenue despite signs of continued growth and profitability. This is psychologically discouraging, but unlike SPACs from this era, these are real companies that went public during a buoyant time.

Growth rates still range from 15-30% for many companies. This should continue for much longer than current valuations seem to anticipate given the lagging adoption of cloud-based IT catching up to a still ongoing increase in cloud software in the US and Europe. Much in the way that 5 or even 10x revenue was cheap in hindsight for US SaaS in the early 2010’s, Japanese SaaS at low revenue multiples is similarly cheap given the clear opportunities ahead. While not all are “cheap” in the backwards looking sense, it is cheap relative to the economics they can generate as growth continues (e.g. 20% operating margins on doubling revenue takes a co from 3x revenue to 1.5x revenue and 7.5x EBIT with continued high margin growth opportunities). Another compelling feature for more traditional investors is that Japanese companies have a broader cultural imperative to be profitable that has a double benefit of being easier to wrap one’s head around a DCF while making a money losing competitor rushing to catch up a lot less feasible. Even a medium term holding period likely won’t entail tolerating the paradoxical nature of running at breakeven to secure the market longer term.

Venture Capital

A distinction with VC money in Japan is that companies are going public at much earlier stages, not after a Series Q round where VC horse trading mark ups capture all the upside of the rapid part of the growth curve. Japanese corporate venture capital (CVC) and VC seem to sell down their stakes in the IPO and then after a 180-360 day lock up. This isn’t novel, but it is worth pointing out that they are doing so into a heavily retail oriented buyer base, as there are few institutional Japanese microcap players.

CVC is typically small checks relative to the size of the investor and mainly meant to improve their own products. Salesforce is a major CVC player in Japan to encourage companies to build their products on Salesforce, with direct profits on the investment a secondary or tertiary consideration. These are also very smalls sums to Salesforce. This should also act as validation of the opportunity for software overall in Japan, as Salesforce is far more active in Japanese CVC than most other countries.

There are also CVC players like JR East, the railway, looking to spur innovation that may help better monetize their real estate footprint. Even Japan Post has a VC arm. These aren’t forced sellers, but they are not seeking to maximize investment profits directly through ownership of these stakes. I sense that CVC money is preferable to overseas Silicon Valley VC money, because the corporation is bringing specific and local business opportunities that are mutually beneficial. All of this is to say that many of the sellers of shares in younger tech companies are receiving economic value primarily through the activities of their core business rather than proceeds from investments.

The incentive to go public early is higher in Japan since there are prestige and recruiting benefits from being publicly listed. The media-centric hype cycle seems relatively absent in Japan, although I simply might not have found the spaces where such narratives are promoted. This means that there is not a cheerleading VC PR campaign building up excitement over several years prior to an IPO or successive funding rounds to achieve a higher mark in their fund.

Corporate Governance

There are still corporate governance reforms yet to be done. Most young tech companies have not announced a shareholder return policy yet. This leads to a lack of interest that could contribute to lower valuations, although this is a backwards looking viewpoint. Outright hostility seems like less of a possibility post Abenomics. The reality is that young companies growing rapidly shouldn’t be returning cash to shareholders quite yet. A cash rich balance sheet is an asset in a company’s growth because it gives customers, who are far more conservative in their purchasing decisions in Japan, more confidence in the longevity of the company.

In one encouraging example, Plus Alpha Consulting, an enterprise HR software company, announced a 5% buyback at the end of 2024 as the share price had fallen dramatically, while the company is still growing ~20% with ~30% operating margins (currently ~4x/18x forward revenue and net income). They announced this on November 29^th, 2024 and were already 20% through it by January 10^th, 2025. This is in line with country wide increases in buybacks and dividends in recent years, but confirms that tech companies are not oblivious to capital market trends.

More broadly, many tech companies have detailed presentations, sometimes in English, even at <$20m market caps. This could be seen as an indication of management desire to attract investors, which increases the odds they don’t have an insular mentality and will ultimately adopt reasonable payouts at the appropriate time. It also helps that there are share grants outstanding at many of these companies. If employees stand to exercise options equal to 6-10% of the company, there is probably greater internal pressure to also do what is necessary to maximize the value of those.

Risk

Competition

The major risk is either fast follower SaaS startups outflank some of the early leaders or that on premise software providers make the shift to a SaaS business model. Given less sprawl of SaaS applications, it may make sense for the ecosystem to take advantage of the blank slate and build on top of more established players, as can be seen with companies built atop Google Workspaces or Salesforce. This may have implications I do not fully grasp. These are general risks that are mitigated by the understaffed nature of the Japanese IT ecosystem, the smaller size of the Japanese VC community, and the relatively lower appetite for entrepreneurial ventures in Japan.

While the on premise to cloud business model transition for individual software companies is also a well-trodden path in the US, the starting valuation for the Japanese SaaS players is a lot lower. While this is an ongoing risk worth monitoring, the hints of legacy players adeptly responding with their own cloud offerings have yet to emerge. OBIC may be an exception to this and is a formidable domestic ERP provider, but they do not satisfy every software need in the economy. If I understand the SIer ecosystem, there are not many nationally dominant providers to displace, as much of the existing software are more customized systems.

In a specific example, a legacy on premise software provider I researched does have monthly pricing plans and a cloud service, which offers a lower entry price and some off site backup. The monthly pricing plan is for on premise style software that is still more expensive than the SaaS competitor. The cloud service is an additional cost and is just hosting the on premise software elsewhere for customers, not a program simultaneously updated across all customers. This type of company will typically require customers to submit requests for any changes to the software. This could be as simple as moving a field in form or adding a new field. This has the facile resemblance to SaaS, but does not offer any of the benefits for customers of a SaaS solution. It is also structurally higher cost – e.g. you need an engineer making requested changes rather than having a systems architecture that allows the customer to customize immediately without intervention.
Culture

The Japanese are Japanese. Japan already had the lowest productivity among major developed countries prior to the pandemic. There may be factors illegible to the outside world that constrain software adoption beyond the bare minimum, since Japan has been unswayed by lagging productivity in the past. Many employees may still harbor a fondness for a paper heavy way of doing business, especially older ones. DX may just end up making paper forms into digital forms, with only minor changes that don’t sustain a wave of software adoption, such as data analytics applications. It’s not as if every corner of the German or Italian economy has embraced every single digital capability possible, so expectations should be tempered on the speed or inevitability.

Like the early stages of Abenomics, the cultural reason to be doubtful is very legible in the rear view mirror, but there is now Japanese self-interest and economic necessity that should spur change on Japanese terms, not on the basis on top down economic theory. Japanese business culture focuses on longevity. The existential reasons to increase digital adoption are far more convincing as appeals to self-interest rather than copying US levels of IT for the sake of catching up to the same output in a data table put together by comparative economists. While the pace may undershoot high expectations, the risk that it doesn’t occur seems to be receding and requires less speculation today than a highly optimistic DX thesis given in 2019 given how much the pandemic catalyzed adoption. Japanese culture is also capable of moving quickly once a consensus has been reached, which make Italy or Germany less direct comparisons.

Technology

Japan may leapfrog a lot of the assumptions of the current paradigm due to advancements in artificial intelligence or other unforeseen innovation. The barrier to creating software may fall rapidly to the point where the supply bottleneck Japan faces turns into an incentive to speed up the adoption of faster ways to write code. While I believe this is more of a risk in horizontal rather than vertical software markets, it could mean fast followers have little difficulty catching up in terms of the modules that compose and differentiate a given software system.

This risk is offset by the present and pressing need for software. More AI-centric development processes may take a few more years to be broadly accepted. In the meantime, the emerging players currently entrenching themselves will also benefit from any efficiencies in software development combined with benefiting from existing customer relationships that will be harder to dislodge. The low valuation of many Japanese companies offers some protection from a massive derating on this eventuality approaching suddenly.

Process Oriented Thoughts

This is a cyber shoe leather affair. My preference is for companies that have clear signs of being one of, if not the, leaders in their niches. I’ve tried to do an intellectually honest Talmudic reading of a lot of Japanese material using Google Translate. There is a lot of subtext in how Japanese people communicate, although there are lots of cultural interpreters that decode communication styles (the most basic one is that a 3.5 star review is a good review). I have endeavored not to work from first principles. The more qualitative musings are pattern matching sociology utilizing observations of others with Japan experience (e.g. employer and product review scales are on the same scale as restaurant reviews, corporations are highly siloed by departments, and IT staff is usually employed by a third party). I’ve gone through marketing materials, filings, presentations, transcripts, and websites for the companies, their competitors, and broader industry players. Online reviews help triangulate the clarity of the value proposition and relative quality of the products.

How do I approach competitive analysis of Japanese software companies? The ideal Japanese software company from a customer’s perspective is publicly traded, profitable, has a clear website with numerous case studies, and is hosting regular seminars to demonstrate its product in front of potential customers (these are in person and can then get posted to YouTube and reconstituted as blog posts).

A distinct aspect of the Japanese market is a preference for lots of case studies, which helps to overcome traditional respect for existing processes. The case studies are critical to the multistep highly documented purchase process, which even has its own word in Japanese, ringisho. Case studies are referenced before a potential customer reaches out to speak to a salesperson. Companies have rigorously documented internal processes. Case studies tend to highlight the ways in which customers can replicate those processes digitally and/or with greater ease. The case studies provide social proof in a consensus driven and risk averse culture. Case studies are a strong signal that a positive flywheel is already underway and a lack of case studies is indicative of a failure to gain traction.

Default Japanese behavior is to seek reassurance a counterparty will exist over the long term. Ringisho revolves around satisfactorily answering someone in a department that won’t even use the software asking, “will this company be around in 10 years?” Public listings and profits convey staying power of a company, which is likely another obstacle for private Western companies or private startups in Japan. This concern is referenced generally, but a good example is Class Method, a $300m revenue software reseller that is private but publishes financials on its website. This is somewhat distinct to Japan and is not random. Management teams directly remark that customers want to purchase from profitable companies.

Many small companies go public for no other reason than to be public (this may also be a pitfall from an investment perspective). This is seen as a mark of credibility as a supplier and employer. I have seen software review sites where a company’s name will look like “The Magic Bakery, Ltd. (listed on the Tokyo Stock Exchange: 1234”), as well as job listings note in the header that a company is publicly traded. A company that is public and has more case studies than a private competitor is likely to be the superior player.

Conclusion

There is a compelling opportunity in Japan’s digital transformation due to favorable supply/demand dynamics for software related companies in Japan. Looking out over the long term, many current players will likely exist at much larger scale due to the likelihood that incremental entrants find a web of obstacles to traction. This overview is meant to serve as context for specific opportunities in Japan.

Business

Nuclear plant valves are a secure niche.  TVE generates ~60% of revenue from replacement parts, inspection, and maintenance at nuclear plants.  There are 33 operable nuclear plants in Japan.  If my cursory research is recent, 12 have restarted as of October 2024, 5 more have passed review to restart, and another 10 are under review to restart.  Not all of the dormant ones may be restarted – Japan has been more open to starting pressurized water reactors (PWR), but less so boiling water reactors (BWR), although some BWR have passed review to restart. TVE is strongest in PWR valves, which have fewer obstacles to restarting (Okano Valve is the leader in BWR). The company’s valves are found in other high pressure high temperature applications - chemical (general, hydrogen, ammonia), and thermal power (natural gas, coal, biomass). They also do some business in China, Taiwan, and South Korea.

Restarting nuclear plants is self-evidently economically sensible and politically feasible in Japan, so this is not an open ended bet with uncertain timing.  Nuclear support is gathering further steam as AI and environmental concerns increase desires for a reliable and low emission power source.  It also appears that every country wants domestic AI computing capabilities, which may further push restarting nuclear power plants wherever they exist.  The AI angle here is marginal, because there is already interest in restarting the plants, but nevertheless supportive.

TVE is aligned with Seika, both of which are aligned with Mitsubishi Heavy Industries. Seika had been a smaller shareholder for years and then recently increased their stake as Kitz, another valve maker and shareholder, sold their holding in TVE to Seika.  Seika launched its nuclear power business in 2023 and has acquired valve companies in the past.  This potentially puts TVE in its crosshairs for a full takeover.  Hikari Tsushin’s stake mitigates the risk of a take under, but their profit motive likely indicates that they have no special affinity for holding TVE shares for the sake of it. I suspect either increased capital returns or an acquisitions gets us to 1x tangible book value sooner rather than later.

Valuation

The shares trade at ¥2,200. There are 2,340,411 shares outstanding for a market cap of ¥5.1bn.  This compares to ¥5.3bn of net cash and ¥1.8bn of investments.  Net current assets plus investments less total liabilities are ¥8.3bn. Tangible book value is ¥10.5bn after taxing ¥1.1bn of unrealized gains on securities at 30%.

For 2024, TVE is forecasting ¥10.3bn of revenue and ¥600m of EBIT, which translates into ¥192 of EPS and a valuation of 11x earnings.  For scope – in FY10, the last year before Fukushima, the company generated ¥1.6bn of EBIT on ¥10.8bn of revenue, a 14% margin.

Reported earnings in 2024 have benefitted from the reversal of a charge taken in 2023.  I believe the forecast represents the ongoing business without the charge reversal as EBIT has been ¥1.1bn through Q3 FY24 (September).  The company has a money losing steel making segment (large format cast products), whose losses are increasingly more than offset by a growing electrical business (electrical and fire extinguishing equipment installations targeting BWR nuclear plants - “paging Sir Martin Franklin-san”).  While the forecast potentially understates the earnings power, the reported number undoubtedly overstates it.

TVE has a very robust balance sheet, indicative of a pre-Abenomics corporate mentality.  Similar to restarting nuclear plants, steps are potentially underway that should see this value recognized in the share price.  The company has made nondescript announcements about corporate value and Hikari Tsushin, a Japanese conglomerate with an investment portfolio, owns 23% of the company.  While the announcement was light on details, it increases the probability of further positive announcements (the company had already reduced one cross holding in July 2023, so there is some thaw).  The shares are illiquid and did not move in the aftermath of the company’s July 2024 announcement to get the company to 1x book value.

Conclusion

This is a very cheap business with several ways for the share price to increase – improved governance, earnings growth, or a fair priced takeout.

Thesis

The Hunt brothers, Herbert and Bunker, had a solid thesis for investing in silver.  Broad trends unfolding over 1960s and 1970s pointed to a high probability of an extreme supply and demand imbalance in silver, which would result in higher prices.

Most of the world’s silver is not produced at dedicated silver mines but as a byproduct of mining copper, lead, or zinc mining.  Lower cost surface mines were depleted and had to be replaced with underground deposits that were more expensive to mine.  The sale of US government silver holdings that had been accumulated since 1934 was a temporary source of supply that would eventually be exhausted.  Silver supply could theoretically come from reclamation – melting down coins, silverware, or jewelry – but this would require a high enough price to garner attention of the numerous and disparate holders (one source of illegible silver supply was distributed across India and had to be smuggled out of the country to Dubai before it could enter global markets).

Silver demand had been steadily increasing in the preceding years and showed no signs of abating.  It was finding applications in photography, electronics, medicine, and aviation.  Silver was critical to the products in these markets but a small portion of their costs, which supported the belief that a huge increase in prices would not affect demand.  Another source of “demand” was generated by the Bretton Woods monetary system collapsing and attempts to identify assets that could protect against inflation.

Execution

The Hunts started buying silver bullion and futures in 1972 and were enthusiastic promoters of the idea to other people.  By December 1973, they had contracts for 35 million ounces of silver, about 10% of silver supply.  From December 1973 to February 1974, a brief squeeze sent silver from $3 to $7, which seemed to serve as a brief introduction to the Hunts of what could potentially be done.

The Hunts spent several years courting followers, especially in the Middle East, while also steadily increasing their holdings in silver.  The Hunts bought control of Greater Western United, a beet sugar refiner, in 1975.  They directed the trading subsidiary to start trading in silver, with the company taking delivery of 21 million ounces of silver in June 1976, about 5% of annual silver consumption at the time.  As insight into their temperament and methods, the Hunts had accumulated 8x as many soybean contracts as position limits allowed by spreading the holdings across family members’ accounts in 1976.  This specific episode is better covered in Merchants of Grain.

The Hunts bought 21 million bushels of soybeans compared to a position limit of 3 million.  Cook Industries, a commodity broker, was short soybeans while the Hunts were buying.  The Brazilian government, major exporters, put a tax on soybean exports to keep global prices high at the same time too.  The Hunts knew that Cook was short soybeans because a distant cousin, J. Stuart Hunt, sat on the board of Cook.  Cook called the CFTC, which had only been formed in 1974, to complain, but the commissioner there had just come from working at Cook.  The CFTC filed a lawsuit against the Hunts, where the judge agreed they violated position limits but did not engage in manipulation.

In the middle of 1979, the Hunts convinced Saudi investors to contribute to a Hunt managed JV called International Metals Investment Company (IMIC) to purchase silver.  IMIC’s purchases of silver showed up on Commodities and Futures Trading Commission (CFTC) reports starting in August, with silver having gone from $6 to $9 per ounce in the first half of the year.  IMIC was not the sole entity trading at the Hunts’ behest or that of their associates – the Saudis bought through numerous Arab front men and the Hunts bought through accounts opened in the names of various family members.

Silver prices were already up 65% from the start of the year by the time IMIC started buying, but prices continued to increase in September, going from $10 to $18 an ounce.  The New York based commodity exchange, Comex, saw contracts settled for physical silver that was taken out of its warehouse and flown to Switzerland.  This was seen as particularly odd, because the frictional costs would have been much lower to exchange the contracts for ones on the London Metal Exchange (LME) and then moved to Switzerland.

Moving physical silver around isn’t outright manipulative, but it sets up the settlement of futures contracts in coming months to confront a supply deficit if the holder opts for physical settlement.  This was the case with a large number of December contracts relative to the inventory in the Comex warehouse.  The Hunts’ futures contracts were concentrated around December 1979, January 1980, and February 1980.  These would mature into a localized shortage of physical silver in the warehouses that was mostly the making of the Hunts.

Another recurring observation in the silver market was a large volume of orders being placed in London.  London is relatively less liquid than the Comex or Chicago Board of Trade (CBOT), but due to time differences it sets the tone for trading later in the day (like modern day overnight trading).  The LME had less government regulatory oversight and greater privacy protections compared to the US, which also cast some broader uncertainty on silver markets because the intention of the large purchases was harder to discern.

Comex kept raising margin requirements throughout September.  One contract represents 5,000 ounces of silver, so at $10 per ounce, a contract would be worth $50,000.  On September 18, Comex raised the margin requirement to $20,000 with silver at $18.30 and a single contract worth $91,500.  The price increase of silver fully compensated for the higher margin requirements on the long side, but not for the shorts.

The opposite side of the market ended up exerting upwards pressure on the market as well.  Metal brokers who owned physical silver used futures markets to hedge and were increasing their short positions in the market.  This meant that players with short positions on the market and long positions off it had to post increasing capital in order to maintain their positions.  The limited size of their balance sheets pushed them to close out their short contracts by exchanging physical silver holdings for them.  The Hunts were often on the other side of these transactions, which meant shorts exited the market and the supply controlled by the Hunts increased further.

Intervention?

The CFTC had information in October showing that large silver positions could be traced to various brokers representing the Hunts – in reality the brothers Bunker and Herbert were behind all the activity, but accounts were being opened in the name of a constellation of family members as well.  The CFTC was in the middle of a lawsuit against the Hunts for exceeding position limits in soybean futures in 1976 as well, so they had some understanding of the type of people involved. The CFTC was not fast to make decisions and the preference was to remain uninvolved in the market. 

The CFTC’s bureaucratic passivity was matched by the financially incentivized kind from Comex.  Comex had the highest exposure to silver trading of all the commodity exchanges.  Since it was owned by its members, that meant the organization’s underlying priority was to maintain trading volumes, which supported the income of members.  While Comex kept increasing margin requirements during the upwards movement of silver prices, the only part of the market forced to actively respond to this were the shorts.

Silver prices were flat for most of October, but then broader events impacted the silver market.  The American Embassy in Iran was stormed in early November, which impacted oil prices and the prospects of inflation.  In early December, media reports came out about how the Hunts and the Saudi Royal family were going to accumulate silver and refuse to sell it until it reached $25.  Then a rogue trader for the Peruvian mining export department was caught in a large speculative short position, which was liquidated at $25.50 an ounce.  The USSR invaded Afghanistan in late December 1979.  Silver ended 1979 at $29.30.

Silver prices increased to $37 on Jan 4, 1980.  Comex became concerned about having enough silver inventory to settle monthly contracts, largely due to the Hunts having taken physical delivery of silver and owning a lot of contracts that settled in January and February.  The Hunts had assured the CFTC commissioners that they didn’t intend to take physical delivery during discussions in the preceding months, but this was no longer credible.  At this point the Hunts and “foreign investors” had 50% of Comex’s silver inventory and 70% of CBOT’s.  The CFTC estimated that the Hunts and associates owned 77% of the world’s estimated privately held silver on January 8.

Comex announced a position limit of 500 contracts for any given month, which would start in February.  The limit represented 2,500,000 ounces of silver, which would be worth ~$90m at prevailing prices.  The Hunts and associates controlled about 18,000 contracts worth ~$3.3bn.  Shortly after the position limit announcement, Comex capped new speculator positions at 50 for the spot month and 251 for longer dated contracts.  A flurry of new accounts opened to circumvent the intent.

Silver went to $42.50 on January 14.  The market was aware that yet another metals broker, Engelhard, was facing massive margins calls.  Engelhard also owned a silver refinery that was bringing scrap silver to the market.  Engelhard would lock in a refining margin by shorting contracts, but this meant they would have to post margin despite being covered.  Engelhard reached an agreement with the Hunts to sell them silver at $35 an ounce in late March and late July 1980, which solved their margin crunch, but increased the portion of supply held by the Hunts.

Silver went above $50 on January 18.  Since the position limits proved ineffective, Comex announced that trading was now for liquidation only.  This took speculative players out of the market completely.  The price fell to $44 on January 21 and then $34 on January 22.  The next several weeks saw a lot of volatility with prices bouncing between $30 and $40 an ounce.

De-Bache-le

On March 14, 1980, the Fed announced a special credit restraint program where banks were “asked” to stop financing speculative holdings of precious metals.  For context, gold had gone from $200 per ounce at the start of 1979 to a peak of $850 in early 1980, a 325% gain compared to silver’s 700% gain over the same time period.  By the middle of March, silver was trading for $23.  The prime rate went to 20% at the same time, which increased the cost of financing the remaining silver as margin loans were typically floating rate.  In contrast to the previous months, the threat of inflation was receding, the ease of financing speculative positions was reversing, and the cost of financing existing positions was increasing.  This was a sharp and sudden reversal in many of the factors driving up silver.

In aggregate the Hunts had borrowed close to $1.3bn to finance 70m ounces of silver (~$18/oz of debt).  One of the key financing partners for the Hunts was Bache, a brokerage house.  While the Hunts borrowed from several banks, Bache in particular had many reasons to be generous with the Hunts.  The Belzbergs were buying shares of Bache in early 1979 and were considered hostile to management.  From October 1979-March 1980, the Hunts bought up 6.5% of the Bache and were friendly to management.

Bache returned the favor with favorable margin terms for the Hunt silver purchases.  Bache had also hired the Hunts’ key broker from another firm that wasn’t as accommodating to the Hunts.  At Bache, the broker was guaranteed 50% of the revenue from the Hunt relationship.  This broker had previously helped the Hunts with the soybean contracts in 1976 that violated position limits.

