2Q20

This is my first letter. I’m starting to write letters because I do not give nearly enough attention to portfolio management. This is my investing “journal” that will help me progress on that.

 

I am very pleased with 2Q20 as the 30%+ drop in equities during February and March presented some incredible opportunities to buy some new names, add to current holdings, and trade around a bit.

My objective with every move is to inch the portfolio closer to some ideal combination of sex appeal and safety, with individual positions falling on a barbell from “high growth, long runway, future cash-generator” to “better than cash, won’t get you killed”. I feel that I’ve made great progress on the objective YTD.

While I do benchmark to the S&P 500, my true mental benchmark is what I get from the bank/inflation. Any after-tax return above that is gravy. That may sound silly, but it helps me on the mental side.

I use the market to learn about the world and myself as much as I use it to build wealth. I am lucky to be able to invest to begin with. As long as I beat that bare minimum, I have little to complain about – and I am confident enough in my abilities that I believe I can do that and more over time. Benchmarking to the S&P 500 or All World indices will matter over time, but in the interim it’s noise.

Thinking About the Market and Opportunities

2020 has been a whirlwind. I think it takes panic to really separate quality stocks from their true values, and we saw that in March. I am fortunate in that I just turned 26 years old. My time horizon is very long, over 40 years. I likely would have felt different about the S&P dropping ~35% (many stocks > 50%) if I were 60 years old.

Pundits have been scratching their heads at the fall and subsequent recovery in equity markets, but in many ways, I think this time really is different. The only true constant has been human nature. I don’t fault the many seasoned asset managers who have been bearish – look at their context – many of them grew up pre-internet in an economy with much higher nominal interest rates. I know the foundation I am building today will likely anchor my train of thought when I am older.

Market-wide fundamentals will likely be poor over the next couple years, but there is one piece keeping hopes alive, especially for growing, high-quality companies – interest rates. Right now, discount rates for equities are very low, and I think you can argue they are still overestimated in world class businesses. Below is a chart of the 30-year treasury yield since 1977, currently sitting at 1.4%.

 

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This framework on discount rates hit me upon reading a 2016 interview with Nick Train:

“I’m sure that if you’re optimistic about technology and innovation then you should be optimistic about equity markets. And in that sense markets are always cheap…To me it appears that “exceptional companies with durable competitive advantages” are in fact cheap almost all the time.”

Train compares the Diageo (one of the largest spirits companies in the world) earnings yield of ~5% to long-term government bonds at 1% and essentially says “look, this business is going to be around in 30 years. It’ll likely grow in real terms, and you’ll get inflation protection thru pricing. If you agree it’s going to be around and doing well in 30 years, you should be buying this all day over a government bond.”

I add some cushion to this and use ~3%, which roughly covers population growth and inflation. I apply this to free cash flow because cash is among the truest accounting metrics, and I generally think in a DCF-type framework. Recall the barbell I mentioned above…framed by the majority of stocks I own around the midpoint of the barbell, any fantastic growing business trading around an unlevered free cash flow yield of 3% warrants attention. Not a hard and fast rule in practice, but the idea remains.

I’m willing to make this sort of long-term 30 year bet on companies like Home Depot, Sherwin Williams, and Waste Connections. Something drastic would have to happen to keep these businesses from being larger in 30 years. I know I can beat the bank with these.

Broadband internet is the new consumer staple. I think we are really starting to figure that out. Many technology and internet-based companies proved in 1Q that their businesses are fairly resilient…even when the world shuts down for a pandemic.

To be sure, 2Q reports will be messier as many companies and their customers are having more trouble now than they were in March. The shutdown occurred very late in 1Q. We are now at 3-4 months of pain for some. Loan covenants are starting to kick in.

Ultimately, I’m glad that I am not in the business of making predictions because I have no idea what’s going on or what’s about to happen. I’m just trying to find individual businesses that stand out from the pack, pick a reasonable price, and hold on long enough that time (& the business) will bail me out if the price wasn’t right.

Portfolio Commentary

I own 25 individual stocks. After building my portfolio from an initial few, I spent a while holding 15-20 stocks but was often nagged by my interest in the nth name + it was hard to let go of a position if I wanted to buy something new. My time horizon is too long to spend much energy wrestling over one great business vs another.

I have since expanded to 25 and believe this is a good size…offensive but diversified. I now cover most of what I want to industry/trend/theme-wise, and I have a few more opportunistic positions that I am not so married to. I think that wiggle room is helpful for when I want to pivot quickly.

Below my two big positions in AMZN and (formerly much bigger) VCEL, I have shuffled the deck considerably over the last few years in an attempt to find my niche. Thanks to a couple blowups, I have realized a slight loss in total since Jan 2018 (and net gains YTD 2020). Tax is very relevant if I want to build a sustainable strategy, especially trading as much as I have. I’m building a long-term portfolio while taking advantage of short-termism and volatility.

I now feel comfortable as ever with the basket that I own and foresee relatively lower turnover going forward.

My top 3 contributors for 2Q were AMZN, VCEL, and AYX. Bottom 3 were each SPY put positions.

Amazon Inc. (AMZN)

Amazon became my largest position in 2017, and I haven’t touched it since. The stock has had a heck of a run and feels pricey around $3,000/share now. Asking myself if I’d be a buyer at today’s price, the answer is almost certainly, “no”, but in weighing the risk of holding on vs the risk in selling shares, I must hold onto this incredible company with an incredible runway. I plan to direct all capital to positions smaller than AMZN until the portfolio is more leveled out.

 

 

Worldwide e-commerce still has a lengthy runway, and COVID-19 has accelerated the shift to online. From the most recent earnings call, Brie Carere, VP of Marketing and Communications for FedEx below:

“..what I certainly can tell you is I believe that the e-commerce change is structural. We have seen a huge uptick in the categories that people are willing to purchase online, certainly moved into a higher value. We saw this trend, obviously, pre-COVID, but it has accelerated when you think about things like furniture, large packages, high-value electronics. In addition, we saw a huge change in who was buying online. Over 65 finally moved to online from an e-commerce perspective. I do not anticipate that these buying behaviors will revert back post-COVID.”

