One of the investors we watch closely here at The Acquirer’s Multiple is Alexander Roepers, the founder of Atlantic Investment Management.
The firm’s investing methodology is differentiated by its: (1) well-defined universe of quality publicly-traded industrial / consumer companies; (2) concentration of capital and research on its highest conviction investments; (3) private equity-like due diligence; (4) constructive engagement with managements and boards to enhance and accelerate shareholder value; (5) strict adherence to its buy/sell cash flow focused valuation discipline; and (6) maintenance of liquidity to allow for opportunistic trading around core positions.
One of the best Roepers interviews was one he did with Value Investor Insight in 2007 in which he discusses his investing strategy and the types of businesses he targets. Here’s an excerpt from that interview:
Since you started out in the business you’ve focused on quite a narrow investment universe. Why?
Alexander Roepers: I realized early on from watching people like Warren Buffett and some of the early private equity players that if I was going to stand out, I needed to concentrate on my highest-conviction ideas, in a well defined set of companies that I knew very well. As a result, I limit my universe inside and outside the U.S. in a variety of ways. I want liquidity, so I don’t look at anything below $1 billion in market cap. I want to have direct contact with management and to be a top-ten shareholder in my core holdings, so anything above a $20 billion market cap is out.
Because five or six unique holdings make up 60-70% of each of my portfolios, I also exclude companies with idiosyncratic risk profiles that I consider unacceptable in such a concentrated portfolio. That means I exclude high-tech and biotech companies with technological obsolescence risk, tobacco or pharmaceutical companies with big product-liability risks, utilities and other regulated companies where the government can change the rules of the game, and companies that lack sufficient transparency, like banks, brokerages and insurance companies.
Then we boil it down further into potential “core” longs and “other” longs. Core longs are those in which we can own 2-7% of the company and have a close, constructive relationship with management. Overall, the potential universe of core holdings has around 170 companies in the U.S. and about 180 outside the U.S. These are the stocks that drive our performance – we’ve made our record by finding our share of big winners among these core longs while avoiding almost any losers. Our most-concentrated U.S. fund, which holds only five or six stocks, has had only one losing investment since we started it more than 14 years ago.
Describe the types of companies that do make the cut.
AR: They’re typically industrial products and services companies, like defense suppliers, packaging firms and diversified industrials. We favor companies with transparent businesses that we can understand fairly quickly and those that have large and recurring maintenance, repair and overhaul revenues from an installed base, such as elevator companies or aerospace-parts firms.
We require strong balance sheets and a long record of profitability, so we’re not usually investing in classic turnarounds. The stocks are cheap because they’ve hit a speed bump of some kind – from a messed-up factory changeover, an unusual competitive pricing issue or maybe some kind of commodity pricing pressure – but we think we can understand the problems and anticipate that the issues are solvable or going away.
We also put a lot of emphasis on the sustainability and predictability of the business. Our companies tend to be in industries that have consolidated, with only two, three or four leading players. For example, we’ve owned Ball Corporation [BLL], the packaging company, as a core long four times over the past 14 years. Ball’s customers require a global scale that only a very few companies can have and, if a competitor doesn’t have it, it’s likely to go away. We can’t take that type of risk in a concentrated portfolio.
How do you generate specific ideas?
AR: With a narrowly defined universe, the ideas typically just fall in our lap. We have what we call a signal system, which tracks hundreds of companies against valuation metrics and historical trading levels. Our primary input is to make sure we have all the right companies in the system and then set the triggers for each company at which we think it deserves a closer look. So if a Constellation Brands [STZ], for example, falls 10% in a day as it did last month, we’ll put someone on it right away. I’ve got an analyst reviewing the company as we speak.
I sit down three or four times a week with all of our analysts and go through the system and make to-do lists. It’s my favorite and most productive time and it’s a disciplined way to ensure we don’t miss things.
I’ll give you a good example of one of our typical investments, in Sonoco Products [SON]. Sonoco is a 108-year-old company in South Carolina that makes industrial and consumer packaging, such as composite-paper cans for Pringles or flexible packaging for Gillette shavers or Oreo cookies. I had watched the company for 10 years and the fabric of the business is just what we look for: it has never lost money, has paid quarterly dividends since 1925, has 250 facilities around the world and has no major technological obsolescence risk.
The problem was that it was never cheap enough, until about four years ago when they had problems in some of their more cyclical businesses and had pension fund losses that hit earnings. The stock fell by a third, the dividend yield got to 4% and we started buying around $20. It may be a boring business, but they were well-positioned, continued to execute very well and the temporary problems got better.
On top of that, with some fairly strong urging on our part, they started last year buying back shares in
volume with excess cash flow. As the share price recently started hitting all time highs, we sold almost all of our position. [Note: Sonoco shares currently trade around $37.]