As late March arrived, the Hunts were supposed to start paying for silver deliveries from Engelhard.  The Hunts also received a margin call from Bache that they could not meet.  Silver was trading for $21 per ounce on March 25.  Bache started to sell the Hunts’ collateral, which drove down the price of silver to $11 on March 27.  The only collateral Bache didn’t sell was the Hunts’ shares in Bache.  Engelhard wanted to be paid as well and the Hunts tried to barter with oil concessions.

Since various banks were now exposed to losses from financing silver trading through lending to Bache and directly to the Hunts, Volcker became more directly involved.  A tense weekend was spent hashing out a deal between the Hunts, Engelhard, all the banks financing the Hunts, Volcker, and the Treasury Secretary.  By 5am on Monday, March 31, Engelhard accepted a 20% in a North Sea oil concession owned by the Hunts.

The Hunts now owned about $1.3bn worth of silver and had debt of $1.1bn tied to the position.  The Fed had the banks agree to lend money to Placid Oil, a Hunt controlled oil company, that would then lend the money to the Hunts to repay the banks. Placid pledged oil properties worth $3bn to the banks, which removed any loan to value concerns for the banks.  The combination of stopping any speculative buying, forced speculator sell downs through financing terms changing cascading into margin calls, and the Hunts running out of money put an end to the silver corner.  The Hunts then spent several years in litigation and bankruptcy sorting out their liabilities.  The Saudis and various connected parties were rumored to have an average cost of $25 per ounce and suffered large losses that various European banks ended up partially swallowing.

Reflections

This episode started off with a very good investment thesis.  There were unique quirks to silver that made it very resistant to a rapid supply response.  It was a small but critical portion of the bill of materials that meant the price could be increased dramatically for a sustained period of time before incremental supply brought prices back into a calm equilibrium.  The US was selling down silver stocks over a multiyear period, a finite supply that would distort prices downwards in the medium term.  Inflation had increased the nominal cost of new mines, which provided another boost to the price needed to exceed the cost of marginal supply.  A steady increase in demand meant higher prices were a matter of time.  Even without getting into monetary theory, there was a strong fundamental case in support of much higher prices.  This should all stand on its own merit, but if you want an appeal to authority, note that Buffett clearly kept these dynamics in mind for close to 20 years and acted on it when the time was right.

Silver returned to mid-single digits per ounce by the mid-1980s.  The price of silver stayed around that level until 2004.  Even ignoring the obvious lesson of not overstaying a squeeze in the short term, the seemingly solid case for much higher prices did not cause a step change over the long term.  This reinforces the peril of ignoring the price paid when investing on the basis of broad multiyear theses.  The thesis was identical in 1973, 1976, and 1979, but the profitability of acting on it was very dependent on the price paid.

The September 1979-January 1980 period is worth reflecting on as if a contemporary market observer.  Silver went from $6 to $10 in the first half of the year, already a sizable move.  By the start of October it was close to $18.  A 300% rise would have been a really enticing entry point for a short seller, but the price still went to $29 by year and then all the way to $50 in January.  There were as many “obvious” entry points to short silver as there were times you would likely capitulate.  Knowing the squeeze was on, or more broadly any type of manipulation, isn’t really insightful.  The only opening for an outsider to “safely” short silver was once Comex and the Fed completely stopped speculative buying.  The exchanges and regulators were incredibly reluctant to act and only did so with things very close to the precipice of disaster.

An investor is better off avoiding political timing in the same way they are with market timing.  The Hunts weren’t wrong to view their experience buying up soybean contracts as tacit permission for aggressive behavior in futures markets.  This same pattern repeated itself with Bill Hwang in Archegos.  While in a twist of fate Hwang’s hedge fund took a massive hit shorting Volkswagen into its squeeze, he eventually shut his fund down due to being investigated for insider trading from 2010-12.  He faced no serious penalties.  He may have judged that further aggressive behavior didn’t face serious regulatory risk, such as avoiding disclosure requirements by obscuring holdings through the use of lightly regulated swaps.  In the case of Archegos, its undoing was Viacom bringing more supply of shares to the market and undoing the squeeze that had been occurring in its stock.

Playing the Money Game in a Squeeze

One of the individuals who profited from shorting the squeeze was Armand Hammer of Occidental Petroleum.  He owned a stake in a high cost silver miner acquired in 1976.  He received a study on the mine in November 1979, which could start production in early 1980 with a cost of $9 per ounce.  Owning a mine meant Hammer could participate in the commodity exchanges as a hedging participant, which is an advantage given the lower margin requirements than speculators.  This reduced Hammer’s risk of a disastrous margin call outright, but more importantly owning a mine also meant he knew what his cost to deliver physical product to satisfy any contracts would be.  He started shorting silver on January 8, 1980.  One lesson in this is to reemphasize the dynamic impact of financing structure, as the corner itself failed on weak financing and shorting it successfully was best done from a position of uniquely low cost financing.  Another lesson is it helps to be lucky with timing.  The metagame here is also reminiscent of Beal Bank or Buffett’s Japanese trading house investment.

An outsider without a proprietary advantage still retains a very powerful ability in markets by doing nothing.  To channel Sklansky and The Theory of Poker, “In all poker games it is far better to be last to act, primarily because it is generally easier to decide what to do after you have seen what your opponents have done.”  In the case of the silver squeeze, this does not simply mean the Hunts or the metal brokers, but also the CFTC, the exchanges, the banks, and the Fed.  Even when these players weren’t playing a visible role in the silver market, that was still an active choice that had an impact.  An outsider will never be in the position of acting last in a squeeze with the exception of having perfect timing.  An individual not sitting down at this table has no influence on the market, but it also removes the market from having an influence on the individual.  Even if you could financially and psychologically handle extreme volatility for a period of time, you still would be at a big disadvantage by not being able to determine the timing of all the players acting.

There is a similarity and an important difference in the silver squeeze and oil going negative during Covid.  The logic of both price movements operated on physical factors reflecting mechanical aspects of markets rather than any financial formula or broader economic concept.  While uncommon, it isn’t appropriate to view these episodes as illogical or even as a market failure.  Oil wells couldn’t be shut down fast enough to compensate for the sudden drop in demand.  Oil had to physically go somewhere to the point where sellers paid buyers.  This is the inverse of the silver squeeze, where a major driver was the lack of physical supply to fulfill all the contracts maturing in a given month.

What the silver squeeze lacked that the oil setup didn’t was the one factor investment decision that arises from a forced seller.  While there was a proprietary physical angle with access to storage, outsiders could have purchased out of the money short term puts if they quickly recognized oil could go negative.  This is a far more pleasant position to be in than shorting a squeeze – i.e. taking the other side of a forced buyer or “buying force” – because there is no margin requirement and forced sellers will have a finite amount of selling to do.  While not a viable strategy to continuously pursue, an assortment of panic playbooks that appreciate the dynamics of forced selling can be useful in generating idiosyncratic profits, such as buying busted mergers where arb funds try to exit all at once or looking at preferred equities that suspend dividends.  The reason to think in such broad terms is that future opportunities of this nature will always have different surface level circumstances rather than conform to anything contemplated in a textbook.  The shift in spinoffs from typically unlocking value in a subsidiary that may see an initial sell off in the shares to ways to rid a parent company of various liabilities that come to light several years after the spin is a good reason to think in terms of forced sellers rather than a particular financial structure.

Conclusion

Following the unfolding of the 1979-80 silver squeeze offers more lessons than a summary of them.  Similar to the Taiwan Bubble or control fraud, the market mechanics are worth examining because they are typically present in varying combinations of the same ingredients in other extreme market periods.  You can better comprehend the dynamics at play in the 2022 nickel squeeze, the 2021 Archegos squeeze, the recurring GameStop squeezes, or nearly any squeeze when using the broad blueprint provided by studying the Hunt Silver squeeze.  Rather than offer a money-making playbook for participating in squeezes, these are often very good ways to substantiate the choice to remain on the sidelines when they unfold in the future.

I am going to summarize the mechanics behind the S&L control frauds and then revisit recent episodes that illuminate the adaptations of control fraud in the stock market.  The key ingredients of control fraud that Black identifies – accounting abuses, rapid growth, ease of gaining control, and lax regulation – are enduring in public markets.  Carvana, Valeant, and the SPAC craze of 2021 are three examples that demonstrate what happens when they all combine.   

Control Fraud in S&L’s

The model of borrowing short and lending long is particularly dangerous when interest rates quickly increase.  S&L’s focused on taking in short term consumer deposits and writing long term fixed rate loans.  These mortgages drove banks to insolvency when Volcker raised interest rates in the early 1980s.  This set the stage for banks to become vehicles for extraction.

Richard Pratt was appointed in 1981 as the chairman of the Federal Home Loan Bank Board (“Bank Board”), the body responsible for overseeing most S&L banks.   His regulatory philosophy was aligned with Reagan, who had appointed him.  Pratt made several deregulatory moves to defer recognition of the industry’s widespread insolvency.

Regulators permitted accounting that helped convey the appearance of good health.  Two insolvent banks could merge and instantly create a seemingly better capitalized entity, which would temporarily stave off regulatory intervention.  The capital hole of the acquired bank could be recorded as goodwill on the acquirer’s balance sheet, which counted towards capital at the time.  The logic was that the market value was whatever someone was willing to pay.  This flattered the efforts of regulators to increase bank solvency without the government bailing anyone out even though loss absorbing capacity never increased.

Real estate owners were allowed to contribute properties that could count as a capital injection into a bank.  This is where a lot of people who were subsequently convicted for fraud entered.  These property injections were assigned inflated values by friendly assessors and auditors.  An opportunist could recapitalize a bank in need of $5m with a property aggressively appraised at $25m.  The bank would gain $5m of actual capital and the property owner would receive cash and/or shares for the “extra” $20m.  This bank could then merge the bank with other insolvent banks, further exacerbating the capital hole.

More rule changes included removing restrictions on one individual from owning or controlling an S&L.  It became easier for a bank to lend more than 100% of net worth to a single borrower.  Rules that would have prevented related party transactions were relaxed. Limitations on construction lending, an area where third party valuations can be particularly fantastical yet legitimate seeming, were eased so that banks could increase their relative exposure to it.  It became easy for an individual to obtain control of a bank and extract money.

Capital requirements, the most basic governor of bank growth, perversely encouraged even faster growth amongst the worst intentioned.  Banks could use their five year trailing average of liabilities to determine if they were in line with a 3% capital minimum.  This meant faster growth required proportionately less capital.  Newly created banks had a 20 year phase in for capital – e.g. they only need 1/20 their required capital at the end of their first year, 1/10 the second year, and so on.  This meant the fastest growth required close to no capital to support any potential defaults.

Rapid growth was easily manufactured through Acquisition, Development, and Construction (“ADC”) lending.  An ADC loan covered the acquisition of the land, then its development to accommodate buildings (sewers, utility lines, roads), and finally the construction of a building that would theoretically lead to refinancing the loan as the building generated cash flow.  You just need raw land to start being handed money.  The profits of an ADC loan could be front-loaded while the risk of loss from defaults was deferred as the higher interest rates and upfront fees could initially be paid from the proceeds of the loan rather than cash flow or refinancing a completed project.  ADC lending exploited all the discussed regulatory loosening in addition to inherently aggressive accounting.  The ADC ponzi is an illustrative demonstration of how the key ingredients of control fraud interact with and amplify one another.

This sequence of seemingly productive economic activity was hijacked and turned into an extraction mechanism.  The terms and conditions of ADC loans resulted in ADC loans being a great vehicle for extracting money from the bank.  Per Black;

• “There was no down payment.

• There were substantial up front points and fees.

• All of those points and fees were self-funded: the S&L loaned the buyer the money to pay the S&L the points and fees.

• The term of the loan was two to three years.

• There was no repayment of principal on the loan prior to maturity.  (The loan was interest only, or nonamortizing.)

• The S&L self-funded all of the interest payments.  The S&L paid itself the interest when it came due out of an interest reserve.  The S&L increased the borrower’s debt by an amount equal to the interest reserve.

• The interest rate on the loans was considerably above prime.

• The borrower had no personal liability on the debt (the loan was non-recourse).  His construction company was indebted, but the developer was not.  He did not provide any meaningful personal guarantee of his company’s debt.

• The developer pledged the real estate projects (the collateral) to secure the loan.

• The loan amount equaled the (purported) value of the collateral.

• It was common for the borrower to receive at closing a developer’s profit that could represent up to 2 percent of the loan balance.

• It was common for borrowers to give S&L’s an equity kicker, an interest in the developer’s net profits on the projects.  At first, these kickers often exceeded 50 percent.  After the accounting profession issued a “notice to practitioners” that said a 50 percent equity kicker was evidence that the transaction was not a true loan, it became common to give a 49 percent interest.”

The many features of ADC loans were a magic trick where a snapshot of the bank’s financial state concealed a rapid escalation in risk.  The borrowers willing to accept these terms – very high interest rates, equity kickers, substantial fees – were typically the weakest.  The self-funding of interest payments could obscure the poor credit of the borrowers for a period of time.  There is no natural limit to growing rapidly when giving out loans to borrowers who don’t have other options.  It was as easy to make it look profitable for a period of time as it would be hard to permanently conceal the disastrous nature of the loans.  This is a good demonstration of the adverse selection that underlies a lot of the rapid growth, which is why it ultimately produces large losses.

One way ADC borrowers were able to extract lots of money was the “land flip.”  A daisy chain of transactions on a property occurs in rapid succession until a large per acre price is paid.  This creates a market value that can be lent against.  The eventual purchaser could be a land developer that plans to build thousands of townhomes but uses the loan proceeds to hire related entities at outsized mark ups.  The various entities that take money out through mark ups on related party transactions represent straws that allow for control frauds to extract money with a veneer of propriety that further undermines the solvency of the controlled entity.

Edwin Gray, Pratt’s successor who started to push back against abuses in the S&L industry, had a Texas real estate expert survey construction lending done along I-30, where Empire Savings and other copycat banks supported the land flips, in early 1984.  The film showed a panorama of incomplete projects along the highway in Garland, Texas.  There were thousands of units in various stages of completion that represented over a decade of demand (paper on Empire).  This evidence was among the many reasons regulators started to push back on S&L control frauds, although it took several more years for many of the banks to finally collapse under the cumulative weight of their intentionally poor decisions.

Ecological Considerations

Control fraud often lacks a natural predator.  It weaponizes the instincts and inertia of other organisms with which it interacts.  Reagan, the S&L industry, Congress, and the public were not interested in a liquidation of the S&L industry when it first became insolvent.  Recognizing the issues stemming from deregulation ran counter to Reagan’s ideology and political calculations.  No industry wants to admit it is insolvent, especially one that operates almost entirely on confidence.  Every congressional district has a bank.  Every voter wants easy access to home loans to realize the American Dream.  Houses are built by construction workers and developers then sold by realtors, all of whom are present and vocal in every congressional district.  While financial firms are very ripe for control fraud, politically profuse entities that serve the purposes of many other interest groups is probably a more accurate test for ripe conditions.  Free money upfront with deferral of the true costs results in viral commercial activity, both in its rapid spread and eventual hobbling of its hosts.

The way a control fraud enlists the ecosystem’s self interest was particularly well documented in the aftermath of the S&L collapse as a result of government investigations.  It was not contemporaneously hidden either.  In 1985 Alan Greenspan was an expert called on to provide opposition to Gray, who was pushing for stricter regulation of S&L’s.  Greenspan was paid by Keating, of the notorious Lincoln Savings, to conduct studies “proving that faster growth and greater direct investments produced higher profits and healthier S&L’s.”  Gray, who was initially appointed as a staunch Reagan ally, moved to clamp down on the basis of tangible evidence such as the aforementioned 1984 I-30 footage.  Gray had shown the I-30 land flip video to Paul Volcker who, according to Black, was “horrified,” which is a decent contemporaneous corroboration that Greenspan’s judgement was intellectually dishonest and corrupt.

Greenspan defended his actions in 1989.  His evasion of responsibility through diffusing the blame reveals how the ecosystem was enlisted in support of control fraud. Greenspan’s opinion was for sale, along with lawyers, accountants, and politicians who could all plausibly deny responsibility by pointing fingers.

In a Feb. 13, 1985, letter to the Federal Home Loan Bank of San Francisco, Greenspan argued that Lincoln deserved an exemption from regulations limiting to 10 percent thrifts’ direct investment in real estate and other commercial ventures.

Lincoln’s management, he said, was ″seasoned and expert in selecting and making direct investments″ with ″a long and continuous track record of outstanding success.″ The institution itself was ″financially strong,″ in a ″vibrant and healthy state″ and ″present(ed) no foreseeable risk to the Federal Savings and Loan Insurance Corp.,″ he said.

Two weeks later, on Feb. 27, 1985, Greenspan told the House Government Operations subcommittee on consumer, commerce and monetary affairs that direct investments, while undoubtedly risky, were essential for thrifts to diversify their holdings.

Traditional S&Ls, which took in short-term deposits and made long-term mortgage loans, were vulnerable to a sharp rise in interest rates and direct investments were a valuable alternative, he said.

He also endorsed a study by economist George Bentsen, now with Emory University, which cited the success of 17 S&Ls in direct investments. Fifteen of the 17 have since failed.

″It was my view then, as it is now, that interest rate risk was the crucial problem confronting S&Ls - the problem of long-term assets financed by short-term deposits. In that particular context, at that particular time, direct investment would reduce risk,″ he said.

Greenspan still believes Bentsen took a ″rather sensible statistical approach″ but he points out that most of the 17 S&Ls cited in his study were located in Texas, later the center of the oil and real estate bust.

The central bank chairman’s views have been cited as one of the reasons why a petition, calling on S&L regulators to postpone direct investment limits, attracted 225 signatures in the House in early 1985.

It is also being cited as a reason why, two years later, five senators decided to intervene with S&L regulators after Keating complained about their efforts to examine Lincoln’s finances.

The five - Alan Cranston, D-Calif.; Dennis DeConcini, D-Ariz.; Donald W. Riegle Jr., D-Mich.; John Glenn, D-Ohio, and John McCain, R-Ariz. - met with the regulators in April 1987.

Two of them - Cranston and McCain - said Greenspan’s views on Lincoln’s health heavily influenced their thinking.

″The problem, as conveyed to me at the time, not only by Mr. Keating but also by Mr. Greenspan and Arthur Young & Co. (an accounting firm) was that federal examiners bore substantial responsibility for creating a most destructive and irrational state of limbo for this institution,″ Cranston told the Senate Ethics Committee in a Nov. 16 letter.

Greenspan said he does not understand why the senators cite his opinion as a reason for actions taken so long after it was given.

″You do not rely on a 2 1/2 -year-old letter unless you call the guy who wrote it. No one ever called me,″ he said.

Greenspan, as president of Townsend Greenspan & Co., was hired to review Lincoln’s condition by the New York law firm of Paul Weiss, Rifkind, Wharton & Garrison. He said he could not remember how much he was paid for his work, but said he charged his usual hourly rate.

The partners of the law firm, he said, were long-time, trusted associates. ″They certainly never gave me the slightest impression that these were other than good people″ at Lincoln.

Greenspan said he recalls meeting Keating himself two or three times, but never for a detailed, analytical discussion. The people working under Keating ″frankly I found fairly impressive,″ he said.

Questionable behavior appears relatively more acceptable when nobody appears to be interfering with it and a diverse array of professionals are endorsing it in a circular fashion.  As more people facilitate a control fraud environment, it diffuses responsibility so widely as to make most people immune to any existential risks.  This procyclical ecology reinforces the rapid growth that also typifies control fraud, creating a temporarily symbiotic relationship between a growth at all costs organization and a political context that temporarily amplifies it for its own benefit through lax regulation.

Contemporary Control Fraud

Contemporary control fraud gives sharp definition to situations where a security represents a vehicle for extraction rather than a business that will distribute profits to shareholders.  There will always be a tussle over how the economics of a business get distributed (principal-agent problem).  At some point the insider enrichment ends up being diametrically opposed to cultivating a sustainable business.  Identifying the four key ingredients of control fraud - accounting abuses, rapid growth, ease of gaining control, and lax regulation – is a very strong sign that impact of control fraud is about to felt even if the intent can’t be proven.

Carvana

The comparison that remained constantly at the front of my mind while reading Black’s book was Carvana.  All the key ingredients of control fraud interacted with one another to result in shareholders nursing losses while the controlling parties dramatically increased their wealth.

Rapid Growth

Carvana targeted rapid growth as an analog-to-digital ecommerce play in a large retail vertical with the goal of capturing a winner-take-most reward.  Carvana’s revenue grew 350% from 2017-2019.  COVID helped fuel massive growth in all areas of ecommerce and Carvana was no exception.  The triple benefit of quarantining boosting ecommerce, broad stimulus for consumers, and the acute shortage of cars were a massive tailwind for Carvana to show a continuation of rapid growth in its business with 225% revenue growth from 2019-21.  Management prominently touts this element of the business.

In Carvana’s framing, the used auto industry has the potential to resemble other retail categories where ecommerce resulted in winner take most dynamics.  The logical extension of the business from a low single digit to potentially 30% market share primed markets to extrapolate rapid growth for many years.  Not only was this rapid growth, but it was secular – Carvana could go from 400,000 units to 12,000,000 in the future, a 30 fold increase, if used car retail reflected other retail verticals.

Abusive Accounting

“Statistics are like bikinis.  What they reveal is suggestive, but what they conceal is vital.”

Carvana management referred investors to the gross profits of the business and then provided projections of the operating expenses in a future normalized state.  Management invited the market to view operating expenses as something to expect becoming more fixed in nature at some point in the future to be followed by operating leverage translating into massive profits.  Under this pretext, management treats gross profits as a plausible window into the potential economics of the business, which makes the rapid growth the necessary means to realize it.

Management often presented GPU as a homogenously composed figure.  While there are industrial drivers to gross profit, such as operational scale, gross profit was composed of distinct activities.  About ~30% of Carvana’s gross profit relies on Gain on Sale accounting.  Gain on sale accounting is connected to the business practice of securitizing or selling loans.  This is driven by interest rates and broad financial markets, not by how many units Carvana may be running through its refurbishment facilities or vending machines.  Merging industrial and financial factors into one line item can be viewed as aggressive accounting, as it obscures the underlying economics of the business.  It is worth noting that Carmax, a competitor, reports its financing and auto retail segments separately, implying an active choice by Carvana’s management to portray the business as it does.

Carvana originates auto loans and packages them into an asset backed security.  This ABS is sold to the market with a much lower yield than the origination yield.  The value represented by the difference in the rate that Carvana collects and the ABS holder collects is what generates the gain on sale.  The spread between origination and securitization yields may compress for a variety of factors, which would shrink the gain-on-sale.  Securitization markets may also demand more credit enhancements in the form of overcollateralization to account for higher potential charge offs on loans, further reducing the amount of cash that Carvana can generate from securitizations.  The nature of recognizing a gain on sale creates the appearance of greater profitability in the short term even if it is not a sustainable model longer term.  This is conceptually comparable to S&L ADC lending, particularly in the front loading of profits to create an alluring financial snapshot.