Cloud is still in the early innings, and Amazon has a significant first-mover advantage with AWS (yes, MSFT is taking share), sporting 47% of public cloud market share in 2019. Global public cloud is projected to grow at ~15% annually for the foreseeable future.

The stock is pricing in a lot of credit for the future, but AMZN has been executing wonderfully under one of the world’s best CEOs in Jeff Bezos. All in all, I think my best bet with AMZN is to do nothing. Satya Nadella at Microsoft is a stud. I wouldn’t be surprised if he turns out to be the biggest “risk” in my AMZN investment.

Vericel Corp (VCEL)

I started buying Vericel Oct 2017 in anticipation for revenues of their hot new product MACI (approved Dec 2016) to ramp up. The 3Q17 report in November was good and kickstarted some great momentum.

2018 was a solid year as the company grew MACI sales to $68 million, displaying nice incremental margins and expanding the target addressable market, among other things. VCEL shares +219.3%.

2019, on the other hand, was tough. I believe VCEL became more of a “show me” story. Revenue guidance for the year was not spectacular (mgmt. tends to sandbag, but still), and costs were rising to expand the salesforce, which wouldn’t be productive for some time. At $15-20, the stock was pricing in a fair amount of optimism, much more than what I saw in 2017-2018.

VCEL stock returned 0.0% in 2019 and -20.6% YTD. I trimmed some in 2019 and more in 2Q to get down to a less aggressive, more normal-sized position of ~5-10%. I still like VCEL, but in hindsight I spent too long holding and adding to what had become a very large position while putting far less capital toward more attractive opportunities.

Pair this with a couple blow ups in early-stage healthcare, and I have taken away a lesson.

I think there are very distinct narratives and investor bases in clinical/early-stage healthcare:

Stage 1 – pre-approval and commercialization – is all about potential. Investors look though the lack of fundamentals (reasonable) and focus on all that the company or product could be. The stock prices in hopes and dreams and does not discount much of the execution risk in commercialization.

Stage 2 – approval occurs and commercialization begins – we got approval, which it great, but now the hard part begins. Commercialization is expensive, and it’ll take time to ramp sales. The narrative quickly shifts from being all about potential to the long road ahead.

Coupled with a lack of patience, I have found stage 2 much more difficult than stage 1. Any future investment in early-stage healthcare will make sure to emphasize the narrative and where the company sits on the timeline from pre-approval to developed commercialization.

SPY (put)

Puts are new to me. I started buying these “insurance policies” Friday Mar 13 and have had a position on maybe ~2/3 of the time since. I have only bought in-the-money as I feel they are priced better for the type of protection I am looking for. They feel like less of a gamble vs out-of-the-money.

While I have realized gains on options, performance has been nothing to write home about. Puts contributed 1% of the 37.22% return in the quarter – positive April and May, negative in June. My biggest takeaway has been that timing sentiment is much easier around “bottoms” where there is more volatility (March, April) vs “tops” (June). Fighting momentum is hard, and while I have been bullish from March, I tried to play uncertainty and buy puts after strong runs. The strategy has only sort of worked.

I think about return on stress and effort as much as I think about return on capital. Option return on stress and effort the last month and a half was very low. Actually, negative. In just the last few days of writing this, I have watched my SPY put position go from +50% to -30%.

I plan to continue using SPY put options but need to be less hard-headed with my application. This last week has reminded me that I need to recognize gains when they come as greed can lead to a quick turn of fortune. Regardless, gains are gains. I made money playing the short side of the SPY, which returned +20.2% in the strongest quarter since 1998. I’ve gained some experience and will be better next round.

Blunders and Regrets

Fastly (FSLY)

I started buying Fastly in January and February, added some in March, and sold in April. Whoops.

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I first heard of FSLY on a Quantlayer podcast (episode 59). While not in my wheelhouse, Fastly sounded like a unique offering that could very well be part of the next wave in technology, and I didn’t sense that many people were aware of what Fastly is doing. I think of it like last mile delivery for content. Content providers must be fast and accurate if they want to attract and retain an audience, whose demands for “better, faster, now” will not subside.

I saw FSLY as a real beneficiary and envisioned a good 5-10 years of momentum for a trend like this. My blunder: almost every company that I buy either generates free cash flow or they are close to generating free cash flow. I need a line of sight to cash to feel comfortable making a purchase. FSLY is a ways from generating cash, and I didn’t do the work required to understand when that might happen. I understood enough to take a stab at the stock and left to focus on things closer to my wheelhouse. The lack of conviction also led me to part with shares very easily when my radar was full of opportunities in April.

The good news is that as I have grown, I am much better at letting things run by me that I don’t fully understand. Timing here was awful, but 2Q worked out just fine in aggregate.

Floor & Décor (FND)

Right in my wheelhouse. Got too cute on an entry price and didn’t buy. Whoops.

During summer 2017, I visited every flooring store that I could find in Dallas and came away thinking FND has the potential to be a hit. If you’re focused on hard flooring, Floor & Décor is the spot. FND carries the most SKUs, has by far the most in stock, and offers great customer service. Smaller shops like Lumber Liquidators and The Tile Shop just don’t compare, and Home Depot/Lowes are spread too thin to offer the product and service that you can get at FND.

Flooring is not e-commerce friendly and often requires consultation and/or visual engagement. You need a physical presence. The high fixed cost model thrives on same-store-sales growth and delivers significant benefits from scale. The company is led by Tom Taylor, who spent 23 years at Home Depot overseeing the United States and Mexico while the store base expanded from less than 15 to over 2,000 stores. Look at HD now.

FND plans to more than triple its store count to 400+ over the next 10-15 years. I think the ball is in their court. The only thing standing in their way is themselves.

I was eyeing FND through May in the low $40s, looking for $30s on market weakness. Didn’t happen. I am watching this one like a hawk.

New Position – Progyny (PGNY)

I’d like to highlight one company that only recently hit my radar and just as quickly joined the portfolio. I could see this position being much larger once I get my head wrapped around competition and valuation.