On what valuation metrics do you focus?
AR: We want to see at least a 10% freecash-flow yield and a 6x or less multiple of enterprise value to next year’s earnings before interest, taxes, depreciation and amortization [EBITDA]. For enterprise value we use the current market value plus the estimated net debt 12 months out. Most of the companies in our universe generally live within a range of 6x to 8x EBITDA. The idea is to identify companies having some earnings or other trouble that leave them trading at the low end of the valuation range.
If our analysis is right that the difficulties are temporary, we get two boosts: from earnings recovering and from the market reacting to the earnings recovering and moving the multiple to the higher end of the range. We believe that dynamic gives all our core positions a very high probability of at least a 50% return within two years. At the end of the day we’re trying to buy companies as if we were buying a $10 million office building across the street.
We do our homework on the tenants and the leases in place and make sure it’s financed in a way that produces a 10% free-cash-flow yield. The idea is to increase equity by paying down debt with the free cash flow and also to benefit from the asset appreciating over time. With stocks, if you focus on companies with around 10% free cash flow yields and highly predictable, sustainable franchises, you protect your downside and set yourself up for nice capital appreciation.
What kind of a sell discipline do you typically follow?
AR: We try to keep it fairly rigid. When a holding hits some combination of 8x EBITDA, 12x EBIT or 15x forward earnings, we’re going to start selling. That means the shares are in the top end of their valuation range and we can’t expect enough further upside. When Sonoco hit a 15x forward P/E there was just no further reason for us to be in the stock.
Same with Black & Decker [BDK], which we also recently sold after a good run. Not only did the valuation get relatively high, but we became increasingly concerned about the company’s exposure to a housing market that is likely to be troublesome for some time.
Central to your strategy is to have position sizes that ensure an active dialogue with management. Why?
AR: Being an activist has taken on a bit of a negative connotation in the past few years, but we absolutely want to be constructively-engaged shareholders. We have 10-15% of our capital in each of our core companies, so I just think it’s imperative that we make our views, particularly with respect to capital allocation, clear. For the most part, management appreciates the faith we’re placing in their business and in them to get the stock out of the valuation hole it’s in.
And when they don’t appreciate it?
AR: When management is unresponsive, we work to change that. We’ve had a successful investment in Schindler, the elevator company based in Switzerland. But when I first called to arrange a meeting with Mr. Schindler after becoming the third-largest shareholder, I was told that he doesn’t meet with shareholders. I suggested that Mr. Schindler could instead arrange a meeting with his bankers about taking the company private, so he could maintain that attitude. We eventually met for 2 1/2 hours and now have a good relationship.
I don’t like proxy battles, I just want to make money and maintain my liquidity. The moment you force yourself on a board, you become illiquid. We do get frustrated from time to time, as a result of management inaction or when we don’t think it’s acting in shareholders’ interest. With Dole Food, for example, it appeared to us that the chairman in 2002 was taking actions that held back the share price and then he subsequently tried to buy the company for a paltry premium.
We were the second-largest shareholder and called him on it publicly and he eventually had to pay substantially more. That’s a rare scuffle; we generally try to operate more behind the scenes.
More than half your assets are invested outside the U.S. Do you do anything differently when investing internationally?
AR: Not at all. We define our universe in the same way in each major developed market. In doing that, of course, some markets offer more opportunity than others. In Taiwan, after excluding tech and banks, there’s little left for us to invest in. There are only five to ten companies each for us in markets like South Korea and Hong Kong. The real opportunities for us are in Japan, the U.K. and continental European countries like Germany, Holland, France, Sweden, Norway and Switzerland.
Japan is particularly interesting right now. It’s a bit of a two-headed dragon, with both quite overvalued and quite undervalued stocks in our universe. You’ve got interesting companies like Dai Nippon Printing trading at extremely low multiples, while other companies in our universe trade at 12-15x EV/EBITDA multiples. While corporate governance is improving in the developed countries, Japan is probably still the furthest behind. Some of the best opportunities today, though, are in companies that have a long way to go in improving corporate governance.
You mentioned your family used to be in the printing business. Tell us why you like printing giant R.R. Donnelley [RRD].
AR: Prior to actually owning it, I had long considered Donnelley to be an ideal LBO candidate. It was run out of large, pompously designed mahogany-paneled offices in Chicago and was just ripe for someone to come in and take out a ton of overhead. This is a very competitive, nickel-and-dime business and the last thing a printer should do is show its employees and customers that it’s making a lot of money.
In late 2003, R.R. Donnelley merged with Moore Wallace, a restructured business-forms and outsourcing company, and that’s when we first started buying the stock. Both companies had been top candidates for us and we saw a huge opportunity for new management to cut costs and find other operating synergies. The CEO of Moore Wallace, Mark Angelson, became CEO of the combined company.