Given the long experience in the used car market at Drivetime, the incubator of Carvana, management is aware of the cyclical nature of auto retail and the challenges that may emerge in a business reliant on securitizations.  Ugly Duckling, Drivetime’s original name when Ernest Garcia 2 (EG2) first entered the used car business, was one of the pioneers of the subprime auto loan securitization market.  Ugly Duckling declared bankruptcy during a downturn in business that evaporated gain on sale profits.  This supports the framing that management was unconcerned with the long term financial health of the underlying business.

Weak Regulation

Carvana has mostly avoided a strong response from the SEC or State Transportation authorities.  The statements Carvana has made about gross profits or in the prospects for the business were all made with standard disclosures about forward-looking statements.  The SEC wouldn’t force them to report in more granular segments, as Carmax does between its financing and auto retail segments, even though Carvana has the same business functions, as this exceeds minimum disclosure standards.

There have been numerous state regulators frustrated by the car title transfer process at Carvana – Florida, Illinois, Maryland, Michigan, Missouri, Ohio, and Pennsylvania, to name a few.  Particularly in the aftermath of COVID with car shortages, it is hard for a state level regulator to shut down a company helping people purchase cars, which speaks to the broader ecology from which Carvana benefitted.  Car sales from Carvana could also originate in a different state, which meant state level regulations couldn’t be enforced, as in Colorado.

The magnitude of this behavior pales in comparison to the behavior of S&L’s, but it does show how regulators have a broader range of constituents to consider when wondering why aggressive measures aren’t immediately taken when business practices aren’t flawless.  Even though Carvana itself is a “young” company, it was incubated within DriveTime, a long time used car seller that certainly would have the institutional knowledge to implement the correct operational requirements for transferring titles.

The broader subprime lending and used car retailing industries are not known for plain dealing and painless transactions, which speaks to the favorable ecology in which Carvana has operated.  It is reasonable to see how Carvana does not attract regulatory attention when reading the CFPB lawsuit against Credit Acceptance, where the actions are more plainly socially objectionable for a regulator or District Attorney to allow.  There is also no government entity on the hook if Carvana were to fail, which decreases the appetite or ability for the government to intervene.

Ease of Obtaining Control

The Garcia family controls Carvana through super voting shares held by EG2.  Ernest Garcia III, the son of EG2, is the CEO of Carvana.  Control is cemented by the corporate governance of Carvana, which simultaneously gives it a veneer of propriety.  Longtime business associates of the Garcia’s are on the board, which creates continuity of control beyond Carvana’s 2017 IPO while providing some veil of independence.  The audit committee head is Ira Platt, an early investor in Carvana who was on the board at both DriveTime and Bridgecrest before Carvana went public.  A second audit committee member, Greg Sullivan, worked at DriveTime between 1995 and 2007, including as CEO.  Ray Fidel, who was convicted in the early 1990s alongside Garcia II for bank fraud related to Lincoln S&L, was the successor to Sullivan as CEO of Drivetime from 2007 to 2015 when Carvana was being created, although Fidel is not involved with Carvana at present.

There are related party transactions between Carvana and several entities owned by the Garcia family.  These transactions are overseen by the board, but this is less likely to be rigorous given the long standing personal relationships.

Drivetime has remained a major business partner for sourcing cars for Carvana.  Bridgecrest is a loan servicing firm that handles loan servicing for Carvana that is owned by the Garcia family. SilverRock is the warranty provider on Carvana’s cars that is owned by the Garcia family as well.  These transactions represent straws into the Carvana entity that allow the Garcia family to earn money independently of the success or failure of Carvana as a stand alone business.  There may also be the inverse possibility, which is that they may be used to temporarily bolster Carvana’s financial results, although that is speculative.  This is all disclosed in the company’s SEC filings and the Wall Street Journal has reported on it:

The Garcia’s took Carvana public in 2017 with agreements to pay DriveTime for various business services. Last year, Mr. Garcia II’s companies took in around $85 million in revenue from providing extended warranties to Carvana buyers, collecting on their loans, and selling or leasing real estate, according to Carvana filings.

Carvana, known for its car vending-machine towers, has continued to strike new related-party deals with companies controlled by the elder Mr. Garcia, a Carvana spokeswoman said, “because they provide the most value in delivering exceptional customer experiences and growing into our opportunity as quickly as possible.”

When Carvana was having trouble meeting customer demand this year, it bought thousands of cars from DriveTime to help catch up. To add buildings for another 1,000 employees at its Phoenix-area corporate campus, Mr. Garcia II bought the land. To help pay for inspection centers getting cars to customers faster, Carvana purchased a building from Mr. Garcia II and sold it for more.

Carvana’s spokesperson’s response to the issues raised in the WSJ article was, “‘at certain companies, there may be concerns with related-party agreements creating risks for investors,’ but she said the roughly 20 times increase in Carvana’s stock since its initial public offering has ‘presumably resolved any potential concerns.’”  This hints at the ecology of control fraud.  The appearance of no issues is validated by some loosely objective measure like a market value and shallowly independent oversight, which has strong echoes of S&L control fraud obfuscation.

One reason to be fixated on the share price is because it can represent an avenue of extraction.  The Garcia’s have been constant net sellers of shares in large quantities.  Share sale proceeds for EGII add up to ~$4bn, far in excess of purchases.  While EGII was already a seller prior to COIVD, he became a significant seller in 2021 as the excitement over Carvana’s growth and prospects propelled the company to a massive valuation.

Rather than raise additional funds for Carvana to sustain its business and solidify its financial position, insiders sold their personal shares.  The company was unprofitable even in one of the most favorable backdrops for the used car market in 2021.  The company could have conducted an equity raise when the market was very receptive to Carvana’s story.  Instead they raised additional debt and equity in the middle of 2022 after the share price had fallen and the cost of debt had increased.  This could be viewed as a strong indication that the shares represented a vehicle for extraction by insiders rather than a long term sustainable business that would distribute profits to all shareholders.

While this is simpler than how opportunists enriched themselves in the S&L era, it is sophisticated in how it sidesteps easily identifiable criminal activity.  The market’s attraction to the Carvana story for a period of time was enough to drive up the price and allow insiders to sell their shares.  If as La Rochefoucald says, “the height of cleverness is the ability to conceal it,” then the Garcia’s are quite clever in how they have used their control of the company to enrich themselves.

Valeant

Valeant is another good example of the finer points of contemporary control fraud.  There was a confluence of aggressive accounting, aggressive drug pricing actions that regulators and insurance companies were slow to respond to, large compensation packages tied to share price, and rapid growth.  The share price climbed up from ~2010 until late 2015 before collapsing.

Abusive accounting

The Valeant situation emphasizes the arbitrage of what one can say in a presentation with a disclaimer compared to financial statements submitted to the SEC.  While unpacking Carvana’s gross profit obfuscation requires some familiarity with securitization dynamics through an entire cycle, Valeant’s abusive accounting was more transparent.

Valeant used adjusted earnings to excite the market.  Bill Ackman of Pershing Square simply repeated the companies adjustments and explanations when presenting the idea in 2014.  A loss of $864 million suddenly turns into a profit of $2.9 billion.  While accounting standards were very permissive during the 1980s in ways that aided insiders’ looting of S&L’s by delaying regulatory intervention, the current permissive attitude is rooted in broad market acceptance of adjusted figures.  Metrics given in a presentation can dominate the narrative of business even when they run counter to what SEC filings show.  There is a lot more leeway before crossing legal boundaries when all the proper disclosures are made and the market simply chooses to ignore them.

The misleading nature of these figures was contemporaneously evident with a basic understanding of the pharmaceutical industry.  Pharmaceutical companies need to make ongoing investments to retain the same level of profitability in the face of patent expiry on key drugs.  Whether a new drug is brought to market via internal R&D or acquisition of an already approved drug, both represent an ongoing investment in the maintenance of the existing business.  Adding back amortization of intangible assets was misleading because the amortization reflected the absence of R&D expensed through the income statement. Moving R&D to the cash flow statement via acquisitions recorded under cash from investing did not change their essential nature to the ongoing business.  The necessity of acquisitions to sustain the same level of business makes the restructuring and acquisition costs an ongoing part of the business.

Rapid growth

Acquisitions were critical to creating the appearance of Valeant’s rapid growth and supporting the misleading accounting the company promoted.  Allergan drew attention to many weaknesses in Valeant’s business, including how the company’s pricing strategy was causing volume to decrease, in a May 2014 presentation defending itself against a hostile takeover by Valeant.  While this would typically be in an industry database or require hands on industry expertise to identify, it became available to everyone.  The day Valeant acquired Nitropress and Isuprel, the prices increased 525% and 212% - which helped temporarily sustain growth.  This behavior was reported in the WSJ in early 2015 as the share price rocketed upwards. 

Valeant presented the acquisition strategy as generating great cash paybacks.  AZValue in August 2015 in two blog posts laid out why the payback timelines and IRR claimed by Valeant in presentations was mathematically absurd.  Amongst other issues, AZValue also pointed out how the revenue growth Valeant claimed on acquisitions was given as an the unweighted amount – 12% vs 6% weighted - which is overly flattering and hints at a broader appetite for deception.

The large price increases had the similar effect of ADC lending.  It puffs up current year results and increases the risk that the business falls off a cliff in the future.  Customers and competitors in any industry typically respond to massive price increases.  This can introduce existential risk if acquisitions are mostly debt funded, as Valeant’s were.

Similar to Carvana’s perceived large opportunity for rapid secular growth by capturing 30% market share, Valeant had a large number of acquisition targets to which it could apply its formula to the tune of $6trn of targets between pharmaceutical and medical device companies in the private and public space.

Lax regulation

Lax regulation was critical to facilitating Valeant’s pricing driven rapid growth.  Valeant used a wholly owned specialty pharmacy called Philidor to conceal this behavior.  Philidor routed prescriptions for Valeant drugs in a way that made it difficult for insurance companies to push back on price increases, at least for a period of time.  Insurance companies stopped doing business with Philidor when these practices received greater scrutiny.  This is partly a reflection of the relative lack of government involvement in the US healthcare system, as Valeant explicitly avoided Western Europe where it is unlikely healthcare regulations would have permitted Philidor’s maneuvers.

Auditors ignoring poor disclosure around Valeant’s transactions with Philidor reflects another regulatory shortcoming.  Valeant had a zero cost option to purchase Philidor for which they paid $100m, which has all the substance of an acquisition.  Valeant pushed the interpretation that it was not wholly owned and therefore didn’t need to be fully consolidated.  The option allowed for the creation of the illusion that the entity’s results shouldn’t be consolidated, which obscured its role in the business.

When Philidor was publicized, the company admitted it represented ~7% of quarterly revenue and a larger portion of revenue growth.  Valeant then announced they were “ending their relationship” with Philidor, an admission it was unsustainable and couldn’t withstand public scrutiny.  Given the role Philidor played in obtaining high prices for drugs, it also likely represented a disproportionate amount of profits, both GAAP and non-GAAP.

Tax regulation was yet another area that Valeant seemed to exploit.  Allergan’s aforementioned presentation credibly pointed to Valeant’s tax strategy as likely to come under additional scrutiny.  This contrasted to Pershing Square’s 2014 presentation where they claimed to have done due diligence on the company’s tax structure with no supporting evidence.  Claims to a low single digit tax rate stood out even relative to similarly domiciled peers.  In the context of Valeant’s other deceptions that defied common sense, this is unlikely to have been any different.  The passage of the Base Erosion and Anti-Abuse Tax (BEAT) in 2017 instituted a 10% minimum, which at least technically shows that a single digit tax rate would not have proven sustainable.

Ease of control

“When you’re a star, you can do anything you want.”

The ease of control angle at Valeant was more subtle than super voting shares, injecting overvalued properties as capital, or incubating the company inside a large organization.  Several investment firms - ValueAct, Pershing, and Ruane Cunniff - had generated large profits on their Valeant shares or from a relationship with Valeant at points in time.  The presence of prominent investors bolstered the stock and the company’s reputation while Pearson profited from his options package increasing in value.  This resembles an investor microecology to the macroecology of political constituents seen in the S&L scenario; a collection of myopic parties who benefit from the misrepresentation without being explicitly complicit in it in a way that prevents forcing a change of course.

ValueAct owned a large stake in Valeant for many years, hired Pearson, and gave him a large compensation package tied to the share price.  This was praised in the WSJ in 2009.  The plan required the share price to go up at a high rate for the options to vest, as did subsequent iterations of the compensation plan.  The shares had gone up dramatically by 2015, which created a permissive attitude around his actions, which included pledging shares that were eventually margin called.  By borrowing money against the shares, Pearson could generate large sums of cash for himself with little regard for the sustainability of the business – e.g. getting 30 cents on the dollar for something that is really worth 10 cents is still a gain.

Pearson enlisted the support of another hedge fund, Bill Ackman’s Pershing Square, by alerting Ackman to Valeant’s impending big for Allergan, which netted Ackman $2.2bn of profits after giving $400m to Valeant in 2014.  In early 2015, Ackman became a shareholder after being impressed at having to pay for his own Chipotle lunch when he visited the company’s offices.  In August 2015, Valeant purchased Sprout, a “female Viagra” company that Ackman had personally owned 1.5% of after investing in its most recent funding round prior to being acquired (Valeant purchased Sprout for $1bn and ended up giving it away two years later).   Ackman was then a public defender of Valeant in late 2015 when the Philidor information became public with another powerpoint presentation.

Ruane, Cunniff & Goldfarb is an investment firm with a reputation for doing extensive independent research and having a connection to Warren Buffett.  While not involved at the board level, they had owned the shares for many years and temporarily had a large profit on their shares, which represented 32% of their portfolio at its peak.  Two of the funds outside directors, one of whom considers Buffett her best friend and plays bridge with him weekly, resigned in October 2015, with the seeming subtext being their discomfort with the Valeant position.  This is illustrative of the general struggle to push back against aggressive behavior of control fraud due to the ephemeral appearance of excellent financial results.  The WSJ reported on Ruane Cunniff’s extensive research not just into Valeant, but specifically into Philidor and their practices, which was not enough for them to change their mind.

Ruane, Cunniff & Goldfarb Inc., manager of Sequoia Fund Inc., said it reached out to former employees of the Philidor Rx Services LLC mail-order pharmacy that almost exclusively dispensed Valeant drugs and sought to speak with them about the pharmacy’s work.

Staff from Ruane Cunniff paid ex-employees and pledged to keep names of those they spoke to confidential, said David Poppe, the firm’s president. He said the firm paid $1,000 to talk with one former employee for two hours and discussed giving that ex-employee several thousand dollars if the person would keep Ruane Cunniff exclusively apprised “about what was happening at Philidor,” though the firm eventually decided against entering into any further arrangement.

“We went into our own due diligence phase, and we reached out to a number of people. Some of them wanted to be paid for their time, and we did pay them for their time,” Mr. Poppe said. He said Ruane Cunniff told every person it spoke with that it “did not want them to violate any nondisclosure agreements they had signed with Philidor.”

…

Sequoia has “always had a history of buying and selling based on its own research, not on what is popular or unpopular,” said Sequoia board Chairman Roger Lowenstein.

On Oct. 28, Ruane Cunniff sent a letter to its shareholders defending Valeant and its relationship with Philidor. The letter said “there is no legal reason Valeant can’t advise, control or own Philidor.”

Ruane Cunniff said in the letter that “we work hard to understand Valeant and its business model.”

“In our view, Valeant is an aggressively managed business that may push boundaries, but operates within the law,” the letter said.

The above article is after many facts were public about improprieties, which included Valeant employees using aliases when conducting Philidor business. The lengths gone to hide the nature of the practices should be a strong enough indication that the consequence of the actions being discovered were known to Valeant to be very negative for the business. RCG’s acceptance of the actions show the extent to which temporary profits can cloud the judgement of people who are well positioned to identify that unsustainable practices are behind the business activity.

SPACs

All the key ingredients for control fraud were actively amplified in the 2021 SPAC boom in a way that shows the market’s sentience to actively offering the control fraud cocktail deceptively packaged as a great investment opportunity.  This is arguably the most comparable set of circumstances to the S&L control fraud.  It happened in a wave with common behaviors and patterns that enriched certain parties without attendant business success.  It also incorporates the more nuanced practices of Carvana or Valeant that show the adaptive nature of control fraud.  Rather than focus on any one SPAC in particular, the focus will be on the ways the SPAC structure offers the opportunity to implement and amplify all the key ingredients of control fraud without having to engage in any activity at all.

Ease of Control

SPAC sponsors immediately gained control simply by raising money.  A SPAC is explicitly formed to pursue a deal.  Sponsors get promoter shares upon the completion of a deal, so they stand to make money simply by closing a deal.  While there is a voting process to approve a deal that the sponsor finds, the general euphoria in the market for SPACs at the time made it highly unlikely that any deal would be rejected.

The initial equity funders of a SPAC received warrants alongside the purchased shares. The warrants would appreciate in value if the shares rose, while the shares retained the right to get their money back if the deal didn’t generate the expected enthusiasm.  In theory, an initial backer could get all of their money back by exercising the redemption feature on the common shares (e.g. voting against the deal), but still obtain upside from the warrants appreciating.

Warrants are highly leveraged to the share price, which could be expected to skyrocket upon announcing a deal during a euphoric market episode.  The warrants explicitly harkens back to the behavior of Michael Milken in the 1980s.  He was a facilitator to S&L control fraud as one of the main capital markets access points for Charles Keating’s Lincoln Savings.  Milken would raise debt through Drexel for a company the condition of warrants being issued alongside the debt, except Milken would keep the warrants for himself while the junk debt ended up on the balance sheets of companies like Lincoln.  It is not surprising that Milken’s family office identified the opportunity in providing initial funding for SPACS and getting founder warrants in the process.

Milken was not alone in being enticed by these warrants.  Altimeter, a venture capital firm, raised a SPAC that did a transaction with Grab, a Southeast Asian delivery app.  The WSJ reported that the promoter warrants were given directly Altimeter partners and SPAC directors in connection with the deal.  Grab continues to lose a lot of money and the shares are down 70%, an indication and some confirmation that this transaction occurred largely for the benefit of the SPAC promoters.

A few other examples include;

“Veteran dealmaker Michael Klein and his team were awarded $275 million worth of stock last month for merging their SPAC Churchill III with healthcare services firm MultiPlan Corporation in an $11-billion deal by only investing $25,000, according to SPAC Analytics. Klein’s team separately invested $23 million to receive warrants, or options to purchase shares at a certain price, in the company.

The combined company’s shares are now trading at 25% less than when the deal closed amid concerns over growth prospects. Yet Klein and his team are still in the black by more than $200 million, because the shares cost him only a tiny fraction of what investors paid.

A spokesman for Klein declined to comment.

Another prolific SPAC sponsor, Chamath Palihapitiya, is in line for a stock payout that on paper will be worth $207 million after investing $25,000 of his own money in a $3.7 billion merger with U.S. insurance startup Clover Health. He also invested $16.4 million to receive warrants in the combined company.”

Both Multiplan and Clover are down 90% from their SPAC conversions.  The windfalls of the sponsors can be substantial even if the company winds up with credible short seller scrutiny, as Multiplan and Clover have. 

These twins forces – sponsors who could quickly make a lot of nearly free money upon the approval of a deal and initial backers who were presented with a close to risk free proposition – creates an adverse selection machine, much in the way that the ADC loans at control fraud S&L’s were structurally low quality.

Rapid Growth & Aggressive Accounting

It is impossible to separate rapid growth from abusive accounting with SPACs.  The presentation of rapid growth stems from aggressive accounting in the form of completely made up forward projections.  A key feature of the SPAC mania is that promoters merely had to allude to a magnificent future rather than going through the lengths of giving some substance to the operations like Carvana or Valeant had to in order to attract interest.  SPACs combine the fabrication of growth like S&L’s engaged in ADC lending with the very permissive attitude towards statements made in presentations that Valeant and Carvana demonstrated.

There has been research that SPACs providing overly ambitious revenue guidance occurs at a systematic level, but looking through nearly any SPAC presentation shows varying degrees of absurdity in presenting fast growing and highly profitable companies several years out.  Electric Last Mile Solutions, whose financial projections are below, is one of 7 SPACs that went bankrupt within a year of completing a transaction.  It should be noted that ELMS declared Chapter 7 bankruptcy.  It was liquidated rather than reorganized, as one might expect if there was any value in continuing to fund the business plan. 

Lax Regulation

Similar to Valeant’s presentations, numbers in SPAC presentations are unaudited and often conveyed fantasy.  Part of the basis for this is that SPACs are explicitly designed to circumvent the IPO process, which has much more rigorous disclosure requirements and regulatory oversight in general.  The biggest regulatory oversight was with the most abusive situations – where the SPAC was taking over an essentially nonexistent business with limited operational history, such as ELMS.  This attracts science project companies that likely couldn’t pass through the IPO process successfully.  For all intents, companies like ELMS never possessed credible substance.

The specific loophole available to SPACs and already public companies but not IPOs is the PSLRA (source):

There is a widely held understanding that the Private Securities Litigation Reform Act’s (PSLRA) safe harbor applies to SPACs whereas it does not apply to IPOs. The safe harbor provides that, when accompanied by appropriate cautionary language, a company making a forward-looking statement without actual knowledge of its falsity will not be held liable in a private action brought under the securities laws. Projections are commonly included in SPACs’ investor presentations and proxy statements, and are essentially never included in IPO prospectuses. This difference in treatment is not the result of a deliberate policy decision by Congress or the SEC. The PSLRA’s safe harbor excludes “blank check companies” from its coverage. But a few years earlier, the SEC had defined “blank check companies” very narrowly to target penny stock fraud, and SPACs were designed to fall outside that definition.

There has been little in the way of pushback from the SEC on any specific SPAC for its actions because it doesn’t seem like any laws were broken.  The SEC has initiated a lawsuit over disclosure around conflicts with one specific SPAC promoter.  The SEC proposed changes in March 2022, including ones to how financial projections are disclosed, which is an admission that the regulations were too weak.  While the PSLRA safe harbor exists for Carvana and Valeant, it is more distinct as lax regulation with SPACs because there is no alternative in the form of SEC filings to contradict the presentations.

Conclusion

The combination of four relatively simple ingredients can create a complex adaptive system that is an effective vehicle for extracting money from the securities market.  This occurs at individual companies or in waves, which shows the phenomenon is scale invariant, further bolstering the case that this formula reflects an enduring dynamic in the rhythms of financial markets.  Control fraud is a very plausible explanation to a lot of behavior in public markets that otherwise gets dismissed as one off episodes with no applicable lessons.

Any individual component of a business model can be amplified by other components to facilitate a flattering appearance – the way lax regulation may temporarily spur rapid growth, or how ease of control increases the use abusive accounting.  Attention is often solely focused on positive flywheels.  The inverse of characteristics that amplify negative outcomes is equally valuable to study.  No company will ever highlight a destructive flywheel.  The reality of negative flywheel can be distorted to convey the fantasy of a positive flywheel as seen with Carvana and Valeant.

The reciprocal mechanism of simultaneously concealing and amplifying risk is a dangerous feedback mechanism to encounter with naivety.  The ripest ecologies for control fraud possess a dependence on it not being brought to attention, particularly if the extraction mechanism is selling shares or cashing in on options packages.  If uneconomic undertakings generate an ephemeral increase in the share price, then management’s commitment to it is likely to increase.