Progyny was an Oct 2019 IPO that provides fertility benefits management to large employers of more than 1,000 people – Alphabet, Amazon, and Microsoft are their largest clients as a percent of revenue. Partnering with Progyny has proven to not only improve clinical outcomes but also save employers 20-30% vs traditional health insurance carriers.

In addition, partnering with Progyny has led to better employee productivity, less absenteeism, and it helps diversity and inclusion programs. Fertility benefits have a strong social tailwind that should lead to them being more accepted, requested, and required.

Infertility (disease of the reproductive system) is a large, growing problem that I do not see slowing down, and it does not receive much attention, particularly in the United States. According to the World Health Organization, “the overall burden is significant, likely underestimated, and has not displayed any decrease over the last 20 years.”

These two resources do a good job laying out the state of the industry:

https://healthcareappraisers.com/birth-of-a-boon-the-rise-of-fertility-clinics/

https://www.fertilityiq.com/topics/fertilityiq-data-and-notes/fertilityiq-best-companies-to-work-for-family-builder-workplace-index-2017-2018

Progyny launched its fertility benefits solution with its first 5 employer clients in 2016 and now has 132 clients with 2.1 million members. Management notes an addressable market of 8,000 self-insured employers representing 69 million covered lives, and the space appears wide open for the taking.

Progyny has integrated with all the major national carriers and possesses a barrier to entry as a result. Carriers are not incentivized to partner with Progyny. Progyny’s pitch all along has been that the carriers’ fertility solutions are ineffective, so “some very influential clients” (likely among the big 3) ended up forcing the carriers to integrate. Further integration and deeper relationships will only strengthen Progyny’s position.

CEO David Schlager has said “when you look at the carriers as potential competitors, we’ve really seen no movement in the past 5 years..maybe it’s because the carriers are focused on the $3 trillion of health care expense that’s running through their companies and not the $12 billion fertility opportunity.”

Research suggests to me that carriers have essentially handed Progyny a runway that is superior to that of its competitors.

2 things that I particularly like about this business if we assume it can keep growing:

  1. Operating leverage. Progyny has experienced near 100% client retention, which reflects well on the company, and it also means they benefit from leverage in sales and marketing after some time. Customer acquisition costs are incurred primarily in the first year of a relationship and to a lesser extent in year two. If Progyny remains a leader, you’re looking at relationships (and revenue) lasting well beyond 2 years. I envision very sticky relationships here.
  2. Relatively predictable. Progyny revenue is a combination of enrolled members and utilization of benefits, both of which are fairly predictable based on current conversations and historical trends. Predictable revenue gives Progyny a low risk investment runway as it grows.

In sum, Progyny is growing like a weed in a space that isn’t getting enough attention. They are debt-free and generating cash under a business model that exhibits high quality characteristics. Progyny has a whole lot going for them, and a $2 billion market value may not price in enough optimism.

Wrap up + Call to Action

I’ve come to realize that stock picking and portfolio management are two very different skill sets, and I need to work more on the latter. Writing this letter is a step in that direction.

One might look at my returns since 2018 and say I’m doing just fine, but the going has been good! I had a great stroke of luck with Amazon and Vericel. In finding quality stocks, I believe the best homework is done at all time highs. I need to button up my portfolio management and do the same while the going is still good, because my strategy to date has largely been “winging it”. For all the time I spend researching companies, I spend very little thinking about the kind of bets I want to make.

In going through my filings, I found something I never would have admitted or even realized – I trade the bottom half of my portfolio a lot. I have a core of ~15 names that I am pretty set on unless the thesis changes. With everything else, I trade around “good enough” companies in which I don’t find enough optimism baked into the price, letting the cream rise to the top and adding as conviction increases. If something doesn’t work after enough time, I likely bail and swap into something new as there are always opportunities.

The bottom half of my portfolio really is on the chopping block with every trading day, but this is probably the highest quality portfolio I have had from head-to-toe. That may affect my activity. As long as I am cognizant of taxes, though, I have no problem trading around. Markets have had a strong recovery amid a ton of uncertainty. Having realized short-term taxable gains in 2020, I am more open to holding SPY puts knowing that if I am wrong and lose money, I’ll offset some of those gains, and my overall portfolio will likely be up with the index.

I plan to work on a couple things during 3Q:

  • Place my positions into thematic buckets. Right now, it’s mostly in my head. Find some way to measure and rank conviction. I need to improve on position sizing, which leads to the next..
  • Be more intentional and aggressive with position sizing. Naturally, as my portfolio has grown, my initial position size has increased, but some of my cost basis relative to conviction is terrible. I need to beef up the bottom so that AMZN doesn’t decide my fate.
    • HD is one of my oldest holdings with a great return, but the cost basis is at the bottom of the pack among my high conviction names. For as much as I talk about HD to friends, I’ve got to own more. I didn’t add much in March because it’s “cyclical”. I did the same with SHW. I am done with that nonsense.
    • SPGI is a high-quality company that I added in March but was careful as the business is highly correlated to GDP. I am now +65% and feel like it’s barely moved the needle. I would love to own more but watched it run from $200 to $300+ without doing a thing.

If you made it this far, I applaud your persistence. Thank you for your interest in letter #1. I am incredibly lucky and incredibly happy to be able to invest, write, and share ideas with others. Please do not take anything I say as investment advice because as I said above, I’ve been winging it to date.

Watsco Inc. (NYSE: WSO)

Watsco is North America’s largest distributor of heating, ventilation, air conditioning and related products (HVAC/R), owning > 10% of a $40 billion distribution market, 3x the share of the #2 player.

Watsco is a prime example of what it means to be a member of the Good Business Repository:

  • They’re a leader in a relatively predictable industry that is not sensitive to the economy
  • The model generates consistent returns above the cost of capital, producing cash flow that allows for acquisitions and a growing dividend
  • Management has significant skin in the game with good long-term incentives in place

Watsco has 603 locations in 38 US states, Canada, Mexico, and Puerto Rico, with additional coverage via exports to portions of Latin America and the Caribbean. The company’s most significant markets lie in the “Sun Belt”, with the highest concentration in Florida and Texas – the largest HVAC markets.

