Josh is the General Partner of Greenleaf Lane Capital Partners LP, a private investment partnership he founded in 2006. Josh graduated from Duke University in 2001 with a degree in philosophy. He has worked at Goldman, Sachs & Co. and has an MBA from Columbia Business School.The mistake:Ambassadors Group (EPAX, Financial)
EPAX is an educational student travel company in United States and the primary service of the company is that it sends students on 2 to 3 week trips.
The educational company was Greenlea Lane’s largest investment during the period of 2007 till 2010. The stock was bought at $17 but it has now gone to $9.
Initial Thesis:
The company has a unique franchise, which is based on People to People International (PTPI). The people to people brand is unrivaled. They have tens of thousands of students a year as enrollment to EPAX is accredited and a resume builder.
The company seemed to have attractive economic returns as the operating margins were solid at 15% (at peak) and the Free Cash Flow generated throughout the cycle is $30 million at peak. Little tangible capital was employed. There was no large capital employed.
However, the company turned out to be very cyclical than expected. 2007 was the peak of 20% annual growth of enrollment, thereafter the company crashed from $40 to $8.38. The Enrollment, gross receipts, and EBIT yearly growth rate went from positive to negative.
The primary mistake was that the impact of recession was underestimated. The cyclical nature of the business was not previously realized. While the service is discretionary, it is not a luxury.
The second mistake was that the company had been raising prices aggressively up until 2007, which was mistaken for pricing power.
The Current Thesis:
The franchise is intact; however, normal earnings power is likely to be lower than initially believed.
The company stock currently trades for $8.80 per share; net of $1.30 of excess cash the EV per share is $7.50 which represents 5x peak FCF ($1.56) and 7x 2009 FCF ($1.05), but the figures ignore $2.50 per share of float
EPAX is also buying back shares.
The current agreement between EPAX and PTPI would remain and both companies are expected to remain committed. The PTPI wants the enrolled students to have good programs and they love the way EPAX runs their programs, and now are in talks to renew their contract, which ends in 2020.
A lesson learned from Warren Buffett is that pricing power is the single most important aspect of evaluation. It is used too often but the reality is that most do not understand it.
There are two types of pricing power:
1. Inflationary Pricing Power: the ability to pass along inflationary cost increases to customers without adverse consequences. If the business cannot do this then it is unhealthy for the company. However, it is a pre-requisite and not necessarily a great thing.
2. Above Inflation Pricing Power: The ability to raise prices in excess of inflation without adverse consequences. Above-inflation pricing power is extremely valuable because the ‘above inflation’ incremental revenue is pure profit. If a company with operating margin of 15% can raise prices at inflation +1% and that would produce a growth of 7% in operating income.
It is very unusual to find a company with above inflation pricing power. The favorable or rather necessary competitive dynamics for sustained above inflation pricing power for a prolonged period of time includes brand franchise, customer captivity, and rational competitive behavior.
Another necessary condition is a gap between the price and the value of the good. The good needs to be underpriced to begin with. The concept is similar to value investment, where it is favorable for the purchased a stock to be undervalued. Therefore, we look for a mispriced good in the same sense that a security analyst looks for a mispriced security and we try to find inefficiencies in markets that are generally, but not always, efficient. US railroads is a good example, when prices went down for 20 years but have risen since then.
Verisk Analytics (VRSK, Financial) is an example of a company that has the potential to increase prices above inflation.
Until 1944, the US property & casualty (P&C) insurance industry was exempt from antitrust laws. Rating bureaus were a central factor in the industry. In 1944, the Supreme Court ruled that insurance was interstate commerce and therefore subject to antitrust law.
Rating bureaus began to consolidate as their influence was reduced and in 1971, the Insurances Services Office (ISO) was formed through the merger of the five major rating bureaus. The ISO remained a non-profit entity controlled and owned by its members (insurance companies). In 1988 the ISO’s members relinquished control of its board as part of a settlement of antitrust litigation. For the first time, ISO became an independent entity, and management began to broaden its activities by developing new products and services. In 1997, management took 5% and the employees took 10% of ISO. Buy accident P&C regulation became the de-facto in charge of insurance regulation. In 2009, ISO went public and became Verisk Analytics, Warren Buffett’s Berkshire Hathaway was the only stakeholder that retained its entire stake.