It is not difficult to identify a control fraud dynamic at work if you are aware of the concept.  The likelihood that benign explanations are correct is very low when all four ingredients are identifiable.  The negative implication of each ingredient is individually debatable and open to interpretation, but the benefit of the doubt shrinks as more of the ingredients appear and should probably disappear when all four are identified. 

Nearly every piece of evidence in the above examples was contemporaneously available.  Much of it was prominently featured in newspapers and major periodicals prior to significant drops in share prices.  Prominent investors with a variety of investment approaches have nevertheless been deceived by control frauds.  This is just a bemused observation.

Similar to a magic trick, it’s still very valuable to identify if one is being performed without identifying the precise mechanisms at play.  Control fraud is likely to prove an enduring phenomenon as long as humans have emotions.  A useful antidote to FOMO is increasing your ability to identify how certain mechanisms increase the likelihood control fraud, which is why I have belabored details in the case studies.  It is arguably harder to be deceived when focusing on specific mechanisms rather than seeking a broader inoculation against alluring narratives or charismatic leadership.  Increasing familiarity with this concept should better equip anyone to respond to the changes in the forms control fraud takes.

Two great pleasures in life are mortadella and cheap stocks, and Italy has plenty of both.  OpenjobMetis is a Milan listed staffing company focused on small Italian businesses.  Temporary staffing continues to gain intentional legal clarity and customer adoption in the Italian labor market.  This presents a structural tailwind in the medium term towards higher penetration of temporary labor as portion of the total workforce, which currently lags other developed European countries.  OJM has the opportunity to grow organically on the back of this shift as well as a proven ability to acquire smaller operators in a cost effective manner.  This also makes OJM an increasingly attractive acquisition target, as a larger player won’t have the same bandwidth as OJM to roll up the smallest players.  The company’s high inside ownership, consistent share repurchases, and prudent balance sheet position it well over long term in spite of present issues in Europe and Italy’s economies that make the stock out of favor.

Business

The Italian temporary staffing industry was only created in the 1990s.  It has gained more clarity over the years, with the biggest jump happening in 2014 with the Italian Jobs Act (read this paper for more details or this one).  Some limitations were reintroduced in 2018.  Italy was in recession in 2019, then some stuff happened in 2020 and 2021 that makes it hard to definitively say the 2018 reforms weren’t an issue, but 2021 revenue was well above 2018 levels.  I’m not an expert in labor law, but temporary labor is about 1.6% of the Italian workforce compared to 2.1% on average in Europe.  Labor market reforms in Italy have been an ongoing tussle since the 1990s, but the general direction has been one of increasing acceptance.  While a derivative on Italian GDP is not that compelling, this more idiosyncratic undercurrent provides some insulation from the broader economic drivers in Italy.

The top 6 players control about 2/3 of the Italian market, with a tail of another 45-50 players.  OJM faces 3 very large global players in Adecco, Manpower, and Randstad, a large international player in GI Group, and a comparable domestic peer in Umana.  OJM organic growth does not always keep up with the larger players, but I believe this is representative of their customer bases.

OJM differs itself from the larger staffing companies by focusing on small and medium sized businesses instead of larger corporate customers.  OJM can be more valuable to these customers, who often lack a large HR department and are only hiring 1-2 temps.  The top 10 customers are <10% of revenue, so there is a long tail of fragmented customers they serve.  While this approach requires a more intense salesforce effort than a large staffing agency signing a framework agreement with a large customer, it also makes it more difficult for new competitors to quickly scale.  OJM also avoids staffing services for public/government jobs, which I view favorably as there are always complications to this customer base even if it can provide a short term boost to revenue.

OJM does not generate a lot of revenue from permanent placement, whereas larger players such as Adecco or Randstad do, which supports higher EBITA margins at competitors.  The larger players also have greater scale in general.    

The staffing business model is working capital intensive, but requires little in the way of PP&E.  Net income divided by net working capital and PP&E averaged 24% from 2017-2019.  It has been 24% and 21% in 2020 and 2021, respectively, which is still good.  The net income return on invested capital, which includes intangibles from acquisitions, is 10%.  In 2020 and 2021, it was 7%.  On a TTM basis to 9/30/22, it is back to 10%.  This is not glorious, but it should increase as they lap acquisitions and COVID disruptions.  The larger players don’t disclose country specific returns for comparison, but they generated ~50% net income returns on tangible capital and ~20% net income returns on invested capital in the same time periods, which is better than OJM (it’s unclear how much of the delta is impacted by geographic exposure and permanent placement profits versus scale).

What’s this thing worth?

At EUR8.30/share with 13.35m shares outstanding, the market cap is EUR111m.  Net debt is EUR12.7m, so enterprise value is 124m. Trailing twelve months EBITDA is EUR28m, net income is 13m, an 11%ish earnings yield and 4.5x EBITDA.

If they can earn ~EUR15m of net income, that is a 13.6% yield, which should be possible when they get all the savings from a large acquisition they completed in early 2021.  If OJM gets acquired for 8x current EUR28m of EBITDA in a few years, that’s a double, not including dividends, reductions in the share count, or earnings growth, which would push this from a mid to a high teens return.  While 8x is ambitious, even 6x would be a double digit return if it happens in the next 5 years.  This also implicitly anticipates a scenario where there is no growth or a dip and recovery in the next 5 years.

This company is hard to accurately model in any given year because margins are thin and small variations in any line item can fat finger the outputs – these numbers are impressionistic and a more precise model would likely only further bolster that the shares are cheap. The first 9m of 2022 saw EBITDA of EUR22.9m, EBITA of 17.9m, and net income of EUR11.4m, which annualizes to EUR30m, EUR23.9m, and EUR15m, respectively so the company seems to be effectively capturing a lot of the cost savings from the deal.

OJM is in a good position to make attractive acquisitions, which it has done several times in the past, most recently with Quanta in January 2021.  There are lots of redundant costs in maintaining branches in the same geographies and at the corporate level.  There is industrial logic and a market clearing price for OJM to get bought eventually.  It’s also worth pointing out that a EUR100m check is much more intriguing for a large corporate player to write than several checks that cumulatively add up to the same amount.  This dynamic puts hard to quantify but still valuable upwards pressure on the value of OJM.

Depending on the pace of recovery, the combined 2019 EBITDA of OJM and Quanta is already EUR24.3m, which they are currently exceeding, and synergies could see OJM generating EUR29.3-30.3m in EBITDA in the next 2-3 years, which they are already clos to and should translate into EUR15m of net income.

One of OJM’s Italian competitors, Obiettivo Lavoro, was purchased for EUR102m by Randstaad in 2016.  Randstaad described the acquisition as “opportunistic” on conference calls, which I interpret as “the price was right.”  Obiettivo Lavoro’s 2015 revenue was EUR436m and EBITDA was EUR20m.  This 5x EBITDA multiple compares favorably to OJM’s ~4.5x 2022 EBITDA.  Even in a “takeunder” situation, which I consider unlikely, that represents 10% upside from current prices.  While I would normally consider this an upside cap, there are long time insider shareholders of OJM who are unlikely to be “opportunistically” acquired and their balance sheet is unlikely to put them in that position.  This is much lower than the 8x average EBITDA multiple from a cherrypicked dataset OJM offers, which obviously implies significant upside.  The .23x revenue multiple for OL was also higher than the ~.15x 2022 revenue OJM for which currently trades.  I think this presentation slide can be viewed twofold – both as the M&A value creation opportunity for the company if it remains independent, as well as broadcasting the price they might be willing to accept from an acquirer.

The shares are not very liquid, but the company has been a regular purchaser of its own stock.  Trading volume makes it difficult to repurchase in size, but it does provide some insight into the Board’s opinion on the valuation.  They company recently became more aggressive with their buyback, offering to buy ~2% of the shares at EUR8.80, a more forceful expression of their opinion than buying EUR10k worth of shares every week for months.  The company is getting quite explicit that the share price is cheap.  This stance and activity is a strong signal that the stock is interesting.

There is a high inside ownership at the company distributed over several different players.  Through MTI Investimenti, the CEO, who is also the founder, owns 3%, HR director 1%, and Commercial Director 1%.  The Chairman and a Director collectively own 17.8% through Omniafin.  The Omniafin holding came through OJM acquiring Omniafin’s staffing company, which I view as a positive indication that the largest shareholder is not that interested in running a staffing company and willing to sell things for the right price.  This is speculative on my part, but that they merged an entity into OJM that they still largely controlled reflects better on their capital allocation shrewdness over the long term than the CEO/founder of OJM, who owns considerably less (this is just a hunch - there have may have been different starting circumstances beyond his control and Omniafin may have been more risk seeking by using more debt).  The seller of Quanta now owns ~4%.  This is a good balance and alignment with outside shareholders.  I take comfort in there being multiple parties who appear to be economic animals with real ownership stakes.  Sensible decisions have been made to date under their collective management – both capital returns and acquisitions – and I suspect OJM will accept the right bid at the right time.

Risks

The most obvious source of hesitation is that this is a smaller player in the staffing market, which itself is already not a phenomenal industry.  It is economically sensitive, consumes working capital to grow, and operates on thin margins.  The after-tax all in ROIC of the business is average.  This becomes even more of an issue during times of high inflation, as the business requires working capital investments proportionate to the revenue, which sucks in capital.  The return on tangible capital is 25%, which is an alright position to be in during inflation, but is obviously not as good as not requiring any incremental capital to respond to higher nominal prices.

The big risk at the moment is Italy imploding on rising interest rates, high energy prices, and a broad European economic collapse.  While I think that is a bit of a doomsday scenario, this can specifically put lots of pressure on OJM’s customer base, to which OJM is also extending credit in the form of payroll.  As in life, OJM’s greatest strength is also its greatest weakness – focusing on SME customers.  These are the companies in the worst position to handle a skyrocketing energy bill or a sharp downturn in revenue.  Eight months into the war in Ukraine, industrial production and GDP has not collapsed, so it is still doomsday deferred.  It remains to be seen what happens as the Eurozone starts to raise rates to combat inflation.

As with any company where there are controlling shareholders, there is the risk of a take under.  I do not know what problem this solves though, because in selling their businesses, several board members are revealing they are looking to get liquidity for their stakes.  Especially given the business model’s consumption of working capital to grow, I don’t think they have taken a lot of cash out of the business over the years that is waiting on the sidelines.  They could all play the game of buying it in its entirety today for a cheap price and selling it in the next upcycle.  The risk for them, assuming I am correct they don’t have a lot of liquid assets outside the shares in OJM, is that they would have to finance the takeover with debt, which would be risky with the economic outlook and the sensitivity of the business model.

At the broader level, the big risk seems to be that the Italian economy is a tough place to operate even when times are good, which can put a damper on growth.  The company went public at the end of 2015 and had good revenue growth in 2016-2018, but stalled in 2019.  Italian labor laws continue to seek a balance around opening up to temporary workers and reforms stalling.  The economy was technically in recession starting in Q4 2019.  Beyond the direct impact of COVID, the rock and hard place of austerity and high debt/GDP has only become rockier and harder in the aftermath, which is unlikely to make decisions easier for legislators to make around labor laws.  At the same time, that it is a difficult place to operate makes the relative attractiveness of using temporary employees for a company that much greater, because it gives flexibility to meet demand they may otherwise just not fulfill because they don’t want to permanently increase capacity into a recession.

The perceived low penetration rate of temporary labor may be a fallacy of composition.  This reveals how little I know about the legal system for Italian temporary labor, which is a clear risk.  The north of Italy is economically close to par with Germany or the Netherlands, while the south of Italy lags.  It is possible that a more granular data set would reveal that the north of Italy, where OJM is already well established, more closely matches the penetration of temporary labor already seen in other European countries.  To an extent the penetration rate is dependent on the legal climate, not a high GDP per capita, as Norway or Denmark demonstrate with their lower rate of temporary labor.  It may be perfectly reasonable that Italy’s labor market resembles Italy’s labor market and there’s no intrinsic reason for it to resemble France more closely than Spain.

In January 2021, OJM acquired Quanta.  Quanta has received a “questionnaire from the Italian Tax Authorities” around VAT treatment in 2015-2017.  While I interpret these circumstances slightly favorably, the risk of getting involved in lengthy litigation with the seller and angering the Italian tax authorities exists.  Quanta got a bill from the Italian government on in November 2020 for EUR592k, which is currently under appeal.  The seller of Quanta gave OJM a specific guarantee to cover any liability from the VAT treatment and there is already EUR1m in escrow.  OJM has also received an inquiry and wasn’t given a bill, so they presumably know what the correct procedure looks like.  The trade association for staffing agencies has gotten involved for common defense and clarification, which reduces the likelihood this is a Quanta specific weakness.  That OJM knew this about Quanta before purchase, the escrowed amount is higher than the current bill, and OJM not receiving a bill supports an interpretation that this is not a risk that could metastasize.  There is also inside ownership at the board level, so I give good odds to them not being rushed into a deal to stroke a CEO’s ego.  It is still something to monitor.

Lastly this may just be an overly cute and dumb idea.  The inside ownership, acquisitions, and buybacks are an attractive proposition at ~8x earnings and a potential windfall from acquiring things cheaply or being acquired dearly.  That said, Manpower, Randstad and Adecco trade for 9-12x 2022E earnings, have large dividends, and have higher returns on tangible capital.  Their exposure to the staffing market is more diversified, which dilutes Italy specific risk, but at an abstract level offers the same “exposure.”  I think what changes the calculus for me is that there is a greater likelihood for “value creation” from OJM in the form of needle moving acquisitions that are still very cheap and its eventual acquisition by a larger company.  The global players, in my understanding, offer GDP type growth and don’t have the same needle moving capital allocation opportunities.  I don’t think I am making the mistake I am alluding too, but this will serve as reference if that happens to be the case.

Conclusion

This is not the most captivating idea in the world.  This is a cheap company with low leverage and an owner oriented management team and board that is signaling the shares are undervalued.  They are ramping up the buyback, have a meaningful dividend payout, and point to the valuation disparity both relative to M&A and its historical valuation.  The macro environment is not great, but that is also how the shares have gotten so cheap.

Sklansky’s Theory of Poker is,

Every time you play a hand differently from the way you would have played it if you could see all your opponents’ card, they gain; and every time you play your hand the same way you would have played it if you could see all their cards, they lose.

The goal of the investment research and portfolio management process is essentially to make sure you are playing as close to the way you would if you could see everyone’s hand.  In poker, Sklansky thinks the ability to read hands it the most important thing on the path to perfect play.

“When a good player makes a play, there is a sensible reason for it, and your job is to find the reason and put that player on a hand.”

Actionable information can be created by observing how others act.  Everyone does something for a reason, but smart people are more likely to do things for smart reasons.  Across many fields, it seems easier to find the solution to a problem knowing that it is solvable.

Sklanksy is specific about how to approach reading hands.  “Before you can technically analyze what your opponents might have, you must have played with them for a considerable length of time, seen how they play their hands against you, and most importantly watched them play hands in which you are not involved.  Even when you are not in a hand, you should not relax your concentration.”  You can apply this in public markets easily because of access to a long track record for many actors – businesses, investors, board members, private equity, activists.

Some players have an imperative to share their thinking on a specific investment or discuss their philosophy.  Others never articulate a process, but you can study their actions to discern a behavior pattern.  You can also learn from how they have played their hands in a set of circumstances, such as David Einhorn with option like levered equities in 2009 and then go find similar circumstances for you to play that hand similarly.  Knowing how someone plays a hand is much more informative than the returns they’ve generated when looking at their activity for ideas – as in poker there are bad players who win hands and good players who lose them.

The concept of reading hands can be expanded upon by seeking out books that offer up a credible account of a corner of Wall Street.  Only reading accounts by investors is an unnecessarily limited vantage from which to make investment decisions.  Fleecing the Lamb, about the Vancouver Stock Exchange, lays out how numerous promoters played their hands.  Dead Bank Walking is by a senior executive at a struggling bank. It shows how he played his hand and the bluffs he makes.  Metal Men shows the culture of commodity trading, written by a great journalist whose research included working at a commodity trader for a year. The lessons could be easily expanded to any kind of trading.  All of these represent perspectives you will encounter in investment situations.

A book I read after digesting Sklansky was The Caesar’s Palace Coup, which solidified for me the overall value of his framework.  It shows the hands of distressed debt investors, executive officers, private equity firms, investment banks, and corporate lawyers at a level that should aid in reading their hands better.  This ranges from the dynamics of an “independent” board to the mercenary realities of a “fairness opinion.”  It is credible because it is based on documents and testimony that came out during a bankruptcy trial, not a one sided victory lap account, surface layer PR spin, or an axe grinder.  The authors can compare sworn testimony and exhibits to what people say in research interviews for the book.  Events such as the Caesar’s bankruptcy had conflicts and that typically causes everyone to talk because they want their side of the story told.

“One of my favorite types of player is the one who never bluffs.  You have a tremendous advantage over these players because you just about always know where you’re at.”

Playing with managers who don’t bluff – who speak plainly, share a thought process grounded in reality not fantasy, or are incentivized on outcomes they can control (ROIC vs relative TSR) – has a deeper benefit beyond being a pleasant way to do business.  Poker, as with investing, involves calculating the reward, risk, and making a decision based on the ratio of the two.  Quantitative measurements can contain self deception because “numbers don’t lie *winky face*.”  With managers who don’t bluff, you will find that the numbers lie a lot less – compare a SPAC presentation or a share based compensation “adjustment” to financial results with a Texas Instruments capital allocation presentation.

Bluffing is not desirable in a business partnership.  This encapsulates a key disconnect when investing in capital intensive commodity businesses.  The current commodity boom aside, shale companies spent the better part of the last decade publishing investor presentations claiming alluring IRRs on their wells in order to attract both debt and equity capital, without which they would not have a business.  Yet they never produced free cash flow and many became financially distressed.  This dynamic makes it difficult to know what cards the company is actually holding, which short circuits attempts to accurately quantify the reward and obscures risks.  Capital intensive businesses are structurally in the position of bluffing because offering a compelling return is how capital is attracted, which is self defeating at best in a commodity business.  This is the truth behind the joke that a gold mine is a hole in the ground with a liar next to it.

As an exercise, of the following examples who do you think as a management team is closer to reality and revealing what is going on in their business and who do you think is stringing you out on increasingly unproven assumptions they want you to conflate with present reality?  Which one is easier to value with accuracy?  Who is more likely to be responding to reality in their daily decisions running the business?

Here is a slide from a company that has grown EPS at 16% annually for the last 10 years:

Here is an excerpt from a conference call of an unprofitable consumer unsecured finance company that claims to be a payments company:

I'll pull the curtain back a little and while I will keep it very high level in part to avoid giving out trade secrets, feel free to tune out for a few minutes while I nerd out.

 [Our company]'s underwriting advantage begins before any of our models are interrogated for a decision with our product design. Because [our company] is predominantly offered at the point of sale, we have a natural opportunity to explain our value and transparent approach to the consumer. As a result, we avoid much of the adverse selection that often comes with traditional lending.

 Coupled with SKU-level data we receive from our partners, our models tend to split the risk far better than those used in traditional consumer loans. Another fundamental structural advantage [our company] has is its total separability of transactions. Unlike providers of lines of credit, we underwrite transactions individually, modeling a consumer's ability to pay us back as well as their propensity to do so.

 This notion of separability is also recursive, a consequence of our product because repayment schedules are highly predictable, our models operate at an individual installment level. This separability is a powerful tool for modeling as well as managing risk. We're able to deliver a reliable forward-looking picture of both consumers and our own cash flow.

 Our proprietary network of directly integrated merchants as well as other sources of nontraditional underwriting data offers us a significant raw data advantage into feature engineering. We maintain a library of over 500 features that we select from as we create new models or update existing ones, while continuously looking for and eliminating any potential for disparate impact in our decisioning, both at individual variable and model levels.

 We train our models using academically well-understood gradient boosting technique with significant proprietary modifications we've invented that help us improve results. Because from the very beginning, we focused equally on consumer and merchant information, we ended up with a large number of models that are specific to our products and merchants who use them.

 Moreover, as we launch new products with new and existing partners, we acquire new types of data that we incorporate into the models and over time, give incremental weight, too. Underwriting models decay over time as macroeconomic conditions and consumer behaviors change. Even the very best performing ones can lose a few percentage points of their area under the curve every few months.

When to fold ‘em

I’ve expanded on how reading hands and bluffing in poker maps deeply onto the investment process.  It unfortunately took several years before I picked up Theory of Poker after it was recommended.  When other people have mentioned the parallels to poker it was only a sentence or two, which made it hard to internalize the value because I didn’t actually understand the deeper mechanics of poker they were referencing.  There is a lot more in the book that is a useful and actionable framework in investing - position sizing, position management, mistakes, adaptability – that makes it worthwhile to read the book on your own and draw the connections.

Business

C Uyemura produces chemical mixtures used in the production processes of electronics and industrial components that improves their end use performance. 

I have a long running interest in businesses that mix commodity chemicals into proprietary recipes that serve a valuable function that’s a small part of the customer’s costs.  These tend to lead to persistent earnings, low capital intensity, and lots of distributable cash flow.  Recipes are typically developed in close cooperation with customers, who are unlikely to waste their time with new entrants who lack experience or broad product catalogs, which creates a nice barrier for incumbents.  C Uyemura is also an expert at the application of these recipes to the customers products, sometimes performing the task for them directly or selling customers application equipment.  This not only creates stable relationships with customers, it means customers are unlikely to just go find a generic chemical blender to copy a recipe and be able to get on fine without Uyemura.

These recipes require a bunch of different chemicals which a company like C Uyemura doesn’t produce and only mixes in batches, a relatively uncomplicated production process that doesn’t require expensive high fixed cost equipment.  Customers, who are producing semiconductors or metal and plastic components, essentially send C Uyemura a check for every unit they produce as consumption will scale with unit production.  The mixtures are a small portion of production costs but mission critical to performance. This is nicely compounded by the fact that the components C Uyemura helps produce are not a large portion of an end product’s total cost either.  The mixtures are put through testing and certification processes by customers that then use them in a production process for around 5 years, so there’s nuisance from many angles when it comes to switching.

C Uyemura has two US listed peers in the form of Element Solutions (ESI) and Atotech (ATC), which means there is a lot more information about the underlying business in the public realm than one would believe just from the C Uyemura annual and investor info.  One thing that stands out is that Uyemura’s margins are still in the same ballpark as larger Western peers.  This hints at the quality of the industry overall and Uyemura not being oblivious to the underlying earnings power their position should command and not squandering it unrelated business lines.

If you would rather not listen to me with my abstractions, here is the Element Solutions CEO at the 2018 Analyst Day basically saying the same things alongside some other nuggets that matter to me:

We bill our customers for products, but what we're selling is technology and service. Our products themselves are manufactured in relatively simple formulation-based processes. So the asset intensity, the capital intensity of this business is quite modest. What the customers are buying is quality, reliability, technology, know-how and service that translate into better outcomes for them and for the products that they're manufacturing towards.

Our innovation team is innovating on existing products that they've developed. It's incremental development. Our customers rely on our technical

service people. These are people with names and faces that show up at their facilities every day and ensure their manufacturing processes go well.  Not only is the chemistry important, but having expertise in how the equipment operates with the chemistry is also extremely important and our customers rely on us to understand how all these things interact.

And finally, all of these products I've listed share some common attributes. They're differentiated, they're difficult to commoditize and they require extensive applications expertise. And all of these attributes produce the high margins that we continually strive for.