Watsco is in the business of providing products and services to approximately 90,000 HVAC contractors employing 500,000 technicians who, in turn, serve homeowners and businesses. Watsco’s revenues in HVAC distribution have increased from $64.1 million in 1989 (when the company shifted its focus from manufacturing to distribution) to $4.5 billion in 2018, representing a 29-year CAGR of 16%.

Industry

Large, fragmented, replacement-driven markets provide the opportunity for steady long-term growth. The North American HVAC market is serviced by 1,300 independent distributors, the majority of which are second and third generation owned. Business is ~70% residential replacement, 20% commercial, and 10% new build. The primary replacement markets are in less weather-sensitive geographies where HVAC use is more frequent and consistent, which is why Watsco focuses on the Sun Belt (~60% of North America).

The installed base of HVAC units has grown at a 3.6% CAGR since 1980. The US alone has ~115 million installed A/Cs and furnaces, 92 million of which are over 10 years old.  Systems last 10-15 years and the current installed base took 40-50 years to build = solid replacement runway.

Heating and cooling account for 1/2 of the energy consumed in a typical US home. Older systems operating below government-mandated energy efficiency and environmental standards give Watsco opportunity to accelerate replacement at greater scale vs competitors. Big picture, HVAC systems are trending from centralized units toward ductless systems, and the US is well behind the rest of the world in this transition. Roughly 80 million of the 115 million systems in the US are centralized.

Demand for HVAC products is seasonal, with greater demand for residential air conditioning in 2Q and 3Q and greater demand for heating equipment in 4Q. Demand in the new construction market (small % for WSO) is fairly even throughout the year and depends on housing completions and weather conditions.

HVAC equipment is manufactured primarily by 7 companies that together account for ~90% of the US market: Carrier, Goodman Manufacturing, Rheem Manufacturing, Trane Inc., York International, Lennox International, and Nordyne. These manufacturers distribute their products through a combination of factory-owned locations and independent distributors who, in turn, supply the equipment and related parts and supplies to contractors and dealers that sell and install the products.

Watsco sells equipment from 5 of these major OEMs along with equipment from 15 other smaller vendors. They do not sell products from York International (Johnson Controls) or Lennox International. Watsco also sells a variety of non-equipment products from ~1,200 vendors and commercial refrigeration products from ~150 vendors.

Business Strategy

Watsco built its network of locations using a “buy and build” philosophy, which has produced substantial long-term growth in revenues and profits.

Watsco has benefited from the valuation multiplier effect of small M&A, acquiring 60 HVAC distribution businesses since 1989 without ever hiring a banker or paying a fee. Significant returns have been earned from valuation arbitrage, buying businesses for 5-7x trailing EBIT, while WSO has traded at > 10x EBIT since eclipsing $100mm in operating income.

Acquisition risk is low as Watsco is buying long-established businesses. Watsco simply provides the capital, relationships, and technology for growth.

“There’s always been a consequence, if you will, of the fact that OEMs approve who can buy a distribution company, there’s veto power over who has the sustained distribution rights in a transaction” VP Barry Logan, JPM conference March 2019 = significant barriers to entry.

Fueled by a Conservative Balance Sheet

“Our conservative mindset toward debt and maintaining a powerful balance sheet provides the safety and the flexibility to take advantage of any-size opportunity especially during periods of economic volatility” CEO Albert Nahmad, 3Q18 call.

Outstanding debt (excluding operating leases) is less than 0.5x EBITDA. It has never been > 2x EBITDA.

In July 2009, WSO formed a JV with Carrier (Carrier Enterprise I), purchasing 60% controlling interest + options to acquire another 10% in 2012 and 10% in 2014. Both options have been exercised. This has been the largest acquisition in the company’s history, right around max pain for the market. WSO has since formed Carrier Enterprise II and III with similar terms.

Watsco paid 9x $30 million profit for the Carrier JV. The JV now produces over $200 million in profit.

Carrier’s 2nd largest customer behind Watsco is Russell Sigler, the 4th largest distributor in the industry. In 2017, Carrier Enterprise I bought 34.9% of the company, and the JV has since inched up its stake to 38.1%. Watsco has the exclusive right to buy whatever remainder the family is willing to sell.  

Long Acquisition Runway

The HVAC business took off in North America following WWII with the advent of affordable central heating and AC systems for residential settings (credit Henry Galson). Such a boom has occurred in Latin American and Caribbean countries in recent years as residential HVAC has become less of a luxury and more of a necessity.  

See this article for a nice little history of air conditioning in the US.

Of the 1,300 independent HVAC distributors in North America, 99% are family owned. Because the industry is ~60-70 years old, many of these businesses are now second and third generation owned. On average, these businesses are doing maybe $30-$50mm in revenue per year. This is Watsco’s target.

Good Business? Yes.

The installed base increases every year, and “machines don’t care” when it comes to the economy, consumer sentiment, etc. Watsco has a relatively straightforward growth runway – do the same thing over and over. Selling the same product to the same customer type in new geographies suggests relatively high odds of growth materializing.

HVAC products and services are not DIY – contractors are the decision-makers and are not price sensitive. Watsco has close relationships with OEMs as they are the largest customer in most cases yet “still far from reaching [their] full potential in scale” Al Nahmad, 4Q18 call.

Watsco’s distribution model and scale have created a lucrative cash-generative model with low reinvestment needs, leading to impressive returns on assets and invested capital.

This has fueled a dividend that has grown at a near 15% CAGR since its initiation in 1985 ($0.0564 -> $6.40). Dividend growth continued through the financial crisis, and the last 10 year CAGR has been 13%.

“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.” Warren Buffett. Watsco stock has added over $5 in cumulative market value for every $1 increase in retained earnings.

Good Management + Proper Long-Term Incentives

CEO Albert Nahmad has fostered an owner/operator management team and culture since 1972.

Nahmad’s de-centralized approach to acquisitions and management has led to strong positions in local markets. “We’re an M&A company…we don’t try to change cultures, we don’t try to change leaderships, we just want to support and to do more and provide capital and provide additional products and whatever and technology and whatever else they might need” Al Nahmad, 1Q19 call.