While early estimates were for around $100 million in cost savings, they achieved $300 million in the first year and-a-half and now are closing in on annual savings of $500 million from the deal. The company now doesn’t really have a peer, given the breadth of services it offers. They are the 800-lb. gorilla in most of the areas they operate in.
Is being the 800-lb. gorilla in the printing business that attractive?
AR: The traditional printing business keeps plugging along. Donnelley currently prints about half of the best selling books, Yellow Pages directories and magazines produced in the U.S. While you might assume all of these are threatened by the Internet, print volumes have remained quite stable. Yellow Pages directories are still a venue for local advertisers that they can’t do without. While some magazines fold, others get launched.
Given the volume and quality requirements of big customers, printing is becoming a more concentrated business and being the biggest is a clear advantage. The catalog business continues to grow for them, for example, partly because it’s hard for some of the larger cataloguers to get their work done anywhere else. Small printers find it harder and harder to compete for national accounts. There are only three major printers that can do the big jobs – Quad/Graphics, which is privately held, and Quebecor, which has had a lot of problems, are the other two – but we believe Donnelley is much better managed and more competitive.
To give you an example of how scale matters: Donnelley claims that 20% of the volume going through the U.S. postal system is either printed or handled by them. In Chicago we visited a gigantic distribution facility, from which magazines and catalogs are sorted by zip code and then shipped closer to their ultimate destination before being entered into the mail stream. Donnelley can do that much more quickly and efficiently than if the items were dropped into the postal system near the printing plant.
That results in cost and time savings for customers that no one in the business has the scale to match, which is an excellent competitive advantage as well as barrier to entry. The growth area of the company is document business process outsourcing, which now accounts for 15% of revenues and operating profit. They do things like help American Express and Barclays with new-customer sign-ups, including managing call centers in India as well as the printing of forms and follow-up materials. They’ll print, assemble and send all the brochures, luggage tags and marketing materials for companies like Carnival Cruise Lines. They’ll produce customized customer statements for companies like Prudential, Charles Schwab, Fidelity and others. In general, this business is growing faster than printing, is less cyclical and has higher margins.
How cheap are the shares, trading at a recent $36.10?
AR: Earnings per share have doubled since 2003, to $2.55 last year. With cost savings on recent acquisitions, the ongoing rationalization of the manufacturing and distribution infrastructure, debt reduction and share buybacks, we think EPS could be as much as $3.40 in 2008. On an EV/EBITDA basis, the shares trade at only a 6x multiple and have a 2.7% dividend yield. For a company that has solid growth potential in a wide variety of leading businesses, sharp management, good cash flow and a strong balance sheet, we think an 8x multiple would be far more reasonable. By 2008, that would give you a potential share price of around $58.
What activist role have you played here?
AR: A year ago we proposed a $1 billion share buyback as part of our filing a 13D after our stake rose above 5%. The math was really quite compelling with the share price in the $30-35 range. Borrowing $1 billion to buy back shares would cost less than $40 million in interest after tax, but the company would save $35-38 million in dividends. So for a few million dollars, remaining shareholders would benefit when the share price reflected a 10% increase in earnings per share. The company approved a buyback plan, but didn’t implement it despite a continued weak share price.
Last August there were a variety of rumors that Donnelley was in talks to do a leveraged buyout. Our concern was that any deal would get done at a level that would relinquish a lot of the embedded upside in the company to the financial buyers, while public shareholders were sitting there with a mediocre return.
We went back with a public recommendation of a $3 billion buyback. I subsequently told the CEO I wasn’t obsessed with a share buyback and that I’d much rather he find accretive acquisition opportunities. But absent that, I wanted to make sure a share buyback was clearly considered as an alternative versus some sort of going-private transaction. Since then, the company has announced close to $2 billion in earnings-accretive acquisitions, giving it additional operating and financial leverage.
Do any market environments tend to give you trouble?
AR: I’d say that when investors focus particular attention on a given sector – like technology stocks in the late 1990s or energy and commodity stocks more recently – we’re unlikely to outperform. Multiples get compressed in our universe in those times, so it’s tough for us to beat an index increasingly weighted by the hot sector. We’ve held our own over the past three years, but it hasn’t been easy having no energy/commodity producers and quite a few energy/commodity consumers in our portfolio.
What’s your biggest single worry about the market today?
AR: In our view, the world economy looks pretty healthy. But I do believe there’s reason to worry about systemic risk that could be triggered rather easily by one type of geopolitical event or another. I think there is an unknown but possibly very large amount of leverage in the system. If there is a dislocation, we’d very much prefer to be invested as we are – without leverage, in profitable companies with strong balance sheets and attractive end markets.