So what sets us apart from other suppliers in this market space? First, we have a deep bench of chemical specialists who provide on-site expertise to our customers, which is in keeping with what we call our high touch business model. Circuit boards are increasingly complex, building them requires essentially an ecosystem of experts. Ours are well positioned globally. They all speak the local language and they're all connected to a system of continuous training. Our moat here is comprised of our employees, applications and technical service expertise, which takes years to develop. We also believe we have best-in-class technology solutions, focused around high-value, leading-edge market opportunities. This is the consequence of innovation driven by the specific needs of our customers and by the technology trends that we see in today's market.

You're going to see the similarity in the business model and the structure. So we produce -- we formulate and produce chemical additives that are used to treat surfaces, both metallic and nonmetallic. We serve almost every kind of manufacturing industry in the world. The most important industry we serve and the largest end-use market is the automotive industry, and that -- we are engaged in the automotive industry everywhere in the world. We -- our finishes, as you can see here, provide anti-corrosion coatings to prevent rust and degradation; decoratives, the most famous of which, I think is, what we would all call chrome on a car or a faucet; wear-resistant coatings, clearly used in all kinds of equipment, including automotive. For films, very soft plastic film that's used throughout industry, including in automotive, we treat with chemicals that produce a hard coating to resist wear and also resist chemical corrosion and degradation for the life cycle and length of a vehicle, in particular. And then finally, with the advent of the new technology cars and the demand for lighter weight, steel is being replaced by lighter metals, particularly aluminum.

And that offers us a tremendous opportunity for new treatments, new surface treatments for both performance and longevity. And this, again, is very much part of the automotive industry.

All right, what sets us apart? Well, first of all, we have a very deep and broad engagement with the automotive OEMs and Tier 1s throughout the global supply chain. This has allowed us to participate in the development of specifications and development of applications and a know-how -- a deep know-how for the needs, meeting the needs of the automotive industry. The automotive industry is attractive because it's a very high-spec, high-value market for us and the technology that we create in the automotive industry is then used throughout other manufacturing industries.

We also have a global base of leading applicators, those are our direct customers. These are people that are part of the supply chain, industrial supply chain around the world. Like in the Electronics business, our applicators use our chemical processes and meet the needs and specifications of the automotive industry and other industries all over the world. We are the market leader in our space. We are particularly involved today in developing technologies for the new technology vehicles, so meeting needs that we understand for the future as we work with the car companies.

And there is an ever -- an ongoing and ever-increasing demand for environmental and sustainable solutions to problems. The elimination of materials of high concern, the elimination of metals that cause problems for people and the environment, all of this represents great opportunities for us.

In 2018, our cost of goods sold was about $1.1 billion. 80% of that is made up of materials, 50% of that was nonmetals and 30% of that was metals.  This whole spend is all flexible to demand. On CapEx, in the middle of the slide, you can see that we've spent meaningfully less than 2% of sales over the last couple of years and we expect that trend to continue. See, our CapEx spend is not on expensive equipment for our production facilities, it's primarily on MRO; environmental, health and safety investments; and growth investments related to our applications labs and our technical service labs.

Element Solutions has a relatively lean operating footprint. And you can see here that we spend a majority of our OpEx on selling and marketing expense. This should not be surprising to any of you, given what you've heard today about our close customer relationships, the local selling and technical service we provide, and it's an important part of the moat around our business. It's also important to note, though, that we view more than half of our SG&A to be fixed to a new dollar of sales.

The business has some patents, but a lot of it is trade secrets, and we protect it in multiple different ways. So first of all, we formulate ourselves. Second of all, when we have really important trade secret technology and products, we'll send coded raws into the field for formulation. So the -- we'll send a concentrate of the product without disclosing what that product is, and the manufacturing team will know to put X parts of Product A and Y parts of Product B to formulate the product. So they won't actually know the specific formulation. Furthermore, as Scot took you through that example of how we deliver a solution as opposed to simply a product, there are multiple different steps to deliver any specific outcome, and each of those products is essential to the process and very, very few people actually know what's in each of those different steps. So simply understanding what's in one of the steps doesn't get you to the same outcome.

Uyemura only gets 40% of revenue from Japan, so they have proven they can operate outside Japan.  Revenue breakdown is 18% from Taiwan, 13% from China, and the remaining 29% elsewhere.  The Atotech prospectus shows that this revenue by geography does not capture revenue by end user demand, shown below, which likely applies to Uyemura as well.

Atotech shows examples of what components are produced in part with these recipes.  These seem evergreen in nature – i.e. they are fundamental to the products.  This breadth of applications reduces the risk of technological shifts undermining the need for Uyemura’s products.

Growth

Uyemura have growth ambitions with a JPY30bn investment plan over the next 3 years.  According to Atotech’s prospectus, both the semiconductor and the industrial sides of the industry have nice tailwinds to growth, outlined below.  While the semiconductor market is on fire, and PCB’s have tagged along for the ride, the medium term opportunity is a combination of diverse secular trends.  While a prospectus is naturally optimistic, I don’t see any of these market drivers as being faddish.  The song remains the same across the industry and the end markets that they are claiming face these trends.

Uyemura appears to be successfully playing alongside their larger peers on the basis of achieving higher growth in most years.  I suspect this is driven more by product mix – Uyemura seems to be weighted more towards chemicals for PCBs than plastic or metal industrial surface applications – than anything else. 

Some things to note about the above - I calendarized results and put in USD this info through Sentieo to get a comparable view.  As stated above, there are cost escalators for the raw materials, which comprise 80% of COGS, which means gross margin is probably a purer representation of absolute growth.  That said, for comparability sakes, all three companies face this dynamic, so revenue is fine for a relative growth comparison.  A gross margin comparison would introduce a different type of noise since Uyemura and Atotech sell more equipment and provide more application services, which have a different margin profile, than Element.  This activity is also part of the whole package that drives the business, which makes disaggregating it misleading.  So I think revenue is the least imperfect metric available for comparison.

Valuation

The valuation is straightforwardly cheap on all metrics.  The FY22 (3/31/22) forecast JPY8.4bn of net income and EPS of JPY475 as of November 2021.

Relative valuation further highlights C Uyemura’s undervaluation.  MKS Instruments is acquiring Atotech for 5.4x EV/Revenue and 13.5x EBITDA ($1.2bn revenue, $480m 2019 EBITDA, $5.1bn equity, $6.5bn EV.  ESI trades for ~3x revenue and ~13.5x EBITDA.  In June 2021, Element announced the acquisition of Coventya for EUR420, for a business with EUR160m in revenue and EUR 30m in EBITDA in FY21 (ended Sept 30), although they expect EUR42m in proforma EBITDA, which works out to 2.6x revenue and 14x EBITDA/10x post synergies.  A 13.5x EV/EBITDA multiple for C Uyemura would be ~2x from current prices excluding any credit for the cash or investments or buybacks.

“Catalysts”

The newly announced repurchase plan and higher dividend payout are translating into meaningful capital returns on top of a favorable backdrop for the underlying business, so I am not too hung up on hand waving over broader Japanese corporate behavior or that one could also find plenty of other cheap Japanese stocks.  Meaningful amount of the profits are being returned to shareholders.

From 3/31-6/30/21 the company repurchased 2% of shares (they even trumpeted it in English) and has a plan to repurchase ~JPY2bn annually from 2022-24, another 6% of the current market cap.  They repurchased 5.5% of shares over FY11-21, so the concept isn’t completely foreign to them, but the quantum appears to be increasing dramatically going forward, as this amounts to ~35% of net income on top of dividend payout amounting to ~25% of net income.  There is at least one Japan activist fund involved that reports spending a lot of time with management.  This likely plays some role in the recent announcements.

The company canceled the c-suite retirement plans and instituted a share linked compensation scheme, which seems like a nice way to get them to be aware of the share price and valuation.  If these moves to be more capital efficient mean their capital allocation shouldn’t be dinged for their cash rich balance sheet, this looks more like a 16% after tax return on net assets business that is worth a lot more than it currently trades for.  They do state they may use shares in acquisitions, which is a risk if they just recycle the cheap shares on something more expensive.  They also have the cash on hand to buy whatever they want with their JPY10bn M&A budget over the next 3 years, so it’s hard to tell what the future holds in this regard.

Conclusion

This is a good business that is not a lumbering dinosaur.  The end markets are attractive, cash generation is inherent to the business, and the product is a low cost mission critical input to products of which the world is increasing its consumption.  The company is cheap on an absolute basis and relative to peers.  There is at least one activist involved already successfully nudging the company in a more shareholder friendly direction. 

“Just tell me where I’m going to die so I don’t go there.” – Charlie Munger

The Taiwan Stock Exchange Index went up over 1,200% over three years in the late 1980s.  For comparison, the S&P is only up 660% from its March 2009 low thirteen years ago.  This presents one of the more illuminating case studies on bubbles despite it being mostly relegated to a dark corner of financial history.  The stock market in 2020 and 2021 highlights the importance of understanding past analogues.  Steve Champion’s The Great Taiwan Bubble recounting of this period is based on the author’s participation as a Taiwan-based, Mandarin-speaking manager of a Taiwan-focused investment fund during this period.

Backdrop

This bubble is not distinct in the archives of financial history at first blush.  There was an accumulation of savings in an export driven high growth economy which generated excess liquidity.  Taiwan went from very little in the way of international reserves in the 1970s to $20bn in 1985 and then $80bn by 1987 with the currency appreciating 60% from 1985-90.  GDP growth was in the 6-8% range with building enthusiasm for Taiwan’s increasing access to the mainland Chinese market.  That optimism drove sentiment past some calm equilibrium should not be all that surprising.

Where the Taiwan bubble really stands out is its relative scale.  Despite being overshadowed by its successors in the Asian Financial Crisis, the magnitude of the Taiwan bubble far exceeded what was seen in the runup to the AFC.  The P/E multiple for the stock markets of Indonesia, Thailand, and Malaysia were 22, 26, and 28, respectively, at their peaks.  The P/E multiple in Taiwan reached 100x near its peak in the fall of 1989. Taiwan’s bubble lacked the large current account deficits, debt fueled malinvestment, or foreign casino capitalist locusts in either the run up or the aftermath compared to its Asian Tiger peers.  The extremity of valuation combined with the inability to dismiss it as stemming from bad behavior makes this case applicable to the present.

It’s the market structure, stupid

The valuable lessons from Taiwan Bubble reside in the market structure and the players. 

Low transaction costs were standard in Taiwan in the 1980s, which enabled trading hyperactivity across a broad cross section of the population that parallels 2020 and 2021.  Commissions were fixed at 0.15% as computerized trading was introduced in January 1987.  The average daily volume on the Taiwan Stock Exchange was equal to that of Tokyo, Frankfurt, and New York by early 1990.  The share turnover (value of traded securities relative to total market cap) for the entire market increased from 200%, already quite short, to 600% from 1986 to 1989.  There were 4.6m active brokerage accounts by 1990 in a nation of 20m people, so essentially everyone was trading a lot.  For context, in the US today there are about 100m brokerage accounts in a country of 330m.

The number of brokerages mushroomed over this period from 27 to 297 from June 1988 to March 1990, facilitating and profiting from this activity.  Pretax profits of TSE brokerages increased from $110m to $1,174m from 1986-89.  This parallels the rise of Robinhood’s zero cost trading and the attendant profitability of Virtu or Citadel.  There is an underlying business model that requires a large amount of volume; either from scale in near zero commissions or scale in consolidating order flow to sell to offset zero commissions.

Trading activity was guided to areas prone to manipulation.  “Full delivery” companies, which are equivalent to shell companies, was a highly active corner of the market.  These companies had no income, assets, or employees, but remain listed.  Specific market structures beyond low commissions enabled sharp price movements.  There were price limits on daily changes which created self-fulfilling share price swings.  The backlog of trades was visible even after the daily price movement had resulted in a halt to trading.  Someone could place a large order without the need to execute it, which would spur others to place orders as well.  While not as explicit as “payment for order flow” today, the order flow itself becomes an important market data point and activity around which a disproportionate amount of money gets made.

One documented manipulation was in a closed end fund called Citizens Fund.  A pumper advertised job openings for officers at the fund in exchange for handing over control of a certain number of shares.  Investors obliged.  This corned the supply of shares in the market as they were effectively taken out of the free float.  The price of Citizens Fund moved from a 28% discount to its net asset value (NAV) to a 227% premium of NAV.  The “officers” of the company were unable to sell into illogical pricing, but the organizers of the scheme could.

Gamma squeezes in highly shorted companies best demonstrated by Gamestop in January 2021 are a similar metagame that takes advantage of market structure and hyperactivity to profit.  DeepFuckingValue did articulate a case for Gamestop prior to its January 2021 squeeze that made note of the short interest combined with hope the death of the underlying business was overstated.  There were professional investors who profited from Gamestop as well, although some may admit more chance than foresight.  There were even more complicated maneuvers some professionals undertook to profit from the temporary structural dynamics in AMC. 

The men and women merely players

Numerous speculators gained attention as major players in the market - Grasshead Tsai, Exorcist Yu, Little Boss Weng, King of the Monster Bulls Cheng, Antique Chang, Chili Pepper Chiu, Little Devil Tsai, Big Tuna Chuang – whose calls were followed by retail investors.  Players with big followings would simply put out a price target on a stock that would then become a reference point for retail players.  There were stock “fan clubs” that placed daily coded advertisements in the financial pages to advise clients of rapidly changing phone numbers that they could call for a stock tip of the day.

None of this is a far cry from the retail investor behavior seen in 2020 and 2021.  The medium is barely tweaked and the message remains the same from r/wallstreetbets or Discord trading groups (Discord trading, r/wallstreetbets trading).  Chamath Palihapitiya puts out one page memos for his SPAC investments (Metromile, Clover, Proterra).  One of the noteworthy drivers behind the price movements in SPACs is a combination of harnessing retail traders interested in zero cost trading fueled meta games like gamma squeezes, more sophisticated players’ knowledge of these metagames, and the low float dynamics created through lock ups. 

Twilight Zones

In Taiwan, there were two ways to become a certified public accountant.  The first was to pass an exam, which had such high standards that only 1-2% of takers passed at a time.  The second was to be certified as a political reward for long tenure as a teacher or soldier.  Pricing for services was competitive because there was a pool of service providers who had no reason to care about checking bank account balances or the age of inventory.  Financial statements were stamped with the personal seal of an individual CPA, not the name of a firm.  So the opinion letter of the auditor in financial statements would appear to be official in some sense, but the numbers are only as good as those who report and validate them. 

The norms of the legal system were distinct from the baseline Western perspective.  Enforcement of a law often depended less on the circumstances and facts than on relationships, according to Champion.  Champion gives the example of an unnamed “near bank” in Taiwan, which was controlled by a wealthy and politically connected family. An American financial institution purchased a minority stake and the resulting episode shows the legal and accounting differences in action.

While the Taiwan finance company was not legally a bank and could not legally accept demand deposits, they did essentially accept demand deposits.  American auditors were not comfortable with this and the American shareholder sought to clarify matters with the Taiwanese management.  Technically speaking the demand deposits were shares in investment portfolios with a fixed term and a variable expected return, but they could also be withdrawn at any time at a minimum guaranteed yield.  Even with the discomfort of the American auditors, the Taiwanese auditors had qualified the financial statements and the regulators had fined them a token amount for the transgression.  This behavior continued because they still earned far more as a result of these “deposits.”  In discussion with the US company, the president of the Taiwan company also referred to the numerous pictures in his office of him alongside major American and Chinese business and political leaders to demonstrate any issue could be resolved through connections.  While this specific company did successfully continue to increase its legitimacy without issue, according to Champion, it does demonstrate how vague the legal and accounting frameworks can be at times.

There are plenty of similar ontological quagmires when it comes to accounting or law in US markets today.  Bill Hwang and the use of single family office exemptions to elude margin restrictions by using multiple prime brokers shows the murky nature of the legal system even in the US.  Considering that he settled an insider trading investigation in 2012 without admitting or denying wrongdoing, his prior experience likely did support his flexible interpretation of the law in his eyes.  Coinbase is in the early stages of its legal and regulatory journey, which has the implication of making some of its practices still open to interpretations.  The US and China are at odds over what they are willing to accept as an auditor on financial statements.

Notes from the underground

Underground financial products, which exist in parallel with regulated financial institutions, were prevalent in Taiwan.  It was common for them to offer 4-10% monthly returns.  The government-controlled press would print underground exchange and lending rates, which were included in monetary data put out by the Central Bank.  It was common to use official bank borrowings at a lower rate to invest in the higher rates offered by underground banks. 

Homey Group was an underground bank that at its peak would have been a top 50 bank in the US ranked by deposits.  There were approximately 200,000 depositors with peak deposits of $7.4bn.  Homey’s Chairman was Shen Chang-seng, who had been prosecuted for robbery, fraud, possession of stolen goods, assault, and forgery when he was younger.  Shen purchased the Taiwan affiliate of a Japanese company that collapsed after a financial scam where pensioners were sold nonexistent gold bars.  In exchange for converting the gold bar claims into deposits in a new company, the pensioners maintained their principal and earned 4%/month on it.  Homey invested the funds in speculative stocks, a department store, a movie studio, a hotel, an ad agency, a basketball team, foreign exchange, and lots of real estate in the hopes of sustaining a high monthly payout.  In the later stages of this scheme, depositors agreed to extend their deposits for a year, but in doing so switched their securities into a Hong Kong affiliate where they gave up their right to receive a return of principal and instead receive dividends instead of a fixed interest rate.  Before eventually declaring bankruptcy in May 1991 with $3.6bn of deposits and 160,000 depositors, the Ministry of Finance had said it had done what it could do under its legal charter and had referred Homey to the Bureau of Investigation seven times, who said Homey was really the responsibility of the Ministry of Economic Affairs, who then referred the matter back to the Bureau of Investigations.

The background of Homey group is a good case study on how warning signs get ignored in favor of greed and hope. There are seemingly novel securities in the US that exist in a legally immature state in the form of cryptocurrencies and their adjacent products, such as savings accounts.  Their existence is not a secret and the fastest government response came from the IRS to secure tax receipts.  Tether, a stablecoin, which would rank as a top 50 bank by deposits today, already seems to be a potential repetition of the Homey saga, from colorful personalities to hard to trace funds (Bloomberg story).

In November 2021, the total valued locked in decentralized finance projects hit $250bn.  That is enough to be the 12th largest bank in the US by deposits, between Charles Schwab and State Street.  Much of this appears to be in “yield farming” products that offer anywhere from 4% to 50% or higher.  You can find articles referring to instances where depositors have found out someone else walked away with their money or the nebulous nature of their regulatory standing.  Despite aesthetic differences, the internal mechanics of opaque financial products and their alluring headline yields appear quite similar across time.

Playing the game

My observations of the present and reading of the past are inconclusive when thinking of how exactly to act when presented with these circumstances.  While there is the Sorosian desire to somehow profit from trading such a bubble, the magnitude of the swings between the bottom and the top present formidable psychological obstacles to doing so.  At the individual stock level, those that had the highest price increases defy any notion of rational foresight that would be necessary to purchase them.

Even with the full knowledge of hindsight, it is hard to conclude that adeptly investing in bubbles would have been easy.  From a summer peak in 1987 of 4,673 the Taiwanese market saw a drawdown of 50% by the end of the year in concert with global markets.  You may have earned 42% from the summer of 1988 to the peak in February 1990, but not before a 43% drawdown at the end of 1988 triggered by a raising of the capital gains tax.  It was just as dangerous to be long the market as it was to short it. There is less value in naming a precise turning point than recognizing the requirement of making many successive difficult decisions that far exceeds the human mind’s capacity to do so without error.

The “rush in” rational irrationality described by Soros seems quaint in the face of irrational irrationality that occurred.  The experience of Stanley Druckenmiller in the dotcom bubble shows the folly in trying to play this specific game in the dotcom bubble:

“So like around March I could feel it coming. I just — I had to play. I couldn’t help myself. And three times the same week I pick up a — don’t do it. Don’t do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself. So, maybe I learned not to do it again, but I already knew that.”

The value of these historical episodes is as much emphasizing what not to do as it is it to give you a deeper context for not doing it.  This allows you to escape the myopia of your personal tilt stemming from an incapacity to time travel beyond any current psychological moment of financial markets.  Simply stacking a Druck parable on top of a perceived market peak doesn’t offer more than an amusing quote to bring up when crafting a narrative justification for your own actions.

The more underrated causes, or at least mechanisms, appears to reside in market structure and the players whose behavior is not touched upon in textbooks.  While you didn’t have to play the metagame of gamma squeezes or the like in AMC or Gamestop, a player of the more pedestrian long or short equity game should still have been aware of what metagames may be played with their games.  There is less explicit literature on this because its main value is to practitioners and the activity itself is an inherent blind spot of academics, but history does offer numerous episodes for further study if you are willing to seek them out.

Braemar Hotels is a high-end hotel REIT that’s part of the struggling Ashford Inc (“AINC”) complex.  While in the beaten down hospitality industry, many of the assets are resort properties that are fundamentally healthy and don’t have concerns over their long term demand.  Only a small portion of the company’s debt is at the corporate level, while most is entirely property specific and non-recourse.  The company has two preferred shares outstanding that look cheap.  Moves by Braemar and AINC, its manager, indicate a focus on making sure the company survives intact with minimal dilution.

There are several dynamics at play.  The company has cash on hand to survive at these levels for at least a year, but half their portfolio is already cash flow positive and likely to return to 2019 levels of profitability earliest in a recovery.  Almost all the debt is non-recourse mortgages tied to specific properties, which should give the company flexibility to survive largely intact even if they continue to burn cash for the next year.  The strong probability of survival provides a solid basis to think about what these assets are worth over longer term.  A 2-3 year outlook supports a higher value than the current market price.

Assets: The portfolio can be divided into two buckets.  The first bucket contains upscale urban properties, which cater to a mix of business and leisure travel, which are plainly suffering.  The urban properties have debt, which is cross collateralized to several similar properties.  The second bucket is luxury resort properties, which skew heavily towards wealthy domestic leisure customers.  The resorts have property specific mortgages, strong operating fundamentals, and sit atop land in supply constrained submarkets.

Note this is looking at the hotel level EBITDA.  Companywide EBITDA was $127m in 2019.  I look at hotel level EBITDA to understand what the underlying assets are worth.

The urban properties are struggling and burning the most cash, whereas the resort properties are around breakeven occupancy levels, with some in positive territory currently.  The quality of the resort portfolio is evidenced in part by the banners, with Ritz and Park Hyatt being for top properties.  The independent hotels are in Yountville, CA (heart of Napa Valley, home of French Laundry, a place about which people write how to articles for getting a reservation) and Key West, FL with similarly high-end positioning.

Urban Package 1 (“UP1”) is in a tougher place than Urban Package 2 (“UP2”).  UP1 is geared towards high end urban leisure and business travel.  UP1 started 2020 with more leverage (whoops).  UP2 includes 1 urban quasi-resort property, the Hilton Torrey Pines, which overlooks a premier golf course.  The Hilton Torrey Pines was also profitable in July, unique within UP1 and UP2.  The Capital Hilton is spitting distance from the White House, arguably not desirable if the President has a respiratory virus, but otherwise linked to the evergreen desire to mix with power rather than typical leisure or business travel.  Hilton owns the other 25% of UP2, so there is also a strong partner alongside Braemar.  While there may be doubts about owning UP1 independent of the company, UP2 is not wholly dependent on a broad recovery in hospitality.  UP2 also has some balance with one healthy hotel possibly capable of supporting one weak hotel.