There’s very little private equity in HVAC distribution after a firm “destroyed one of [Watsco’s] peers about 15 years ago…they went to a very centralized, synergized business model where they bought a lot of eclectic local business, tried to assemble it into one thing and it went out of business…for Watsco, we bought 60 businesses, there’s not one of them that says Watsco” Barry Logan, JPM conference March 2019.   

Al’s son AJ is currently the President and has been with the company since 2005. Each of the top 30 employees has been with Watsco for an extended period, often greater than 20 years. The company has a unique equity inventive plan in that restricted stock granted to executive officers and 55 other key leaders does not vest until the employee is at the end of his/her career, usually 62 and older.

Among the executive officers, 97% of restricted stock awards have not yet vested. Al’s stock does not begin vesting until 2022, and AJ’s does not begin until 2043.

In all, Watsco’s long-term share-based incentive compensation plan has 230 participants. Insiders and employees together own almost 15% of shares outstanding.

Unique Board of Directors

Watsco is considered a “controlled company” by the NYSE as Al Nahmad controls 52.2% of the voting power. Because of this, Watsco isn’t subject to certain corporate governance policies such as majority independent directors. 7 of Watsco’s 12 board members are independent as they still do elect to maintain a majority. Regardless, this is something that proxy voting services would likely flag.

I have no problem with this. I’d prefer that the directors have some skin in the game when it comes to making decisions. Outside opinions are important, but you see many boards that are entirely independent. I think these boards are at risk of being too disconnected from the business.

Going Forward -> Investing in Technology

“I get asked often what will this industry look like in five years or so? And my answer is that there is going to be the haves and have nots and the differentiator is going to be technology, and that’s going to be true at the distribution level and at the contractor level” Al Nahmad, 1Q19 call.

Watsco’s size enables significant long-term investments that small fragmented competition cannot afford. Nearly half of the company’s capital expenditures are currently going toward computer hardware and software, and while increased technology spend has been reflected in little-to-no margin expansion, clear benefits have shown through this chart posted in 2Q18:

“We’re seeing customers that use our apps and technology grow at 3 times the growth rate of our customer that’s not using technology. We’re seeing attrition be a fraction year-over-year for users versus non-users” Barry Logan, William Blair conference June 2019.

Watsco works with approximately 90,000 contractors and notes just 12,000 active online/app users. The runway ahead is long.

These investments in the supply chain, mobile, and e-commerce will ultimately create stickier, longer-lasting relationships with contractors and their customers. If technicians can complete more jobs in a day, contractors will be more efficient and profitable, and contractor loyalty will increase.

I think Barry sums up the attractiveness for contractors and homeowners well:

“We bought a company in April in New Jersey called DASCO, $57 million company that is dominant in that market. The owner we’ve been in touch with for 20 years reached a point where he got the technology. He brought his team to Miami to hear it, and I believe it made the difference in joining after 45 years of independent ownership” Barry Logan, UBS conference June 2019.

These are the types of benefits that cannot be calculated but further justify a premium valuation.

What Might the Long-Term Model Look Like?

What I like most about Watsco is the relative predictability of the business. I think you can confidently model out a happy medium type scenario that could point to buying opportunities when the stock sells off (see end of 2018 / early 2019).

I feel obligated to answer the question…if Watsco is such a fantastic company, why did the stock sell off nearly -31% peak to trough to end 2018? (S&P 500 -20%).

Northern HVAC companies put up exceptional summer metrics on warmer-than-usual weather. The HVAC industry saw double-digit increases in the North, while the Sun Belt was rather flat. Add in a historically rich valuation with dampened near-term earnings growth, and shares traded down. The good news is that I believe this presented an opportunity to purchase shares of a best-of-breed business + management team in an economically insensitive industry.

On to the model, revenue growth should remain at GDP+ levels over cycles. Replacement runway exists (volume) and price should work in Watsco’s favor (trend toward more energy efficient systems + efficient equipment costs more + distributors easily pass price through to contractors). Longer-term, I envision a mismatch between the supply of labor and the consistent demand that will exist for contractor services. This, too, should be a positive for Watsco.  

“The only thing we’ve found over the last 30 years that we’re steady. Sometimes we grow at a faster rate and in other times, but we always grow…I wouldn’t be happy with 3% growth rate in revenue.” Al Nahmad, 4Q18 call.

Operating margin expansion was strong coming out of the financial crisis, and it’s clear that things have slowed down since Watsco began committing to technology investments in 2014/2015.

Watsco is starting to show flat same-store SG&A. The entire increase in 3Q19 SG&A ($11.5mm) was attributed to 35 new and acquired locations. Barry has said that historically 60% of SG&A is variable – my math suggests more like 75%, but I think he is talking about same-store while I am looking at the total number. Regardless, when looking at my projections, know that I am using 75% to project operating expenses.

Al’s long-term operating margin target is > 10%. Many locations are already there. Regions with smaller market share / newer locations are not. I don’t use anything close to 10% in valuing Watsco because I don’t have near that kind of foresight. I consider it potential upside.

Summary: What Makes Watsco Special?

  • Leading distributor with significant benefits from scale – relationships + data + technology
  • Economically insensitive industry – “machines don’t care”
  • Family owned and operated + proper incentives – long-term focus
  • Conservative balance sheet – always acquisition-ready
  • Cash-generative model with low reinvestment needs – growing dividend

Risks

  • Watsco’s top 10 suppliers account for 84% of the company’s purchases, with Carrier accounting for 62% and Rheem 9%. In calls management doesn’t seem too concerned about UTX spinning off Carrier in 1H20. The 10K states “It is too early to determine whether the proposed spin-off of Carrier will have any impact on us and our results of operations”. I don’t foresee any problems, but business is changing at Carrier…and Watsco does a lot of business with Carrier. This could actually turn out to be a positive as Carrier will have a new mandate for growth as an independent company. The existing JV agreement is perpetual and exclusive in 30 states + Canada, Mexico, and the Caribbean. Regardless, I don’t think Carrier will get into distribution:
  • Directors possess 56% of the voting power. Family ownership combined with good long-term incentives across executive leadership suggest this is okay, but the past is no indication of the future. Prospective common shareholders may not like the lack of voting power.
  • Equity dilution. Watsco does have a share repurchase program, but they haven’t used it since 2008. They tend to issue shares at the market to help fund acquisitions.  