They have two segments:
1. Legacy ISO - ½ of revenue and EBITDA and Mid single digit growth
2. Decision Analytics- 15-20% top-line growth.
They have very attractive business characteristics.
· VRSK’s products directly impact the ability of its P&C customers to generate revenue (premiums) and estimate the cost of that revenue (claims)
· VRSK’s solutions are highly integrated into customer workflow
· 70% of revenue is under subscriptions or long-term contracts
· Negative working capital cycle; customers typically pre-pay on a quarterly or annual basis
· Capex is minimal (~3% of revenue) and less than D&A
Despite the great market power, VRSK prices are low at 0.2% of its P&C customers’ revenue. VRSK estimates that for its customers’ ROIs for industry services are 5x and for value added services are 9x-37x (This is the gap between price and value).
ISO is cross selling to large customers even though they could possibly raise prices aggressively as the company estimates there is a 900m opportunity in cross-selling.
Insurance is about managing risk, and it gets very confusing and more types of insurance are developed each year. Zip codes are not well aligned with insured losses, thus, there are numerous of varieties within a zip code. VRSK is rolling out new block groups for example now Milwaukee, Wisconsin has 34 zip codes, and VRSK has split that up into 664 segments.
Even after price increases the company is still very attractive and in the basis of current price the company is at a modest discount. When insurance market goes up, VRSK would resultantly benefit and company stocks would go up.
Evaluating the attractiveness of VRSK at 22x FCF:
Inflation = 3% (trailing 19-year industry premium inflation = 3.4%)
Operating margin of 40% implies that the 3% above-inflation price increase in the first year produces operating income growth of 7.5%
Year-1 FCF growth of 10.5% (= 3% + 7.5%) decreases over time as margins expand
Conservative terminal multiple (Year-26) = 10x
Discount rate = 10%
DCF yields FCF multiple of 26x
Another way to look at it is 5% FCF yield plus 12-18% compounding FCF + or – capital allocation. They use 60% of their FCF to buy back stock.
Conclusively, latent pricing power can be viewed as a hidden asset. The current stock price of ~$34 represents a modest discount to intrinsic value. Management owns 9% of stock, and employees own 15%. VRSK appears to represent high-teens compounding over the long term.
Disclosure: Long VRSK
http://www.valuewalk.com/
EPAX is an educational student travel company in United States and the primary service of the company is that it sends students on 2 to 3 week trips.
The educational company was Greenlea Lane’s largest investment during the period of 2007 till 2010. The stock was bought at $17 but it has now gone to $9.
Initial Thesis:
The company has a unique franchise, which is based on People to People International (PTPI). The people to people brand is unrivaled. They have tens of thousands of students a year as enrollment to EPAX is accredited and a resume builder.
The company seemed to have attractive economic returns as the operating margins were solid at 15% (at peak) and the Free Cash Flow generated throughout the cycle is $30 million at peak. Little tangible capital was employed. There was no large capital employed.
However, the company turned out to be very cyclical than expected. 2007 was the peak of 20% annual growth of enrollment, thereafter the company crashed from $40 to $8.38. The Enrollment, gross receipts, and EBIT yearly growth rate went from positive to negative.
The primary mistake was that the impact of recession was underestimated. The cyclical nature of the business was not previously realized. While the service is discretionary, it is not a luxury.
The second mistake was that the company had been raising prices aggressively up until 2007, which was mistaken for pricing power.
The Current Thesis:
The franchise is intact; however, normal earnings power is likely to be lower than initially believed.
The company stock currently trades for $8.80 per share; net of $1.30 of excess cash the EV per share is $7.50 which represents 5x peak FCF ($1.56) and 7x 2009 FCF ($1.05), but the figures ignore $2.50 per share of float
EPAX is also buying back shares.
The current agreement between EPAX and PTPI would remain and both companies are expected to remain committed. The PTPI wants the enrolled students to have good programs and they love the way EPAX runs their programs, and now are in talks to renew their contract, which ends in 2020.
A lesson learned from Warren Buffett is that pricing power is the single most important aspect of evaluation. It is used too often but the reality is that most do not understand it.
There are two types of pricing power:
1. Inflationary Pricing Power: the ability to pass along inflationary cost increases to customers without adverse consequences. If the business cannot do this then it is unhealthy for the company. However, it is a pre-requisite and not necessarily a great thing.