This divergence is clear and the categorization of the state of the resort properties is borne out by the 9/24/20 release by the company (link):

Cash Burn: The company had $103m of cash and $41m of restricted cash as of 6/30/20.  On their Q2 results call at the end of July they claimed monthly cash burn of $8.8m - $5m at the hotel level, $2.5m in interest, and $1.3m in corporate costs – or $105.6m/yr.  The $2.5m in interest assumes no forbearance.  They’ll end Q3 with around $115m of total cash, inclusive of paying the preferred’s quarterly dividend of $2.5m, which is 13 months of cash burn if the business remains at current levels.

The restricted cash is property level cash that they have gained access to as part of discussions with lenders, so a material portion of the restricted cash should be burnable.  This is also not the environment into which banks want to dispose of hotel collateral, so it makes sense that they will be flexible with Braemar when it comes to kicking the can down the road.  The low occupancy 4-hotel urban package mortgage, as an example, does not have forbearance but was granted access to the restricted cash.  There is also a real probability, based on the performance of the resort properties, that over the next year the cash burn is reduced as the resorts’ recovery continues, which lengthens the runway for the company.

The company projects $15-25m of capex for 2020 and has spent $12m so far, so they might spend another $3-12m.  They also have yet to cancel the preferred dividend, which is $10m/year, and they are unlikely to do so.  Assuming they can burn all the restricted cash, they still have enough cash for the preferred dividend and operating at current levels for another year. 

On the flip side, the resort properties – Florida, skiing, California wine country, US Virgin Islands – should all be well positioned for any winter travel and are well positioned in the medium term as there is not a lot of supply growth in these regions.  Wealthy Americans – the target demo for these properties – have not been impacted by economic fallout of COVID and there are not many international or urban destinations for their travel dollars.

Since all the resorts have single property mortgages, the company has the flexibility to sell off one to raise cash to support the rest of the portfolio, even though they wouldn’t need to do this for another year.  This would not be the ideal scenario, but it would not materially impair the company longer term and it would still leave plenty of coverage for the preferreds. Management, via AINC, has the incentive to own as many gross assets as possible, so my sense is if they end up in a tough spot they will sell one resort to hold on to 4-6 hotels for longer.

The company does have forbearance on some of the individual properties – Tahoe, Sarasota, Pier House, Yountville, Bardessono – but they have the cash to make these whole and these properties are likely to be generating cash currently.  The company doesn’t have any debt due until 2022 either, so it doesn’t face any liquidity issues for some time.

The following are cherry picked, but they indicate several assets with solid results that are close to occupancy levels where they will have high incremental margins, which translates into cash to support the weaker hotels.  the Ritz Sarasota was EBITDA positive in Q2.  The Ritz St Thomas reached 70% occupancy over the summer until it was closed for a month (8/19-9/19) due to a COVID spike.  On their Q2 call management stated they are reaching 50% occupancy at the same room rates as 2019 for the resort properties.  Management also stated that the Bardessono, Yountville, and Pier House have lower breakeven – “efficient boxes” and high rates – at lower occupancy than most resort hotels.  These are 5 of their 7 resort properties.  The company released monthly property data through August and 6 of their resort properties were EBITDA positive.  I haven’t found anything nice to say about the UP1 hotels outlook in the coming months, but the resorts do appear positioned to eventually balance out the cash burn at the hotels with lower occupancy.

Asset value: The value of the resort properties should prove resilient for two reasons.  First, while travel demand has fallen, these properties don’t face open ended money pit questions related to the return of business travel or large group bookings, which I believe makes the bid-ask spread narrower.  None of these are 1,000 room convention hotels or massive tourist warehouses in Times Square.  Second, lower interest rates should go some way in cushioning the cap rates for transactions.  Cap rates for upscale hotels have been around 8%.  Within the upscale category, the subsegment of resorts like Braemar’s should be far more resilient than upscale hotels in Beverly Hills or in other top tier urban submarkets.

All the resorts were purchased as individual assets with solid disclosure.  Both the urban hotel packages were purchased as part of much larger packages and dropped down to AHT by AINC.  Some of this data serves as a reality check on the asset value.  The 20-30% COVID discount on hotel transactions have been for assets that were not close to 50% occupancy over the summer, but lower quality assets and/or facing longer uncertain cash burn.

I don’t think the resorts are precisely worth the amounts paid, but I suspect these figures are still in the same ballpark today, all things considered.  On a valuation matrix, any COVID discount is likely cushioned by the drop in interest rates.  For a random hospitality asset (AHT), that is a more speculative assumption, but the resort assets have historically demonstrated their relevance and it appears very likely this continues regardless of broader trends in the hospitality industry.

The urban assets are struggling and they are worth anywhere from zilch to prior levels implied in BHR’s equity value.  I struggle to put a specific value on them, and management has never disclosed their arm’s length individual purchase prices.  They historically have been positioned at the higher end.  The valuation of the individual assets is less important at the moment than their cash burn and their aggregate health as it relates to supporting the mortgages until a recovery.

Part of what is attractive about the prefs is that their value isn’t dependent on there being any value in UP1 or UP2.  This is not to say they are worthless.  The Capital Hilton is walking distance to the White House.  The Torrey Pines Hilton is next to the Torrey Pines golf course.  The Chicago, Philadelphia, Seattle, and San Francisco properties are close to dense tourist and business centers, both segments which do not have promising near term outlooks, but in normalized times command attractive ADR’s.  These properties are not on the outskirts of Terre Haute or North Platte, so the land is inherently valuable to the extent there are desirable alternative uses for the properties in otherwise land constrained markets.

One way to frame the security (the common or pref) is disaggregating the resorts as an equity and the urban hotels as an option.  The resorts fund the option.  If the option expires worthless, i.e. too long of a cash burn runway/no recovery in sight, then the cash flow from the resorts will again revert to being distributed to shareholders.  The non-recourse debt creates a dynamic where this synthetic security does reflect the underlying possibilities given the way the assets/debt are structured.

Management: One shouldn’t overlook that AINC and Monty Bennett will never enter the pantheon of great business partners.  The leverage they feel comfortable with and the management agreements they enter with properties don’t seem sustainable for counterparties.  Despite this less than stellar setup, the management team appears to have little incentive to cut the preferred dividends at Braemar and has explicitly stated such.  The management team uses Braemar as a fee feeder for AINC.  AINC-managed Ashford Hospitality Trust is on weaker footing than Braemar, as is AINC, so Braemar is AINC’s Obi-wan Kenobi…its only hope.  They are paid the preferred dividend to shareholders on record date of 9/30/20, so they seem to be communicating that they feel comfortable not cutting it.  We can observe how AINC behaves in a distressed situation (here), but Braemar’s assets are not close to the point where such measures would be taken.

Prior to COVID the company had a registration for a $700m preferred equity offering, with a short term goal to raise ~$350m.  Not paying the preferred dividends, which amount to ~$10m/year, would increase their cost of capital on future preferred share issuance.  People purchase equities for many reasons, but purchasers of new issues of a preferred only do so for the dividend.  Given the situation AINC faces, they would likely hope to issue BHR preferred equity, and collect a fee off it and whatever assets they buy with the proceeds, sooner rather than later.

On their Q1 conference call in May 2020:

Q: That's helpful. And then another kind of follow-up on liquidity. How are you guys seeing it at the preferred dividend today? Obviously, liquidity is at a premium, but you kind of balance that against the fact that it is a relatively small outflow for you. And the preferred market could be a source of funds for you guys in the future.

A: Yes. I think, Amanda, you're spot on. It's not a big outflow for us. We're -- so we take that into consideration. I think also, you're right. I think the preferred market is something that precrisis we were prefer -- we were planning to access, certainly in the nontraded space and filed a registration statement to that effect. So that also kind of weighs in our thinking in dealing with the preferred as well. But yes, I think it's a relatively small cost to the company. And there are a lot of benefits to keeping it going.

This is just interesting to note, but a non-Ashford hotel owner is interested in Braemar as well (13D).  Brad Hasselwander is an Arkansas entrepreneur who made his money in selling auto dealer warranties (https://web.ascwarranty.com/index.aspx).  Brad bought a Cape Coral resort hotel in 2011 that is now a Westin (https://www.businessobserverfl.com/article/arkansas-company-buys-resort-marinavillage).  It wouldn’t shock me if he owns other hotels.  He bottom ticked the prefs at $5-8 and owns the common in the low $2’s, about where they still trade.  It wouldn’t be noteworthy if he hadn’t invested in hotels before, but he owns at least one so I would consider him a relatively informed outsider.  This may have just been a quick trade though, as by the end of May he was selling down his stake (13D/A).

Prefs: There are signs the prefs could trade for par once this is viewed as stabilized by the market.  There are already signs of stability and recovery at enough assets to keep the company wholly intact and decrease the likelihood of the company burning all its cash.  If the prefs return to par and pay a few dividends over the next 2 years, it’ll be a nice return.

There is $40m outstanding of the Series D and $125m of the Series B.  The B is convertible at $18.70/share, but this option is not worth much given the current share price.  The D is redeemable starting in November 2023.  They’re cumulative, so one would be caught up in a recovery, although there is no sign they are cutting it.

Using 2019 Hotel EBITDA of $142m as equivalent to NOI, an 8% cap rate implies $1,775 of asset value.  A 30% COVID discount implies $1,242 of asset value.  Less mortgage and corporate debt that leaves $112m against $166m of preferreds, which is $17 of value in a liquidation.  This is a faux-conian case, as in faux draconian, currently priced by the market since they have a year of operating at current levels before they theoretically “fire sale” the whole company.  There is a good chance the resort properties start generating enough cash flow to cover the entire portfolio of assets as occupancy continues to recover.

The resorts are a pocket of value that exists independent of the performance of the rest of the assets.  One way to look at the coverage for the preferreds is to look at their purchase prices referenced above, subtract the mortgage, subtract the corporate debt, and see how much is left.  There is $435m of mortgage debt on these properties, which would leave $314m of property level equity.  Less $65m in corporate debt that leaves $249m for the equity.  There is $165m of preferred equity, so that is solid coverage even if the company returns the urban hotels to lenders.  This ascribes no value to the cross collateralized properties, which more likely than not have some value greater than zero.  Note, this is also approximately where the equity currently trades (249-165).

The resort properties, given their performance, should be able to find a buyer.  Even at 10x 2019 EBITDA, BHR could get cash out of these properties after paying the mortgage.  This would total another 2 years of cash burn to hold out for value on the urban properties.

The current pricing might also be negatively impacted by the events at Ashford Hospitality (AHT), which makes Braemar related securities guilty by association.  The underlying quality of the assets at Braemar are far more readily apparent, as is management’s incentive to preserve the preferred dividend and current capital structure, as is Braemar’s ability to fund its operations.

Conclusion: As I said about Ashford, if you like the debt, you’ll love the equity.  My position is 2 parts B to 1 part D and a small bit of common equity.  As outlined above, the prefs would likely be covered even if UP1 and UP2 is returned to lenders.  While unlikely, such a scenario would take away a lot of upside the common has currently, so the risk/return is a different, obviously.  If the company remains intact and resumes a similar payout as 2019, the common has ~25% yield, although I don’t envision that happening for several years.  The potential return for the B shares is a little higher, although one gets a good amount of cash out of the higher coupon D shares at an earlier date.  The returns will be attractive if this works out anywhere over the next 2-5 years and there is arguably some real downside protection is things don’t work out that well.

The key point of distinction for Ashford is that all of the debt is at the property level.  Many of the hotels can be worthless and turned over to lenders, but the remaining hotels will still give value to the equity.  Most options expire worthless, as this very well may, and the leverage makes the residual value for equity very sensitive, so this isn’t for the faint of heart.

The trend in hotel occupancy points to both an extending runway from a cash burn perspective and the likelihood that some asset sales might occur at reasonable enough valuations in the coming months to support the remainder of the assets through the downturn.  Asset values could receive a positive offset from interest rates being lower, but won’t totally offset the hit from COVID and negativity around hospitality.  It is important to think of proceeds from asset sales to in the context in which their sale will occur, which will be months, if not a year, out due to the cash on the balance sheet and pockets of assets reaching break even if not positive territory. Management may also find ways to raise additional cash to survive until the industry recovers that don’t involve selling assets.

Background: Gee golly the chickens have come home to roost for the Ashford complex.  Ashford Hospitality (“Ashford”) is in essence a financial product assembled by Ashford Inc (“AINC”) for the benefit of AINC.  It generates fees for AINC and provides “value” to customers who want an optically high dividend yield.  These customers are unlikely to have yachts.

Ashford has been run with a high debt load relative to anyone else because it meant more assets could be bought and fees upstreamed to AINC.  Against $425m in adjusted 2019 EBITDA, the company went into COVID with $4.1bn of debt and $565m of preferred shares, which is already 11x 2019 EBITDA.  Pretty wild for an entity with no contractual cash flow.

Ashford and AINC’s business has unwound in recent months as COVID hit the operating results of the hotels, the financial leverage became an issue, the dividend was cut and retail shareholders sold, and now the management team is trying to exchange the preferred equity into common equity and massively dilute the existing equity.

The people who want to own this, let alone even care to look, let alone can, are minimal – size, management quality, leverage, industry, high risk of appearing stupid, and macro preclude interest in many different dimensions.  So I guess that leaves schmucks like me.

Payoffs: The payoff is unknown and uncertain with a real chance of zero.  This makes me think it is mispriced to an overly pessimistic degree.

There are probabilistically favorable factors to consider.  The debt is entirely property specific.  The corporate entity has no debt.  The worst assets from a cash flow and leverage perspective will likely be returned the fastest.  Debt levels and cash burns will decrease when the worst hotels are returned to lenders.  This means that even though the quantity of hotels in the portfolio decreases, their average quality increases and the probability of residual value for the equity surviving increases. 

The reason to suspect this presumed path unfolds is because of greed.  Ashford Hospitality pays a lot of fees to AINC.  The last thing AINC wants is the fees to disappear.  The quickest way to make them disappear is for the entire Ashford portfolio to be taken over by lenders who can then find other managers.  The individual hotels are not just a fee generator for AINC, but the Ashford entity overall generates fees for AINC as well at the G&A level.  The incentive - and AINC demonstrate an inclination towards money without consideration of appearances – is to retain as many of the hotels as possible. Even this fear inducing presentation, below, from the company in September shows a $11 of value for the preferreds (link).  If the company actually returns more hotels to the banks, there is a chance value to equity increases as the “Other Assets,” which includes cash decrease at a much slower rate at the trough of occupancy and higher debt properties are jettisoned first.

This, from management assumes a 10% cap rate, a trough distressed cap rate if they had to sell all the properties today (spoiler: they don’t).  Any type of normalization that may occur if a recovery becomes more apparent would see the cap rate move down.  Every 10 bps improvement in the cap rate is worth $40m of value that cascades to the prefs and common, compared to a currently implied value of ~$110m (market cap plus total market value of the prefs).

Even if NOI decreases due to returning hotels, debt will shrink fairly proportionately. The fulcrum NOI is around $200m. At a 10% cap rate that is worth $2bn and at 8% $2.5bn, which would almost cover the preferreds, assuming debt/NOI is ~10x. As long as they retain more than ~$200m of NOI the prefs will be worth more than current pricing indicates by a wide margin. So they could still return close to half their current portfolio to lenders without really impairing the prefs.

There are scenarios that can play out where the prefs are worth par and pay deferred dividends and where the common is 3-24x+ from here. The prefs could get back closer to par without being impaired too badly by whatever steps are taken between now and a full recovery. The common has a rockier path, which potentially involves dilution or total loss. Upside is based on $2/share for the equity and $5/pref share.

There is a saying, of which I am quite fond, about highly levered situations that if you like the debt you’ll love the equity.  My position is a small one and 6 parts pref and 1 part common. There will be things that occur in the coming months that will shuffle around some of the value, such as a high yield issuance ahead of pref and common equity, to help keep management in control. I don’t know when and and on what terms they will occur, but it’s something to keep monitoring.

Assets: The company currently owns 104 hotels after giving 13 hotels to lenders over the summer.  The hotels are mostly full service with above industry average RevPAR.  Properties are spread across the country, but weighted to major metro areas – 38% suburban, 35% urban, 16% airport, 8% resort, 3% small metro, <1% interstate. Group bookings in 2019 accounted for ~20% of occupancy, so they are not overly reliant on a type of travel that is done for the foreseeable future, but there is still a very material business travel component to their mix.  There’s not a strong unifying theme or iconic assets to hang one’s hat on.

I am making a broad assumption the Ashford portfolio occupancy mimics the national behavior.  I am also assuming there is no property that looks like the average, but is either struggling with low occupancy or is close to, if not already, profitability. A challenge with the disclosure is that there is not an abundance property level information, which makes it hard to identify pockets of value that either could be sold to elongate the company’s runway into a recovery or be the remaining core of quality if the company jingle mails the junk.  There’s no historical property level EBITDA or occupancy that can be matched up to property level debt, which is also cross collateralized in some cases.  There are about ~30 different mortgage pools, so the dynamic where poor performance in a few assets doesn’t take down the whole company stands.

Given the geographic diversity, I am making an assumption they are doing better in some regions (FL, TX, AZ, etc) than others (CA, NY, etc).  Even post labor day, national occupancy has been holding up in the high 40’s, which is not optimal, but not the devastating levels of March or April (link). 

Cash Burn: At of 6/30/20 they have cash of $165m and $95m of restricted cash.  The restricted cash is at the property level and can be used to fund property expenses, so it seems reasonable to treat it as applicable in the cash burn runway for the company.  This totals $260m of cash, which is a little under 3 quarters of trough cash burn, which would take us to March 30, 2021.  There are puts and takes as to what the actual go forward cash burn will look like.

On their Q1 conference call, May 21st, they cited current $20m/month of cash burn and $13m of interest expenses.  Weirdly this wasn’t discussed on the Q2 call on July 30th, but occupancy was higher in Q2 than May so cash burn in Q3 may be lower.  The May figure also includes 13 hotels that have subsequently been returned to lenders, despite the company having cash on hand to service the debt, which makes it probable they were relatively high cash burn properties.  They have not updated cash burn, but they are not stupid.  I don’t believe they returned hotels without careful thought around cash burn, equity value, and speed of recovery specifically because they do have the cash on hand requiring them to make these cost/benefit decisions.  As an example, the largest hotel they returned was an Embassy Suites Time Square, which requires Simone Biles level of mental gymnastics to envision not having high per room cash burn and a very long recovery period.

It’s difficult to extrapolate the summer season cash flow into fall.  The customer mix shifts from leisure in the summer to business in the fall, but this won’t happen this year and occupancy may drift back down to negative cash flow territory.  So maybe the $20m/month figure is close enough to carry out through the rest of the year, but this may be overly pessimistic.

The hotels will burn another ~$120m by the end of the year from 6/30/20.  There’s another $13m per month interest expenses, likely closer to $12m to account for hotels returned to lenders.  The interest payable accrual could potentially get tacked on to the principal and not need to be at the end of the forbearance period, which would give more breathing room.  The current forbearance agreements have interest repayment starting at various points from September 2020 to January 2021, but the company has the cash to handle this. Loan modification structure is something to monitor both at the company and industry level.

The “potential operating shortfalls,” from this September presentation, hints at my suspicion the hotels are in a better cash flow position that they want to imply, since it could have been positive for certain summer months.  The debt service is fluid as they have 61% of their debt is in forbearance (link).

Valuations: The cash burn, continuing at current rates, becomes an issue at the start of 2021 if it continues at the 6/30/20 rate.  While this is a shorter time frame than my preference, its worth noting there is a chance a COVID vaccine is front page news and the forward outlook in January is more positive than it is today, opening up a whole range of fundraising options.  This might allow some properties to be sold with positive equity between now and whenever they might run out of cash based on projections using 6/30/20 figures.

A lot of the current market value hinges on the assumption that valuations for hotels will be at a massive discount to 2019 levels, but there will not be a fundamentally different view on the earnings power of a hotel.  This is where a wide range of outcomes comes into play.  On 10/1/20, a Residence Inn in Boston sold for a 7.8% cap rate on 2019 earnings (link).  That one is in Cambridge. Ashford owns a Hilton with $97m of debt on it in the Back Bay part of Boston. That Xenia hotel currently has a nightly rate of ~$161 vs ~$158 for the Ashford property, although former is in the middle of MIT/biotechland and latter next to Fenway and Northeastern University. Assuming 10x debt/NOI for the Ashford property implies $9.7m of NOI. This has no residual value at a 10% cap rate, but $27m of equity at an 7.8% cap rate. It’s not productive to obsess over precise cap rates, just the direction, if any, they head in from 10%, because it creates the opportunity for Ashford to dynamically respond to whatever situation unfolds.

Pensions and other institutions are starved for yield and interest rates are low such that there could be buyer interest in these assets if they start to stabilize.  If hotel pricing goes down 20%, that implies cap rates moving from around ~8% to ~10% for full-service hotels, which is most of Ashford’s portfolio.  At the end of 2019, people were interested in 7.5% cap rates and the interest rate outlook is biased towards lower rates.  This is a PWC real estate investor survey on the desired rates of return on hotel deals (link):

A longer term view of hotel cap rates shows that even in 2009, hotel cap rates peaked at 10% for all hotels and full service hotels peaked at 9.5% (link).

Ashford alluded to there being some hotels they could turn to cash the Q2 earnings call, implying some have positive equity even under current conditions, which also indicates the 10% cap rate projection is not representative of reality.

Q: Got it. That's helpful. And then where do asset sales fit into this equation? And why wouldn't that be a good source of liquidity for you today?

A: That's a good question. We -- prior to me stepping into this role, the company had marketed a couple of assets that have, in our opinion, significant equity value to get a market check and to see if that was a source of capital that we wanted to raise. The company decided obviously to pull those back given the -- how dramatically lower those values were than pre-COVID prices. So those weren't really particularly attractive. I think it's something that we'll -- they're not entirely off the table. But as I sit now, it's a lesser of a priority. We've got a variety of different capital raising options we're looking at and investigating. And that may be a part of it. It's just right now we've got kind of enough other things that we're focused on that frankly, I think, are more substantive and can give -- raise more substantive capital than asset sales. But as we continue to go down the path with our lenders, and we'll see, we just don't -- it's not a focus right now.

Contrast the potential values (8-10% cap rates) to the implied value of the residual today.  The $1.00/share price is the output if the total market value of both equity instruments is the value of the residual equity if all ~126m shares that can be issued in the exchange offer get issued.  Even the prior pessimistic presentation slide from management implies $260m to the prefs in a liquidation at a 10% cap rate.

Exchange offering: The management is pushing an exchange offer for the preferreds by October 30th.  It was initially 1.74 shares if you don’t agree or 5.58 shares or $7.75 in cash if you do.  Now you can just sit on the prefs based on changes released on October 2nd or exchange it for common/cash. 

There’s at least one distressed real estate fund that doesn’t want the exchange to happen on its initially proposed terms. What will be interesting is to see who actually owns the preferred and common shares now.  The people who wanted the dividend on the common and preferred have all sold.  This might already be shark territory and AINC doesn’t realize it, or at least they didn’t until the past few weeks.  Common shareholders rejecting the October 6th vote allowing management to issue shares in the preferred exchange may or may not happen.  If it doesn’t succeed the equity represents a very tiny sliver and the preferreds remain intact with the potential to return to par.  If an exchange does occur, the resulting equity sliver will still have an asymmetric payoff.