Valuation

Promising numbers and commentary from last few quarters have the market once again baking in GDP+ growth and margin expansion, putting the stock back at or near an all-time-high valuation on many measures.

This isn’t alarming, but the market is clearly starting to bake in a positive future as you can see in the simplified DCF model below – revenue growth > GDP and operating margin expansion.

Also, notice how much of the DCF’s value is coming from the later stages – Stage 2 (years 6-20) and the Terminal Value (years 20+). This is the opposite of what you’ll commonly find baked into “deep value” stocks, where the market is pricing in little to no confidence in the terminal value = there’s a chance this company loses its competitive edge / goes extinct.

To the question “how much optimism is baked into the price”, my answer is “a good amount.” It’s enough to keep me from recommending the stock at today’s price.

That said, there are a few positive things to note:

  1. Do remember that with a DCF model, if the future pans out exactly as predicted (it won’t), you can still expect to earn the cost of capital (7.5%) + dividend (~3.5%) annually. That’s not bad. Watsco’s business and management team have proven reliable. I have no problem buying a stock around “fair value”, particularly if I think the potential for an upside surprise outweighs the potential for a downside surprise.
  2. If Watsco continues to grow organically + acquire smaller businesses, 3% FCF growth beyond 2023 will prove conservative. I’ve chosen 3% because it is a floor I believe I can count on, but I could be grossly undervaluing the company in the mid-term.
  3. I trust that Watsco can hit 9% EBIT margins with time, I’m just not ready to make that call right now. 9-10% EBIT basically guarantees that Watsco has taken share and grown beyond $6 billion in revenue. Such a combination would likely send the stock above $200.  

Watsco is worthy of a spot on the Mount Rushmore of distribution companies. Stocks like these do not come cheap, and they are rarely “screaming buys”. I believe that homework on such companies is best done at all-time highs so that when things do get messy, I can confidently take action.

I am long shares of WSO and would be happy to add more, but I believe the opportunity cost is too high at the current price. I would start getting interested again in the mid $160s.  

Vericel Corporation (NASDAQ: VCEL)

Vericel is a leading producer of autologous cell therapies with two unique FDA-approved products: MACI for cartilage defects in the knee and Epicel for severe body burns. The company has also signed an exclusive license and supply agreement for NexoBrid, a registration-stage product for the debridement of severe burns with an expected commercial launch in early 2021.

Background: Aastrom Biosciences -> Vericel Corporation

Vericel began as Aastrom Biosciences (IPO 1996) with a focus on cell therapies produced from a patient’s bone marrow. The bottom fell out as the company did not get particularly compelling results. The FDA also gave hospitals a long list of rules and regulations to use bone marrow therapies. Hospitals ultimately ended up saying “no thanks” and stopped buying Aastrom’s marrow machines.

Aastrom pivoted toward cell therapeutics, focusing on ixmyelocel-T for the treatment of advanced heart failure due to dilated cardio myopathy. After doubling-down on small clinical trials, Aastrom found that this, too, was a tough model.

In early 2013, Aastrom effectively cleaned house and hired Nick Colangelo to be the new CEO.

In 2014, Aastrom acquired MACI, Epicel, and Carticel from Sanofi for $6.5mm as part of the legacy business leftover from their $20b acquisition of Genzyme. At the time, the business had declining revenues and negative gross margins. MACI was still in development stage, and Epicel wasn’t being invested in. Carticel was the main product, a first-generation, second-line autologous therapy for cartilage defects in the knee. Carticel was discontinued in 2017 following FDA approval and launch of MACI (December 2016 / January 2017).

Following the acquisition, Aastrom changed its name to Vericel Corporation and moved the headquarters to Cambridge, Massachusetts, initiating a transformation from a clinical-stage company to a commercial-stage biologics company.

Product Overview

MACI is a minimally invasive first-line implant for the treatment of cartilage defects in the knee. It is the only FDA-approved product (Dec 2016) that applies the process of tissue engineering to grow cells on scaffolds using healthy cartilage from a patient’s own knee.

The process begins with a tic-tac sized biopsy, which is sent to a lab for 4 weeks to grow and form more cartilage. If the patient elects to get surgery, the membrane with the new cartilage is then put back into the knee. Vericel earns revenue separately on biopsy kits and MACI implants.

Cartilage has limited intrinsic healing capabilities. An injured patient has three basic options for care:

1. Chondroplasty (palliative care) relives pain, but it does not address the underlying injury.

2. Microfracture (reparative care) is the most common procedure. The surgeon drills small holes into the bone, and bone marrow fills the defect. This ultimately produces fibrocartilage (“scar cartilage”) which lacks the durability of normal cartilage and has proven to be a relatively poor solution for medium to larger lesions.

Another reparative option is an osteochondral allograft (OCA), typically performed after a failed microfracture. This is cadaver-based, where the surgeon is mincing a corpse’s cartilage to plug a defect. With OCAs, the supply of grafts is often limited, and the procedure is highly invasive. Clinical trials have also not been run as tissue bank products are not well regulated.  

3. Autologous (restorative care) produces a more durable hyaline-like cartilage that is naturally present in the knee, leading to a more durable, longer-lasting treatment. The only current option in this space is ACI – Autologous Chondrocyte Implantation.

Data from the SUMMIT trial and follow up Extension study demonstrated statistically significant improvement from MACI over microfracture in terms of pain and function over 2 and 5-year periods. The Orthopedic Journal of Sports Medicine published another study in July demonstrating high levels of patient satisfaction and tissue durability beyond 10 years after an accelerated weight-bearing rehabilitation program. 

Patients are typically able to get back to full weight bearing in 6-8 weeks.

As a biologic, MACI has data exclusivity through 2028. There is no generic pathway to enter the market. A competitor must go through clinical trials.