2. Above Inflation Pricing Power: The ability to raise prices in excess of inflation without adverse consequences. Above-inflation pricing power is extremely valuable because the ‘above inflation’ incremental revenue is pure profit. If a company with operating margin of 15% can raise prices at inflation +1% and that would produce a growth of 7% in operating income.
It is very unusual to find a company with above inflation pricing power. The favorable or rather necessary competitive dynamics for sustained above inflation pricing power for a prolonged period of time includes brand franchise, customer captivity, and rational competitive behavior.
Another necessary condition is a gap between the price and the value of the good. The good needs to be underpriced to begin with. The concept is similar to value investment, where it is favorable for the purchased a stock to be undervalued. Therefore, we look for a mispriced good in the same sense that a security analyst looks for a mispriced security and we try to find inefficiencies in markets that are generally, but not always, efficient. US railroads is a good example, when prices went down for 20 years but have risen since then.
Verisk Analytics (VRSK, Financial) is an example of a company that has the potential to increase prices above inflation.
Until 1944, the US property & casualty (P&C) insurance industry was exempt from antitrust laws. Rating bureaus were a central factor in the industry. In 1944, the Supreme Court ruled that insurance was interstate commerce and therefore subject to antitrust law.
Rating bureaus began to consolidate as their influence was reduced and in 1971, the Insurances Services Office (ISO) was formed through the merger of the five major rating bureaus. The ISO remained a non-profit entity controlled and owned by its members (insurance companies). In 1988 the ISO’s members relinquished control of its board as part of a settlement of antitrust litigation. For the first time, ISO became an independent entity, and management began to broaden its activities by developing new products and services. In 1997, management took 5% and the employees took 10% of ISO. Buy accident P&C regulation became the de-facto in charge of insurance regulation. In 2009, ISO went public and became Verisk Analytics, Warren Buffett’s Berkshire Hathaway was the only stakeholder that retained its entire stake.
They have two segments:
1. Legacy ISO - ½ of revenue and EBITDA and Mid single digit growth
2. Decision Analytics- 15-20% top-line growth.
They have very attractive business characteristics.
· VRSK’s products directly impact the ability of its P&C customers to generate revenue (premiums) and estimate the cost of that revenue (claims)
· VRSK’s solutions are highly integrated into customer workflow
· 70% of revenue is under subscriptions or long-term contracts
· Negative working capital cycle; customers typically pre-pay on a quarterly or annual basis
· Capex is minimal (~3% of revenue) and less than D&A
Despite the great market power, VRSK prices are low at 0.2% of its P&C customers’ revenue. VRSK estimates that for its customers’ ROIs for industry services are 5x and for value added services are 9x-37x (This is the gap between price and value).
ISO is cross selling to large customers even though they could possibly raise prices aggressively as the company estimates there is a 900m opportunity in cross-selling.
Insurance is about managing risk, and it gets very confusing and more types of insurance are developed each year. Zip codes are not well aligned with insured losses, thus, there are numerous of varieties within a zip code. VRSK is rolling out new block groups for example now Milwaukee, Wisconsin has 34 zip codes, and VRSK has split that up into 664 segments.
Even after price increases the company is still very attractive and in the basis of current price the company is at a modest discount. When insurance market goes up, VRSK would resultantly benefit and company stocks would go up.
Evaluating the attractiveness of VRSK at 22x FCF:
Inflation = 3% (trailing 19-year industry premium inflation = 3.4%)
Operating margin of 40% implies that the 3% above-inflation price increase in the first year produces operating income growth of 7.5%
Year-1 FCF growth of 10.5% (= 3% + 7.5%) decreases over time as margins expand
Conservative terminal multiple (Year-26) = 10x
Discount rate = 10%
DCF yields FCF multiple of 26x
Another way to look at it is 5% FCF yield plus 12-18% compounding FCF + or – capital allocation. They use 60% of their FCF to buy back stock.
Conclusively, latent pricing power can be viewed as a hidden asset. The current stock price of ~$34 represents a modest discount to intrinsic value. Management owns 9% of stock, and employees own 15%. VRSK appears to represent high-teens compounding over the long term.
Disclosure: Long VRSK
http://www.valuewalk.com/