I will assume every preferred share wants cash, which means everyone will get a mix of cash and shares.  It is $7.75 in cash or 5.58 in shares.  If everyone wants cash each preferred gets $1.32 in cash and the remainder in shares.  The way I calculate the conversion factor is $7.75 divided by 5.58 to get the cash equivalent share value, which is 1.388 (this may be incorrect).  If everyone gets $1.32 in cash, that leaves $6.43 in cash equivalent in shares, which is $6.43/1.388 or 4.63 shares.  4.63 multiplied by 22,589,393 total preferred shares outstanding is another 104,448,813 common shares.

In this scenario there will be 114,610,813 total shares outstanding.  Each preferred gets 4.63 shares and $1.32 of cash.  Considering that the preferreds are getting flushed and trade for ~$5.00, one is paying $3.68 for 4.63 shares of AHT or $0.80/share and getting $1.32 in cash.  The implied market cap through the preferreds where everyone elects for cash is $140m.  This is for a potential residual value ranging from $0 to $960m ($380m NOI at 8% cap rate less $3.7bn debt).  If the exchange doesn’t occur, the prefs still have a lot of coverage to potentially get back to par over the next 12-36 months).  If the exchange occurs, making the prefs and common the same, the implied value is ~$140m versus a $0-960m payoff. 

The common votes to issue the shares on October 6th and the exchange offer for the prefs expires on October 30th.  The exchange was originally closing on the 9th, but they seem to be having trouble procuring the $30m that the exchange offer is contingent on.  They also removed the requirement that 66 2/3% of the preferreds have to approve of the exchange.  This makes the situation more fluid and the above calculations far more impressionistic than realistic because I don’t know how the votes will be cast or the number of shares issued in the pref exchange.

Activist: The activist involvement of Cygnus Capital/Chris Swann makes this interesting because the outcome is inherently path dependent.  The maximum payoff scenario faces a lot of resistance from management, so the presence of an activist offsets some of this unfavorable weighting to the upside scenarios, albeit not close to entirely.  The recent activity through 10/2 gives some hope they might pressure AINC to pitch in by cutting fees to help reduce the cash burn at Ashford, which would also be a positive for the common and prefs.

The firm’s origin was in buying distressed real estate loans from banks in the Southeast and they do not appear to be a public equity focused firm, so they likely understand the interesting risk/reward the debt structure presents.  To the extent that they have a strong real estate creditor/workout perspective, their presence is noteworthy compared to an equity tourist like myself.  They own 8.3% of the common and ~600k shares of the prefs.

Interesting to note, per the 13D, the swan dive personally into some options on the stock with a $5 strike for December 2020 and March 2021 and common shares outside to the tune of ~$1m between Chris and his family.

The Shares purchased by Mr. Swann personally, including Shares held in an IRA Account in Mr. Swann’s name, and held by members of his immediate family, which Mr. Swann is deemed to beneficially own, were purchased with personal funds (which may, at any given time, include margin loans made by brokerage firms in the ordinary course of business) in open market purchases. The aggregate purchase price of the 172,000 Shares, including 100,000 Shares held in an IRA account in Mr. Swann’s name, beneficially owned directly by Mr. Swann is approximately $532,618, including brokerage commissions. The aggregate purchase price of the 206,625 Shares, including 70,000 Shares underlying certain call options, held by members of Mr. Swann’s immediate family, which Mr. Swann is deemed to beneficially own, is $488,935, including brokerage commissions.

Conclusion: It’s an option, which often expire worthless. 

I am most inclined to the Series D of the prefs because it has the highest coupon, to which no value was being ascribed as the market has been pricing in a full exchange, which valued the prefs equally.  On the flip side, it is the smallest issue, making it more likely to be less liquid, so it might be a wash.

There’s nothing like a low price to stimulate demand for plane tickets, but many people don’t feel that way about stocks.  One was never paid to take the risk of a pandemic at $40-50.  But with anywhere from $2-4+ in earnings power in the medium term and higher in the long term one might be well compensated for the risk there is a disruptive pandemic.  Everyone already knows all the bad things, they are front and center.  “Already priced in,” is usually what someone says before a name goes down another 50%, but maybe this time is different.

This is just my personal journal, not investment advice.  I wanted to vomit writing this as much as you will reading it. Sorry for ruining your keyboard.

What is the earnings power of Spirit?

Yadda yadda yadda, unit economics.

If they survive, this all boils down to how many planes they fly and profitability per plane.  There is a lot between revenue and EBIT, but its not super important.  Every player in the industry has their cost structure – legacy players have high costs, Southwest has medium costs, Spirit has low costs.  What matters is the relative cost structure.  I have no idea if the middle seat will exist, but whether or not it does will likely be an industry practice and the resulting cost structure will move in tandem.  The reason these cost structures exists is informed by their focus.  As fleet permutation, seat configurations, and customer segmentation increase, so do the costs.  By serving business and long haul customers, legacy airlines have a higher cost structure which creates a pricing umbrella for Spirit or others to come in and serve the leisure segment at a lower price point.  This relative advantage appears unlikely to change.

To put some dimensions around it, I look at EBIT per avg aircraft going back to 2008, which average $4.123m per plane. 

So this thing earns $4m in EBIT per plane without much sensitivity to fleet size.  We don’t need to plug in a bunch of forward looking projections with inputs given to us from management (LTV/CAC) in order to get a sense of the economics.  Spirit’s earnings around 2022-24 will likely resemble the past.  2020 isn’t going to look like this and most likely neither will 2021. 

Check out my model below, which just assumes $4m/plane.  You won’t mistake me for Jim Simons.  There will be years in the future when EBIT/plane is $6 or 7m, but lets not get our hopes up just yet.  I assume $17m of debt per plane because that’s what the company currently carries.  In the current debt stack there is big slug secured by assets that they can jingle mail without impairing their per plane earnings power.  Leases might be more difficult to exit, but only 54 planes are leased.  I’m also assuming a 5% interest rate, higher than their current rate, and 25% tax rate, higher than their effective rate.

Here’s the math on shares

They ended Q1 2020 with 151 aircraft.  If one assumes the airline industry is down 1/3 and Spirit moves in line with that to a 100 plane fleet, earnings power still looks robust, especially assuming they just jingle mail 50 planes and their attendant debt.  Even assuming another, or cumulative series of, equity raise that’s quite dilutive, the earnings multiple is still quite interesting. 

An interesting facet of the business model is that it uses pricing to stimulate demand, which has typically meant converting nonfliers to fliers.  The allure of cheap flights remains in tough economic times as potential customers can trade down to it.  This means Spirit can still be successful in a world where the economy remains weak but C19 is not a concern.

Prior to C19, Spirit had the opportunity to add more planes to its fleet.  Post C19, that opportunity remains and it is potentially accelerated.  They have an advantaged cost structure that allows them to grab leisure traffic away from legacy airlines, but growth has been contained in part by gate availability and suppressing tactics by the majors (basic economy).  This historically hasn’t stopped them from growing and the pain in the industry now should see competitors less focused on Spirit and more on survival.  ULCC’s are 30-40% of European traffic, but only single digits in the US, so even a 15-20% penetration rate would be a huge growth opportunity for Spirit.  One could even imagine a world where the economy sucks and air traffic is down, but low priced leisure travel gains share and leaves Spirit flat relative to pre-C19 levels.  This is still likely the case in 2022-25.

Figuring out what EPS is in 2020 or 2021 is challenging.  The profits from a single flight will depend on how many seats are filled.  The profitability of a 200 seat airplane flying 200 customers at once is dramatically different than that same plane flying 50 customers four times.  There should be some adaptability in driving load factors, but it remains to be seen how Spirit’s high density seat configurations and fast gate turnaround times suits it to the coming months.  Typically the operating model necessitates higher utilization – more hours flown per day – that might not be possible in order to earn an economic return for a period of time.

C19 could be bringing forward opportunities for Spirit to grab share as the legacy airlines grapple with C19 and retrench.  American Airlines, not in the best of shape, overlaps with ~50% of Spirit’s routes, as an example.  There is even greater opportunity to drive costs down as well since airports, especially the lower cost secondary airports, will be desperate for volume and tourist destinations will be accommodating as well to drive volume.  Is it possible that in 2022 the market starts talking about Spirit flying 200 planes and earnings $5m/plane in EBIT in the medium term?  I don’t think that’s the highest probability outcome, but it is something people might start reasonably entertaining once the dust settles.  That would be $6 in EPS plugged into the above model.  Spirit will have 186 planes by the end of 2021 if their current plans are executed.  200 planes generating $7m of EBIT would lead to ~$9 in EPS.  But let’s just make sure we survive first.

Survival

Let’s look at the debt, the cash, and the likely cash outflows.  This is the updated debt stack from after the convertible raise.

I would add another $50m for the remaining payroll support program debt they’ll take on in July, taking total debt to $2.72bn

Cash was $915m on 4/30/20, per their Q1 call, which includes the $135m revolver draw and the first slug of payroll support.  They will get another $168m of cash in July from payroll support, a projected $180m on income and excise tax relief, and already have another $201m from their  equity raise.  That gets us to May 1st cash of $1,639m. 

In the draconian case for the remainder of 2020 I see the following cash outflows:

The above assumes a daily cash burn of $4m/day from 5/1/20 to 12/31/20, a total refund on all their air traffic liabilities, full cash payment for airplanes, and not rolling over their revolver.  None of this seems realistic.

Spirit has a commitment to purchase a lot of planes from Airbus.  The associated cash flow is less than the gross amount, even with capital markets potentially closed.  The airlines have already proven an ability to raise capital, so it isn’t the main concern.  As part of the purchase agreement Airbus agreed to provide backstop financing for a majority of the aircraft included in the agreement.  Spirit is already under discussions to reduce the $702m by $185m, which leaves $517m, which can likely be financed at around 75% LTV, taking the $702m cash outflow down to $130m. 

It is also unclear how much of their air traffic liability can instantly be redeemed for cash, but management said on the Q1 call that $285m of it was credit sales.  I’m reluctant to accept management telling me that a liability isn’t a liability, but this does indicate the full amount isn’t immediately fungible with cash.

They should also be able to roll their revolver as that is a senior piece of debt and they still have $650m of unencumbered aircraft that could pledge in part towards it.  The burn rate should be dynamic as well, so the daily burn is $4m/day through the end of September and then drops to $2m for the last 3 months of the year.

These various nuances reduce the cash outflows quite a bit, to less than the $1,639m of cash they have currently.

This cash burn assumes no revenue.  Cash burn rate would change dramatically if the summer season is successful.  It’s noteworthy that any flying this summer will likely be for leisure and not business, and Spirit is already focused on this customer segment.  If one looks at TSA Passenger Throughput, it appears there are more travelers in May so far than April.   It’s still down 90% YoY, but there is increasing interest in traveling that points to airlines have revenue greater than zero.  Sunday was the busiest day since March 25th.  It is still down 90% YoY, but these are very tentatively an indication that over time more people return to air travel. 

So it seems like they can make it beyond the end of 2020 without running out of cash and there’s a possibility the summer months are break even if not cash generative, giving them more time.

Cash burn is not a static figure.  Spirit’s cash burn as of their May 7th conference call was $4m per day, based on zero revenue.  That is the sum of OCF, debt service, fleet capex (net of financing and PDP), but doesn’t include payroll support funds and capital raises.  The DOT initially denied Spirit’s request to cancel certain routes in April, but reversed course on May 5th, although its unclear is that benefit is included in the $4m figure.  On October 1st, when CARES Act payroll support runs out, staff that isn’t being utilized will be let go.

Here is Allegiant saying they can cut there cash burn figure on their Q1 Call.

“In April, we obtained financing of $31 million secured by 2 A320 aircraft at a very low interest rate. Also in April, we received our first installment of the CARES Act payroll support for $86 million, and our monthly cash burn was reduced to $65 million or $2.1 million per day. The cash burn partially offset these 2 liquidity inflows to bring our ending April total cash balance to $516 million. In addition, Allegiant's portion of the payroll support under the CARES Act is $172 million, half of which we received in April, and we will receive the bulk of the remaining amount in the second quarter.

As we look ahead, we expect the cadence of average cash burn for the second and third quarters to be approximately $2.1 million and $1.5 million per day, respectively. These average burn rates assume gross bookings per day of $750,000 for both quarters, which is based on booking trends we saw in mid-April. We have continued to see modest improvements in bookings since that time, as Drew mentioned. This is down more than 85% from 2019 levels. In comparison, a year ago, this amount would have been approximately $5.5 million per day in gross bookings. For reference, our low point in gross bookings during the last 2 months was about $250,000 per day.

So to be clear, the $750,000 average bookings per day is not our forecast, it is just simply held constant to highlight the area we can control our costs. However, should demand stay at these low levels, in the fourth quarter, we estimate an average cash burn well under $1 million per day.”

It’s not an apples to apples comparison, because Allegiant is assuming some revenue, but they think they can halve their cash burn in Q4, which starts the day they can start adjusting their workforce in line with demand.  Spirit probably can do something similar.  So over the next 12-24 months, Spirit likely has substantially more flexibility than a simple arithmetic of cash on hand divided by initial disclosed cash burn indicates.

Leisure travel will return first, and people are already getting into fights on Spirit flights, a sign of a return to normalcy.  Business travel is dependent on tens of thousands of corporate decision makers who will be reticent.  Leisure travel is dependent on millions of Americans, as far from a bureaucratic hive mind as it is close to a reflection of humanity’s basic desires, the last of which is to stay inside all day.  There is a disconnect with what people are doing with what Wall Street/the media thinks people are doing. 

Here is the Apple mobility trend for NYC and the US, which I think encapsulates the divergent viewpoints between Wall Street and the people who purchase Spirit plane tickets.  This isn’t a sure sign they get on planes, but people are returning to normal life faster than New Yorkers, who are still reluctant to go for a walk.

Here is what Allegiant is doing to give people comfort with booking airfares and flying, from their Q1 conference call:

“Allegiant is going the distance for health and safety, revamps our cleaning program for all aircraft to include scheduled and deep cleaning procedures, implemented hospital-grade standards across the system, established routine treatment schedule for all aircraft with advanced antimicrobial protectant that kills viruses, germs and bacteria on contact.

We were the first to provide customers with a complementary health and safety kit upon boarding, which included a single-use face mask, disposable non-latex gloves and sanitizing wipes. We deployed VOC filters on our aircraft, which exceed HEPA air quality standards. Social distancing practices have been put in place wherever possible during check-in and at our gates and onboard aircraft. Health acknowledgment certification during online mobile check-in. Also, we've extended our voucher redemption policy from 1-year to 2 years from initial booking, and that's important because for basically the 60-day period beginning 1st of March, we have returned $235 million in vouchers to consumers. So that allows them to extend for an additional year.”

These types of measures are being adopted industry wide and they are being discussed nationwide (1).  The Southwest CEO is facing the nation to discuss the steps they’re taking (1).

Let’s also check in with the Allegiant CMO on their Q1 call for what customers are actually thinking:

The majority of people in our surveys report their personal financial situation has largely stayed the same and/or gotten better. Obviously, most of those and stayed the same, getting better than the ones that might have got the bigger checks. But the fact is, in the Midwest, mid-Atlantic, the Upper West, I got to tell you, they don't share the opinion that the evening news is putting out there. And we see and hear that one more step before you fall, most tracking surveys out there have asked the question about, do you go all in for public health? Or do you balance public health with the needs of the economy? The nation as a whole has been 50-50. The Allegiant customer base has been 75-25, every time we've asked that question in favor of you balance public health with the needs of the economy and you get out there. So our footprint just so happens to mirror where the sentiment is very different than a general pop survey that captures, New York, Dallas, Atlanta and Los Angeles.

So there is definitely a core customer base still interested in flying and the safety precautions that give people peace of mind are being identified and widely advertised.  I lean towards the aforementioned measures airlines are taking as increasing the percentage of the population that plans on flying as time goes by, but even so there is still a core customer base that exists even now.  If more states in the South open while those in the North remain restricted, this further bolsters the case for people to hop on a plane.  Many people will drive, but it seems unlikely leisure flights don’t see summer demand exceeding current levels.

A big boost to their chances of survival is that Spirit has growth opportunities and people know it.  It’s not the Ottoman Empire of airlines, like American or United, so counter parties have a stronger interest in it staying in business and aren’t just waiting for the right moment to carve it up.  There are a lot more airlines that creditors will be skittish about.  This gives Spirit a stronger hand in conserving cash.

Check out Arnold Palmer airport, a regional airport outside of Pittsburgh, which Spirit flies out of:

“We’re happy to get the business started again and we’re taking every bit of caution we possibly can trying to make sure passengers are safe,” said Gabe Monzo, executive director of the Westmoreland County Airport Authority.

The airport is requiring travelers to wear masks and providing social distancing. It also is disinfecting all areas used by the public — including chairs, handrails and boarding bridges — after each flight.

In addition, Plexiglas shields have been installed at ticket counters and at the security checkpoint. Hand sanitizers also are available throughout the terminal.

“We’re going to great lengths to ensure the most amount of safety we possibly can,” Mr. Monzo said.

…

Even before resuming service to Arnold Palmer, Spirit had been using the airport to park some of its Airbus A320 jets. It currently has nine lined up on an old runway at the airport.

The airport is not charging Spirit to park the planes.

“We feel it’s important to do everything we can to help them to get through this and get back to business,” Mr. Monzo said. “It’s not costing us anything so we’re not charging.”

Pittsburgh International also has been parking dozens of planes for American Airlines while charging a fee to do so.

This dynamic potentially applies to the Airbus order Spirit has for 2020 and 2021 deliveries and prepayments, which total $710m in payments just in 2020.  Spirit is trying to defer at least $185m of these payments.  It remains to be seen if this will be successful, but the odds of this are more in Spirits favor than they would be for a punch drunk airline, like United or American, where everyone is likely to scramble to get what they can while they can.  But Spirit was, and likely still is, very visibly a net purchaser of airplanes in large quantities in the future and suppliers are likely to recognize that as a reason to contribute to their survival and future success.  It would be one thing for Airbus to screw Spirit over to get paid on the 41 planes they are hoping to deliver through the end of 2021, but this would put the other 107 through 2027 at risk.

Also interesting is that in the filings, Spirit indicates Airbus is on the hook for financing these aircraft as part of a backstop financing agreement.  It says “a majority of” the airplanes, so there are some nuances unknown to the public at the present, but it does indicate another reason for Airbus and Spirit to have aligned instead of opposing interests.

A possibility if push comes to shove is jingle mail.  Most of the debt is secured by specific airplanes.  If planes aren’t flying any time soon, Spirit can say “thank u, next.”  In the static short term there are fewer airlines and more planes, so supply swamps demand at this point.  There is no point in seizing an airplane, so there is greater flexibility than a single stock analysis done in 2019 would lead one to conclude solely thinking about financial distress localized to Spirit.  Per the WSJ, repossessing an Airbus SE A330 can cost a lessor $2.8-6.2m assuming a successful replacement with another airline within six month.  Plane lessors, with significantly more debt, have less leeway with their creditors.  Given the current circumstances, planes won’t be picked up by other airlines for quite some time so the path of least resistance is to be flexible with the airlines.  This is especially true for industry players who will survive this intact, which will result from cost structure and liquidity, which Spirit appears to have.

Of their 151 plane fleet, 54 have operating leases, 97 are owned, and 29 of the 97 owned are unencumbered.  That means there are 68 planes that Spirit should able to walk away from easily should they right size their fleet to a prolonged slump. The interest payment on the financing for the 68 aircraft is ~$75m/yr.

They have 27 planes financed through EETC, as of 12/31/19.  Total EETC debt it $965m, or $36m/plane.

I’m not a big believer in the first order thinking that Spirit wouldn’t want to damage their “reputation.”  In 2017, people were buying debt issued by Tajikistan.  People will buy anything to clip a coupon.

Risks

1)      I’m sure management and the board are all nice people, because that seems to be the primary reason they’re all in their seats.  Management and the Board are disgustingly obviously short sighted greedy.  Their actions demonstrate a needless absence of thought even for a “safe hands” consensus group of folks with a great playbook sitting in their laps.  I won’t hold Spirit management to the exact standard as Allegiant because nobody at Spirit owns 20% of the equity, but Allegiant reduced all executive salaries by 50% and the board is forgoing cash compensation.  Spirit’s Chief Clown Ted Christie reduced his base 30% and “all senior and EVP and members of the Board of Directors have temporarily reduced their compensation as well.”  Is that the kind of language one uses if the pay cut is greater or less than 30%?  The tone is set at the top, so the whole Spirit organization is likely mimicking the clown behavior demonstrated at the top.

Allegiant’s Board and C-suite aren’t exactly denouncing their possessions and fleeing to a monastery so much as preserving their upside in a way that makes the bitter pill of tough times easier to swallow for everyone else in the company.  The important thing in these situations is to have every employee at the company feel like they’re in the same boat and T-Christie the Clown would have a stronger hand convincing his team to batten down the hatches to ensure survival if he just forwent his cash comp, senior execs slashed their salary 50%, and the Board got no cash comp.

These things are typically the tip of the iceberg, not a mountain out of a molehill.  One doesn’t have to dig that deep to see business which theoretically should have a serious culture of thrift to maintain the positive flywheel of low prices is building a new $250m headquarters. It is hard to argue that is a sign management and the board think long term.  And they’re supposed to build a 200 unit apartment as part of the 99 year lease they signed as part of the HQ deal, a distracting circus that suits the clowns in senior roles.  Thankfully, the business is structurally sound from the strong structural position Spirit was put in by Risk #3.

2)      I do not know enough about Bill Franke to determine if would be the Warren Buffett to my Vicki Hollub, but his background is that of someone you would rather on your side.  He helped create the modern Spirit, but left and created the modern Frontier, both A320 fleet ULCCs in the US.  There is a logical consolidation opportunity for the two regardless of the macroeconomic backdrop, but it might be even more compelling now.  Being public might also be expedient access to money, although Franke seems the type to already have dry powder, if not the talents that lead to its quick procurement (please put me down for a couple grand if you pass the hat, Bill). He fortuitously cashed out a lot of his shares in Wizz just the other month.  The Spirit setup is risky, but there is a lot of reward on offer.  This would be short circuited if Bill somehow captured all the upside.  There are other players out there who might play a similar role, but Bill seems proximate to the situation and pretty competent.  Spirit adopted a rights agreement in late March, so these discussions are potentially already under way.

3)      Competition is this thing that sometimes exists in a market economy.  There is currently some disruption in the market.  There will likely be bankruptcies that will create opportunities for people thinking about launching a ULCC.  There may be airlines in 2023 that weren’t of consequence in 2019.

Thanks for reading.  I do not know much, so please feel free to comment or reach out through email if I am overlooking something.  If you have any better ideas for structurally advantaged and growing companies that could be 3 baggers at 10x 2022 EPS, please let me know. If you would prefer cheap stuff that is unlevered and has enough cash to go many years without revenue, check out Japanese stocks.

Showa Paxxs (3954) makes strong paper bags for chemicals and food products.  While it does not have an activist, it is a robust business that is very cheap on both earnings and assets.  This is an example of a company priced as if none of the change in Japan is occurring. 