MACI Competition

In the ACI space, MACI had a potential competitor in Histogenics’ NeoCart, but the therapy failed to meet its primary endpoint at the one-year mark in Phase III trials. Histogenics has since dissolved and sold NeoCart to Medavate.

Aesculap Biologics is currently performing a Phase III study for its product NOVOCART 3D in comparison to microfracture. Expected completion is May 2021.

Other competing products are cadaver-based. Zimmer Biomet markets a product DeNovo NT that does this with juvenile cartilage, but there is no clinical data yet to support the procedure.

As the only approved regenerative therapy for cartilage, MACI is alone in its class with a head start. Management sees no competition until “mid next decade”.

MACI Market Potential

Of the 750,000 cartilage procedures performed annually, Vericel narrowly defines an addressable market of 60,000 patients with large lesions who are likely to secure authorization for MACI. At ~$40,000 per surgery, 60,000 patients create an opportunity greater than $2 billion. More than 90% of covered lives in the US have access to MACI as all the top health plans have a policy.

After initially targeting 3,000 sports medicine surgeons, management has increased the target audience by 2,000 to include other orthopedic surgeons that do high volumes of cartilage repair. 1,300 surgeons have submitted biopsies in the last 12 months (+26%). This is a key leading indicator, and additional growth will come from increasing the number of biopsies per surgeon as well as improving the biopsy to implant conversion rate, which is how the sales force is incentivized.

Through the first half of 2019, Vericel had more implanting surgeons than it had in all of 2018.

Vericel’s sales force is the primary driver for MACI adoption and expansion. In the 3Q19 call, management announced the largest sales force expansion to date, highlighting the success thus far and opportunity ahead. The 48-person salesforce will grow to 76, and it will cover 9 regions versus an original 6. Reps are hired in 4Q, trained in 1Q, and enter the field in 2Q. Management expects productivity per rep to dip in 2020 before reaching new highs in 2021.

MACI sales are strongest in 4Q due to insurance timing and patient preference to rehab in the winter.

Epicel    

Epicel is a permanent skin replacement for burns covering more than 30% of one’s total body surface area (TBSA). It is the only FDA-approved permanent skin replacement for adult and pediatric patients with full-thickness burns. With Epicel, Vericel is able to take a post-stamp size biopsy of healthy skin and grow enough skin in two and a half weeks to cover a patient’s entire body. The manufacturing process is similar to MACI.

Autografts have traditionally been the go-to treatment for catastrophic burn patients, but for particularly large burns (> 60% TBSA), there is often not enough healthy skin to do repeat autographs. The skin required for an autograft is typically minimum ~75% the size of the burn.

A 25-year study published late 2018 in the Journal of Burn Care and Research demonstrated markedly increased survival rates for patients treated with Epicel at a mean 67.5% TBSA.

In February 2016, Vericel secured a pediatric label expansion for Epicel, expanding the market size and allowing the product to be sold for a profit.

Epicel Competition

In September 2018, the FDA approved Avita Medical’s RECELL to treat burns in patients 18 years and older. RECELL uses a small amount of a patient’s healthy skin to produce a spray-on-skin in as little as 30 minutes. One RECELL kit can treat a ~10% TBSA burn, and its relative cost is cheaper than Epicel at about $5-10k per unit. A credit card size skin sample can treat an entire back.

A key differentiator is that clinical data does not exist to support burns > 50% TBSA. 

RECELL launched in 1Q19 into what management initially views as a $200 million market opportunity in the US, with potential to expand to $2 billion. The product has quickly gained traction, as 56 of the 132 burn centers in the US placed orders in 2Q 2019. Avita stock (NASDAQ: RCEL) currently trades at a $900 million valuation, well above VCEL.

Epicel Market Potential

There are 40,000 hospitalized burn patients every year. About 1,500 fall within the Epicel label, but Vericel is typically treating burns > 40% TBSA, a category of about 600 patients annually. The average Epicel order is a couple hundred thousand dollars, so this equates to a $100mm opportunity.

Epicel remains underutilized to date due to lack of consistent promotional effort prior to Vericel’s acquisition of the product. Vericel has since grown the salesforce from 1 representative to 9.

Vericel is currently only treating about 100 patients per year with Epicel in ~40 of the 132 burn care centers in America. They’ve recently increased the Epicel salesforce (6 to 9) and hired clinical specialists to grow the customer base and develop deeper relationships at burn centers.

Epicel sales are volatile and difficult to predict, but demand is typically strongest in 4Q and 1Q when the weather is cold and people are building fires, using heaters, etc.

NexoBrid

In May 2019, Vericel entered into an exclusive license and supply agreement with MediWound to commercialize NexoBrid in North America. NexoBrid is a topical product that enzymatically removes dead tissue (eschar) in burn patients without damaging healthy tissue. This initial step applies to almost all 40,000 hospitalized burn patients whose current standard of care is a surgical procedure that leads to healthy tissue loss and blood loss, but the product focuses on the other end of the spectrum for Vericel – patients with burns less than 30% of TBSA.

Vericel is targeting a BLA submission in 2Q20, and pending approval, launch in the first half of 2021. In the meantime, the companies have announced an expanded access treatment protocol (NEXT) to allow for continued use of NexoBrid to treat patients and further familiarize physicians and burn centers.

Vericel will pay MediWound $7.5 million upon approval and up to $125 million if certain sales milestones are met. The first milestone payment of $7.5 million will come when NexoBrid sales surpass $75 million. Vericel will also pay MediWound HSD/LDD percentage royalties.

MediWound is obligated to supply NexoBrid to Vericel on an exclusive basis for five years.

The addition of NexoBrid has potential to more than triple the size of the burn franchise’s addressable market to over $300 million.

NexoBrid Competition

Smith & Nephew market Santyl, the only currently approved enzymatic debriding product. While Santyl can be used for partial thickness burns, it focuses more on ulcers and wounds. Clinical data does not exist for the application of Santyl on burns.   

Investment Thesis

Almost 3 years into the MACI story, Vericel appears to be hitting its stride as the management team just announced the largest sales force expansion to date. Vericel has a virtual monopoly in an underpenetrated articular cartilage market, and I expect compounding benefits as MACI adoption and awareness grows.