The company’s financial results and state follow a similar path to 8085 and 4611 in that there appears to be a structural improvement in operating margins and the company has used cash flow to pay down debt in the past decade.  The company went from Y800m of net debt in FY07 to net cash of Y6.4bn as of 12/31/19, with cash accumulation really taking off since FY16, from Y1.6bn to Y6.4bn, when margins dramatically increased. 

Showa’s primary business is making heavy duty paper bags, which is the bulk of profitability. These are used in a range of industrial markets like chemicals, food, cement, fertilizer, and agricultural products. They are single use and a fraction of the cost of the product it holds. These are a little different than paper bags used in the grocery in that there is some selectivity about the characteristics of the bag that might make it a little more difficult to order sight unseen from a catalog.For example, this product is a bag with two layers, an outer layer for basic protection and then an inner layer that can be various materials that provides a moisture/gas barrier.Preventing contamination seems to be the main value the products provide across the offering, both from an environmental regulatory and quality assurance.

The business has been consistent and slowly growing for many years, indicating the CCP’s 5 Year Plans have yet to result in the subsidy and capacity ramp up in heavy duty bags. Packaging is also typically a local product given its absolute low cost and customers typically not holding loads of inventory on site.  This isn’t Transdigm, but it’s a straightforward product that doesn’t appear at risk of displacement or subject to intense competition.

The company sells sealing equipment for the bags.  Since many of the bags have 2 layers of different material, the company’s equipment focuses on achieving the appropriate seal to maintain hygiene (http://www.showa-paxxs.co.jp/top/products/p04/p04-01/).  This isn’t rocket science, but it means Showa likely goes direct and knows exactly who their customers are, which is typically helpful in holding onto them.  The machinery is sold within the “Other” segment.

The rest of the business is packaging related adjacencies that serve similar customers. They sell some plastic film products used in packaging and agriculture. These products are less attractive than the core bag business since it seems more general in purpose and would be more fungible.  Container segment hovers around break even with the occasional minor loss, but is just selling larger quantity bags that handle the same contents as the core bag business.  This could potentially be a positive if management can improve margins on this business, but its not a large enough business to move the needle of the enterprise either way.  It is helpful that they break this out, in contrast to 4611, to give a better idea of where they make their money.

Capex is lumpy, but a 6-year average going back to FY14 when it was last a big number shows Y570m of average capex, which is 2-3% of revenue. The FY07-19 average is Y520m.  So this isn’t a capex hog and they are earning a decent return on capital they have invested in the business.

They own their HQ in Shinjuku, a central Tokyo neighborhood. It was built in 1994.  The FY19 Securities Report gives a market value of Y2,064m, which is 25% of the market cap.  This building is likely the bulk of the Y200m of EBITDA the real estate segment generates, although the disclosure alludes to plural office buildings in Tokyo and other areas.  This is different than Soft99, which also has a real estate segment that contributes to earnings but in less obviously valuation locations.  With Showa, I can assess there is obvious value here by looking at a map and saying, “location, location, location.”  I’m assuming the big “V” on the façade stands for “valuable.”

The company has ~Y4,9bn of investment securities as of 12/31/19. This is spread across a variety of Japanese chemical companies, their main customers.  There are also some banks, suppliers, and other packaging companies they are aligned with.

One of their portfolio holdings is a 11.3% stake in Sun A Kaken (4234). They did a capital tie up in 1979 to help in material procurement and selling products together.  Sun is dirt cheap and owns ~19% of Showa. It is less attractive than Showa in my eyes given it has been less consistently profitable, but it is cheap.  The other chunky shareholder of Showa is Shinsei Pulp & Paper, likely a supplier, with a 19% stake.  They aren’t public, but they do disclose some financials on their.  They have a large real estate and securities portfolio.  It could be an interesting opportunity for the company to repurchase a large block of shares should they decide to go down the route of reducing cross shareholdings.

Showa has the high returns on net assets and low earnings multiple of DNT combined with the huge liquid asset hoard of Soft99, but it lacks an activist.  It is possible the company unlocks value itself as part of the broader trend in Japan or that it ultimately attracts an activist, neither of which seem reflected in the share price. They only have a 25% payout ratio so there is clearly room for improvement.  They only have a 40% free float, which might be problematic for an activist to accumulate a stake.  Of the names discussed here, this has the most abstract investment case.

Narasaki Sangyo (8085) takes us to a bit of a hybrid of Soft99 and Dai Nippon Toryo, where the liquid assets make up the market cap and the earnings multiple is low.  Narasaki Sangyo is a grab bag distributor for several Japan companies; Mitsubishi Electric, Sumitomo Osaka Cement, and a few others.  The diversity of business lines makes it a little hard to wrap ones arms around it in the same way as the previous companies, but distribution is a universal business model, NS plays in markets that should exist for some time, and the company is exceedingly cheap at ~6x earnings and 60% of TBV.

The company sold ~Y2bn of PP&E from FY07-2010 and revenue is down, which accounts for the decrease in net tangible assets employed in the business.  Of Y8.4bn of PP&E at FY19, Y5.4bn was land, so the ongoing capex needs of the business are quite small and there isn’t much capital in the business.  Cumulative capex FY07-19 was Y6bn and average annual capex is Y460m.  A major attraction in NS is that has practically no working capital.  This does raise the question as to what exactly they do then, because that tends to be one of the main attraction of distributors to suppliers, although several Japanese distributors I have looked at have had negligible working capital.

The two biggest segments are Electrical Machinery and Building Materials & Fuel, which is really 3 businesses, has been around since 1947 when the company became a distributor for Mitsubishi Electric (who owns 7.89% of the company), Mitsubishi Oil (now JXTG Energy), and Iwaki Cement (now Sumitomo Osaka, who owns 2.05% of the company).  Somewhere along the line they also became a distributor of Kyokuto, a specialty truck manufacturer.  They have sales locations across Japan for everything except Fuel.

The Electrical Machinery business sells what is broadly three ranges of product from Mitsubishi Electric, which is most clear from reading their recruitment page.  They sell industrial widgets related to power (motors, inverters, etc) to power distribution board manufactures, heavy electrical machine manufacturers, etc.  They sell building equipment like air conditioning and elevators to commercial buildings, schools, hospitals, etc.  They sell precision machining devices to the electronics industry.  The Japan Company Handbook says they have a particular strength in laser processing machinery.

This is from IPG Photonics, which is a neat company expanding the addressable market for laser processing by dramatically lowering the cost of laser sources, the key widget.  Fiber lasers use a semiconductor as their source, which has lead to rapidly decreasing costs, the main obstacle to their adoption.  Mitsubishi is selling fiber lasers, amongst other types.

They opened up offices in China in 2008 and Vietnam in 2013, indicating Mitsubishi Electric sees some use for them beyond their legacy relationship that started a long time.  A 5% EBIT margin is indicative of a solid, albeit not high value add, distributor; Ingram Micro ~1%, Avnet 3.5%, Univar 5%, Beacon Roofing 5.5%, Watsco 8%.  This is the type of business which is admittedly cyclical, but should continue to remain relevant in the longer term.  I am not an expert on Mitsubishi Electric, but they have $40bn in revenue and spend 5% of it on R&D, so it should remain somewhat relevant in the fields in which NS represent their products.

There are two other Mitsubishi distributors that are public.  Kanaden (8081) and Ryoden (8084) are good comps for Narasaki Sangyo.  Kanaden is 25% owned by Mitsubishi Electric   They focus on sales to government agencies according to the Japan Company Handbook, but their product portfolio has a lot of overlap with NS, and that Mitsubishi Electric is ~70% of their suppliers is a decent proxy for NS too.  Kanaden only earned a 3.7% EBIT margin compared to 5% for NS’s Electrical Machinery segment in FY19, which I consider comparable because NS does not carve out corporate costs.

Ryoden is 34% owned by Mitsubishi Electric.  They have a focus on semiconductors and electronic components.  Their EBIT margin in FY19 was 2.4%.  Both Ryoden and Kanaden’s results indicate that NS is likely focused on a specific product line within Mitsubishi Electric’s portfolio even though it isn’t that explicitly stated.  More importantly, the higher margins is a possible indication NS is well run.

Building Materials sells cement, concrete, etc for Sumitomo Osaka.  The fuel arm is mostly gas stations on Hokkaido.  They agent for JXTG Energy on Hokkaido, so kerosene and diesel oil for heating factories are some unquantified contribution.  While I think operating the production facilities for cement or fuel in Japan is going to be tough longer term since these assets need a certain level of utilization to be profitable, cement and fuel will likely be consumed in Japan over the next 5-10 years and distribution can flex much more easily to movements in demand.

The Construction Machinery segment sells snow plows, road cutting and paving machines, and concrete pump trucks.  NS represents Kyokuto, who owns 2.6% of NS, and Sakai Heavy Industries, who owns 1.87% of NS. These are niche categories where an OEM is unlikely to have the scale to support a sales force for irregularly purchased low volume products like these.  NS isn’t limited to Hokkaido as they mention benefiting from construction in Tokyo related to redevelopment and the Olympics.

The Shipping segment is basically Matson if I understand it correctly.  They either just operate the cargo handling operations at ports or they also operate some boats, such as a cement transport for Sumitomo Osaka. Matson handles maritime transport between the mainland US and Hawaii, which is protected by the Jones Act.  NS is the Matson of Hokkaido, as Japan has a similar cabotage law.  They have some handling operations in Tokyo, Yokohama, and Osaka, the major Japanese international ports, and facilities in Tomakomai, Muroran, and Ishikari, the main Hokkaido ports.  There is a rail tunnel to Hokkaido but it won’t expand to the largest city, Sapporo, until 2030, and the freight it handles is so far are agricultural products that face spoilage, but shipping by water is generally much cheaper than rail.  While I typically think of shipping “investments” by US investors as playing Russian roulette with others who actually know if there is a bullet in the chamber, I do not believe this has similar economics to US listed shipping companies as it has been profitable every year since at least 2006, as has Matson’s Ocean Transportation Segment. 

None of these business lines are going to draw the compounder crowd, but the company has maintained resilient revenue levels (please submit your corporate euphemisms for zero growth), expanded margins, and built up a nice cash position.  It’s also noteworthy that net debt was Y12.6bn in FY2007 and there is now net cash of Y6.5bn, which means the company has generated about 2x its market cap in cash in the last 13 years.  Similar to Dai Nippon Toryo, if they can maintain their post Abenomics EBIT margins without a huge drop in revenue, cash generation in the coming years should be even higher than the historical result.

There is one, possibly two, activist involved here.  Horizon Capital Management is an activist and owns 6.1%.  They crossed the 5% threshold in September 2015, peaked at 7.92% in January 2017, but decreased a little and sold their whole stake to HBM Investment Management, a BVI administrator, which shields the underlying ownership.  It either is Horizon or someone who had an interest in a large stake in NS that isn’t a Japanese entity.  The same thing happened in another name they have been active in, Watanabe Sato where Horizon sold the stake and the HBM entity acquired it, both on the same date, so it appears technical.  Horizon was investing through a Uruguayan entity prior, which is likely less familiar to LP’s than a BVI entity, but I have no insight into what is going on here besides there is still one owner of that chunk of NS who is also probably still the owner of Watanabe Sato.  Fidelity increased their shareholding from 6.22% to 7.23% in October 2019, on top of increasing their stake from 5.1% to 6.2% in January 2019, so it’s possibly not some long buried and forgotten holding.

NS has consistent profits but only a 20% payout, so there is an easy case to make for increasing the payout.  Even at the current rate the dividend yield is ~3.5%, so increasing to a 40% payout would draw a lot of attention to the company as 7% would be a very high yield in the Japanese market.  It’s also quite cheap and has excess cash making repurchases attractive as well.  Management is not terribly ambitious based on their 2020 outlook, but they still see the business generating a double digit ROE and keeping earnings steady.  Horizon unsuccessfully pushed Watanabe Sato to buyback shares and dispose of non-performing assets in FY19, which is the likely playbook they will pursue at NS, hopefully with greater success in the next 3-5 years.

There are positives to glean from Kanaden and Ryoden.  Kanaden has repurchased 5% of its float in the last 5 years, which means Mitsubishi Electric is not violently opposed to the idea.  Both Ryoden and Kanaden have enough cash to purchase NS at tangible book, ignoring the fact that anyone could basically finance a purchase of NS from its own balance sheet.  Mitsubishi Electric might also just decide to buy in these companies

Dai Nippon Toryo (4611) is a different beast than Soft99 as it does not have a massive stockpile of readily distributed liquid assets to immediately extract.  It’s cheap, has good returns on capital, and is already starting to do the right things with cash.  The company mostly makes paint for big stuff – skyscrapers, tunnels, bridges – and industrial applications, which total about 85% of revenue.  They also make lighting for commercial displays, rounding out the other 15%.  It trades for ~7.5x earnings and ~75% of adjusted tangible book value.

Because a bucket of paint contains largely homogeneous inputs, cutthroat price competition is difficult, which deters new entrants and makes market shares fairly static, except during technological shifts that advantages those who have invested in R&D (solvent to water based paints, as an example).It is not a product that transports well due to relatively low weight to value and local distinctions (environmental and regulatory), so low cost overseas producers typically don’t play a major role.The icing on top is that the manufacturing process is primarily blending chemicals, making it a capital light and cash generative business.While I am not an expert on the Japanese paint market itself, these characteristics are inherent in the product and how it is consumed, which can be observed globally and across time.

An important thing to note with the valuation and returns on capital is the company has an Y10.9bn pensions surplus (23.7bn in plan assets, 13.4bn in obligations per FY19 securities filing footnote, 12/31/19 BS shows 11.7bn in retirement assets and 866m in retirement liability – it’s 75% invested in stocks, but I don’t know which ones other than whichever ones have gone up a lot).  So tangible book value is Y43.5bn, but should be adjusted down to Y32.6bn unless you know about extracting pension surpluses from Japanese corporations, which bumps the ROE up to ~10%.  The company still trades at a sizable discount to adjusted TBV, but more importantly the pension asset ballooned recently on its own accord, which has the impact making capital allocation look worse than it is.

Their results are indicative of one of the many companies in Japan that have responded to Abenomics and have worked on managing their business more profitably since 2012, which has been the trend across Corporate Japan.  As it relates to paint companies, their margins do not appear to be flattered by a move in oil prices, as margins have steadily increased.  There is some benefit in FY17, which included the fall of oil prices in 2016, but subsequent results didn’t give back all those gains, so I don’t believe this is unwittingly a proxy for oil prices.  Also noteworthy is that SG&A averaged  23.5% from FY07-12 and 21.9% from FY13-19, without much benefit from operating leverage.  And to boot, the core business is generating very attractive returns on net tangible assets.

The company has improved margins in recent years and used cash flow to pay down a historically large debt load (3.5x net debt/EBITDA in FY11 to net cash starting in FY18), but is now positioned to rapidly build cash that it appears poised to deploy intelligently.  Net debt peaked at Y22.5bn in FY10 and was basically zero at 12/31/19.  That amount of cash generation is close to the current market cap.  If one uses the most recent 5 years instead of the past 10 to think about the future cash generating capabilities of the company, it should throw off even more cash relative to the market cap.

The domestic paint segment is largely focused on structure paint, which is for steel framed structures (big stuff).  Overseas paint is largely focused on auto production in Thailand and Mexico, but they are also trying to sell structure paint in China and ASEAN.  This catalog of theirs has a lot of reference projects.  There isn’t a specific breakdown of end market contribution to revenue, but I suspect a large portion of the Domestic segment comes from structure paint.  Given the state of Japan’s economic development, it seems likely this business is heavily biased towards repair and maintenance of existing structures. Revenue was down ~15% in FY10, so it is not immune to cyclicality as there is industrial/auto exposure and repainting a structure can be deferred.

There is something going on between the Overseas and Domestic Paint businesses, given the divergence in margins.  One contributor is that Mitsubishi Chemical represents 20% of company revenue, which is about 25% of the Domestic Paint Segment.  I’m unable to figure out why Mitsubishi Chemical is purchasing all this paint though as their website only mentions selling ingredients for paint and doesn’t have a visible construction arm.  Part of DNT’s legacy is connected to Mitsubishi Corp, which owns ~1.2m shares of DNT.  DNT’s stock portfolio includes a whole array of Mitsubishi related companies.  This has been the situation for a long time and the segment has still improved margins over time, so it is not a large concern.    

Another contributor to high Overseas margins is that it likely includes royalty income.  These appear to be outbound based on the language – e.g. a license to a Taiwanese company to sell corrosion resistant structure paint in Taiwan.  A tertiary insight is also that the IP of the business is valuable and they aren’t a dinosaur just getting along because of a special relationship with Mitsubishi or other Japanese companies.  This is also supported by the company having a 51% share in JVs with Kansai paint for powder coatings in Japan and automobile component coatings in Mexico (whatever is less pertinent than tertiary, I assume if one gets 51% of a JV there is a favorable reason for it).  I also suspect the Overseas segment isn’t burdened with corporate overhead whereas the Domestic segment is.

What about this lighting business?  It’s not a money pit, which I think speaks well to current management’s ability.  These aren’t light bulbs sold by the case off a shelf in Home Depot.  Their products are going into commercial spaces – retail, offices, etc – which means a designer or architect is making the purchase.  They don’t get paid based on how many different lighting providers they consider in making the purchase, so they are focused on matters besides pricing.  This means revenue is probably based on numerous relationships that took years to establish.  The Chinese are unlikely to suddenly take this business by storm and new competitors are unlikely to economically enter a zero growth industry that requires hundreds or thousands of relationships.  The company says the market is driven by maintenance demand, which further bolsters the belief that this earnings stream is stable.  If the maintenance demand is just replacement in existing installations, there is also some comfort in that these are nonstandard sizes in very low volumes, which is arguably less defensible than selling through designers but still not easily displaced.

The company has even managed to expand margins with revenue basically flat. 

Here are some reference projects.  These places probably require illumination in the future.

DNT has raised their payout ratio slightly and introduced buybacks into their shareholder return in recent years.  I interpret 5 years of continued buybacks as a sign they will likely continue in the future.  The quantum is debatable, but it is in the right direction.

Once upon a time the company aspired to a 10% EBIT margin in FY20, prior to recent events.  Should this ever come to fruition, the company would become even cheaper.  Conversely, paint manufacturing has a low of variable inputs whose cost is tied to oil, which gives makes margins relatively resilient in a downturn.

Mostly the company is cheap and poised to get cheaper.  No activists show up on the register, but there are several catalysts that are already underway.  First, they are positioned to build up their net cash position in coming years after deleveraging dramatically in the past years.  This is quite material relative to the market cap, unlike with Soft99.  They have been consistent repurchasers of their shares in recent years, although the magnitude leaves a lot to be desired.  Another value creating opportunity is in further domestic market consolidation, as there are several smaller public paint companies that are cheap to both earnings and tangible book.  The two JVs with Kansai Paint may also be an indication that KP could have an interest in purchasing DNT.

Soft99corpoation (4464) is hard not to find straightforwardly compelling.  They manufacture a wide range of low price consumable stuff people use on their cars like washes, waxes, paint refinish, minor body repair, wipers, tire chains as well as low priced consumable cleaning and filtration widgets used primarily in semiconductor production.  These two business lines, Porous Materials and Fine Chemicals, account for 80% of the business.

This is a resilient business.  Can you point out the GFC or Tohoku in these results?  The segment reporting doesn’t tell a divergent story either.

Tangible book value is Y48.2bn.  The magnitude of the assets far outweighs the potential contribution of earnings to future returns.  The liquid assets amount to more than 10 years of profits.  The RoNTA isn’t great, but neither is it abysmal.  Y15.5bn of their Y22.3bn of PP&E is classified as land, although its not clear how much of this is deployed in their core business, as the 10 year average of capex is Y920m.  The past 5 years have seen an incremental cash balance of Y4bn on the balance sheet, about 23% of the market cap, which is ok.

To get a better idea of what they sell, you can look on their respective websites for car product, “Fine Chemicals,” and filter/scrubber/grinding material business, “Porous Materials,” in English.  In math, a universal language, the business looks nice too.  These two segments account for 80% of EBIT, with the rest split evenly between real estate and services.  Real estate is mostly real estate rental, but includes a spa.  Services appears to mostly be a body shop that does repair (20,000 cars per year) and operation of a driving school. .

The FM business hums along.  It’s encouraging that it has grown, which means that it should hold its own into the future despite Japan’s poor demographic trends.  Porous Materials is tied to semiconductor production, which is already divorced from Japanese demographics.  I suspect margin fluctuations are due to fluctuation in oil prices as the many inputs for both businesses are petrochemical related.

Overall, no customer accounts for more than 10% of revenue, although PM is ~25% of revenue and FC is 50%, so if there’s a 9% customer, it might actually be 20-35% of one of these segments.  Autobacs Seven and Yellow Hat, two large aftermarket auto retailers and repair shops are large customers of PM.  They are the 2 largest holdings in Soft99’s securities portfolio, Yellow Hat (great commercials) and AUTOBACS Seven.  Autobacs stands for Appeal, Unique, Tires, Oil, Batteries, Accessories, Car audio and Service.  The risk of losing them is mitigated by offering a wide variety of products in the car care space.  It is a broad catalog of low cost infrequent purchases, which doesn’t typically lend itself to easy dislodgement by aggressive or new competitors.

PM manufactures consumables for cleaning and polishing medium primarily used in the semiconductor production process.  This is less volatile than it sounds because this means sales are linked the semiconductor unit production, not capex.  Cleaning and polishing is tied to the etch and deposition stages of semiconductor manufacturing, which is fundamental to their production.  Some chemicals are deposited on the wafer, then a pattern is etched into them.  This is how semiconductors are made.  Soft99 makes the scrubbing rollers that remove the excess material after etching, cleans off electronics (sponges), as well as filters and grinding material.

Soft99 clearly isn’t in the most lucrative niche of this market, but my broad understanding of the semi and electronics industry is there are high purity requirements and dozens of process steps in the production process that make fabs reluctant to switch around providers of any inputs in order to avoid disrupting a delicate calculus and the requalification of the production output.  It seems difficult for a cheap Chinese competitor to take the market by storm or to circumvent the necessity of the product.  Even if Soft99 is the tier 2 player in this market, which is likely, equipment OEMS and fabs don’t want to give 100% of the business to the tier 1 suppliers so that everyone stays honest.  Soft99 filings qualitatively indicate that PM gets a high portion of sales from overseas, which means their products aren’t just present in Japanese fabs, who lag TSMC and Samsung.  A reliance just on domestic demand would be a sign of a deterioration in future results.  This should lead to a business for Soft99 that is unlikely to see huge shifts in its positioning, and historical results support that intuition.

The company also discloses the real estate for rent profit, Y139m, which is a subset of the real estate segment, which did Y258m in EBIT overall.  This is good to know, because at least the spa and driving school aren’t losing money.  Nothing about the real estate jumps out as obviously valuable, like a building in the center of Tokyo.

Its business is simple enough with a track record indicative of robustness that should support future cash flow generation.  It’s fairly interesting on this alone, but what is really interesting is the presence of two activists.  Simplex shows up in the securities report as holding 9.48% of the company, and Asset Value Japan mentions owning 1.3% of Soft99 in their annual report.  I have no idea what either plans for the company and it isn’t a very largest position for either of them, but it could be potentially meaningful over 5 years given the low starting valuation.