Current studies focus on new therapy X vs microfracture. Absent of head-to-head data against MACI, many surgeons will be hesitant to switch, and the multi-year commercial head start for MACI offers a significant barrier to competitor adoption.

While Epicel is not a home run product and does face competition, it does well in a niche segment and is a revenue source that is not economically sensitive. NexoBrid increases Vericel’s addressable market in burn care and should lead to deeper relationships in the space.

There is a clear runway for growth with an operating model characterized by high incremental margins (80% GM, 50% EBITDA) and limited capital investment needs. They’re at an inflection point of profitability and consistent cash generation, and I believe the 3Q19 surprise in operating cash flow was a sign of things to come.

The combination of difficult-to-predict sales and usually conservative guidance has led to consensus estimates that appear beatable. Operating leverage may continue to surprise going forward.

Catalysts

4Q19 – 28 new MACI reps are hired and begin training

2Q20 – New MACI reps enter the field

2Q20 – BLA submission for NexoBrid

1H21 – Potential commercial launch of NexoBrid

Commentary

“Since acquiring this business five years ago we’ve more than doubled the volume of MACI and Epicel without any material increase in fixed costs. As a result, we consistently increased gross margins, a trend we expect to continue given that we can meet forecasted demand for several years without significant capital investment . The increase in gross profit combined with the operating margin leverage resulting from our high sales force productivity gives us confidence that we’re well positioned to generate strong profit and cash flow growth in the years ahead” CEO Nick Colangelo, 3Q19 call.

“We expect to maintain strong double-digit revenue growth in the years ahead, and based on the operating leverage of our business to generate gross margins in the mid 70% range and operating income 20%-plus range in the next few years” CEO Nick Colangelo, 3Q19 call.

Beatable 4Q19 (Report late Feb / early March 2020)

Guidance provided in the 3Q19 call was for full-year net revenues of $116 – $118 million. MACI revenue growth of 35-36%, implying 33-36% in 4Q. Epicel growth of 10-15% for the full year. 4Q gross margin in the mid-70s, bringing the full year gross margin to approximately 68%. Full year operating expenses including the $17.5mm NexoBrid payment (2Q19 R&D) will be approximately $92 million.

Consensus estimates call for 4Q revenue of $39.15 million, a gross margin of 73.3%, and net income of $8.777 million. I think each of these is beatable.

Management has been conservative in its guidance, consistently increasing revenue as the quarters pass. Quarterly estimates have proven low, which is why I project a modest beat in my 4Q19E numbers.

I back into 4Q MACI revenue using the high end of management’s guidance for 35-36% full year. In 2Q they guided for 37-38% of the year’s revenue coming in 4Q. 35.8% growth in 4Q implies 37%.

Projecting Epicel is difficult, but the sell-side expects a drop y/y. I’m seeing estimates for $5.8mm, -6.8% for the quarter, which would hit the midpoint of guidance for full year +10-15%. 3Q was exceptionally strong, but those sales have no effect on 4Q demand. The Epicel sales force is now double the size that it was when 4Q sales were last below $6mm (4Q16). I think guidance may be conservative yet again.

On to 4Q gross margins, management set expectations for 4Q in the mid-70s and full year gross margin of approximately 68%. Management regularly touts their incremental margin profile – 80% gross margin, 50% adjusted EBITDA (aggressively defined). In the past, they’ve talked about 15-20% marginal cost of goods. It’s been showing in the numbers, and 3Q was a surprise to analysts. Again, a likely conservative guide:

The sell-side estimate is below guidance:

I believe 68.5% gross margin can be expected for FY 2018, as that would imply 74.2% in 4Q and an incremental GM of 80.2%, which has proven possible. This would lead to a full year incremental GM of 81.3%, below 86.3% over the last twelve months.

Finally, 4Q net income is projected to be $8.777 million (range $8.2mm – $9.58mm). I think this is a fair number but certainly beatable if revenue and/or margins surprise.

Beatable Longer-Term

If an ~80% incremental gross margin proves sustainable, these estimates will have to move closer to the margin profile that Nick talked about in the 3Q call (highlighted above under “Commentary”).

Risks

  • Vericel is protected by limited IP. Epicel is not patent protected, and only portions of the MACI process are still patented. While trade secrets, the long trial process, and commercialization are barriers to entry, companies with know-how in cellular regeneration could produce a competing product.
  • Heavy competition is on the way. Aesculap’s NOVOCART 3D is due to complete phase III trials in May 2021. It is unknown how long the product could take to reach the market if approved. Other different but one-step (vs MACI two-step) therapies will continue to receive significant investment and research.
  • Breakdown in expected operating leverage. Vericel hasn’t shown enough to prove the operating leverage in the model over four quarters, which is part of why shares trade at a discount to more profitable peers. Without operating leverage, revenue growth and incremental gross margins will not be enough for investors.    

Valuation

VCEL shares trade at 4.9x EV/Sales on a blended forward basis, below an average ~5.2x EV/Sales since a blowout 4Q17 report in March 2018.

Since March 2018, VCEL has:

  1. More than quadrupled its addressable market for MACI from 11,000 patients to 60,000 patients, representing an increase of over $1.5 billion in market opportunity (Aug 2019)
  2. Tripled its addressable market for the burn care franchise with NexoBrid (May / Aug 2019)
  3. Primary competitor NeoCart failed its phase III trial, delaying commercialization of competition (Sept 2018)
  4. Raised $74.8 million in equity (May / June 2018) 🚩
  5. Began generating cash flow and has paid off all debt

Increased estimates + equity dilution have justified a flat multiple over the near-term, but Vericel’s medium and long-term prospects have improved.

At 4.9x EV/Sales, VCEL trades at a discount to other high-growth MedTech peers (7.7x). Removing the larger more profitable companies (ISRG, EW, ALGN) leads to a more homogeneous group trading at 6.7x. This implies a valuation range of $20-23 for VCEL.

I expect shares to outperform over the next few years through better-than-expected results and a multiple re-rating, leading to a price target of $22. Analysts should be able to value the company on more of a profitability and cash flow basis come 2020/2021.