In this episode of The Acquirers Podcast Tobias chats with Kyler Hasson, Portfolio Manager at Delta Investment Management. During the interview Kyler provided some great insights into:
- Tax-Conscious Compounders
- Focus On Free Cash Flow On Invested Tangible Capital
- Weeding Out The Best Investments
- Businesses That Can Grow Intrinsic Value
- Figure Out Why Customers Use The Product
- Share Ideas With Like-Minded Investors
- Constellation Software’s M&A Process Up Close
- TransDigm’s Competitive Advantage
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: Hi, I’m Tobias Carlisle. This is The Acquirer’s Podcast. My guest today is Kyler Hasson of Delta Investment Management. We’re going to talk compounders value, quality. It’s a fascinating discussion, right after this.
Tobias: I saw in your note that you said that you were making a small change to your philosophy from value to quality. What prompted that?
Kyler: Yeah, so I think that was in my annual report about a year ago. So, a lot of– or maybe everything what I do is really driven from my clients. So, I invest money for roughly 40 individuals and families. Many of them live in California and pay California taxes and so their marginal rates can be pretty high. So, when I first started, I think I looked– I like many other people probably learned through Buffett and when I was maybe 18, I read all his letters. At the time, he owns railroads, and banks, and all those things. So, when I first started the business for the first few years, I owned I think what you traditionally call value stocks. I’d focus on quality, and I tried to own good companies, but my portfolio had– if you go back to 2013, 2014, 2015 maybe, I owned a lot of Berkshire, I owned some railroads, banks. At one point, I owned some Exxon, which didn’t go so well. Luckily, stopped doing it. But I owned all these sorts of companies and then I said, “Well, listen, if I do it right, I can make okay money. If I don’t, there’s some real downside here.”
What really hurts for me is, I report after-tax returns to people. So, let’s say I get one right and I own JP Morgan, and when I buy it, it’s cheap and then after a few years, it gets to where I think it’s worth. If I sell it, and redeploy the proceeds somewhere else, I might take a 2% or 3% hit to the IR I just made or maybe a little more. So, I think, recognizing, one, that hey, maybe these things are cheap for a reason. And then, two, if I’m looking on a real after-tax return basis for my clients, it’s really hard for me if I almost ever sell anything. So, can I move into some companies that are a little better? Doesn’t mean they’re growing at 30% a year and traded at 2% free cash yield, but a little better, a little more durable, maybe a little less debt, little less downside. And if I can sort of accurately do that while not overpaying, then I think the results are going to be better, and especially after-tax results should be better.
Focus On Free Cash Flow On Invested Tangible Capital
Tobias: How are you thinking about valuation in that context, though? I’ve got your portfolio in front. It’s still a reasonably traditional value portfolio. It’s not at the super growthy end of value, which I talk to a lot of guys who’ve got a lot of compounders in there, who are a lot of SaaS companies, which still falls within the definition of value the way that they’re defining value. It just depends on how you’re treating that growth. So, I look at yours and this is not an uncommon collection of businesses. So, you’re still thinking about value in some context, how are you doing it?
Kyler: Yeah, that’s a good question. For me, actual valuation, I think a lot of people make it complicated. I don’t think it has to be super complicated. It’s cash in, cash out. So, for me, I really, really focus if I’m going to own anything, what are the cash flow characteristics of this business? Everything I own, I hope that I plan for it to grow. I don’t own sort of distressed situations or anything like that. So, if this company is going to grow, my first question is, well, how much capital does it need to grow? I think that’s– if you have a price to earnings multiple, it doesn’t always tell you that story, and the bridge from price to earnings to free cash flow is return on invested tangible capital is what I look at.
So, I want to make sure, well, P/E ratio is 13 and it’s going to grow 4% or 5% and so that should be good. Well, what’s the return on tangible capital? How much of those earnings if you’re going to grow with that 5%, do you need to retain? If the return on invested capital is low enough, it could be a lot. Most people will look at the Capex needs of the business. I look a lot at working capital.
Heico is a name that I own. They generate about 500 million pre-tax and their working capital’s around that same number, about $500 million. So, if you think, well, Heico is going to double its revenue and earnings in five years, well, you’re going to need to retain $500 million in working capital, most likely. So, I really try to track those cash flows, if they’re going to use leverage, will they increase it with earnings, all these things. From there, it’s how much do I think the company can grow? What portion of its earnings does it need to grow? And that gives you your free cash yield and an estimate for growth, and I just sort of add them up.
So, if something is– if I think it can grow over a long amount of time at 5%, and the P/E is 10, but at that growth, the free cash yield of 7, then I’m saying, “Well, I think I can make seven plus five.” I don’t do super complicated modeling. But I do try to be really reasonable and how I think about that long-term growth. Make sure I’m not being really aggressive with my assumptions obviously, I try to be conservative, like most other people.
Weeding Out The Best Investments
Tobias: So, besides valuation, what’s important? What’s your process for assessing a company when you–? You first come across it however you find it, how do you think about it?
Kyler: Yeah, I would say I spend– if I’m looking at a company, I probably spend 95% plus of my time on the qualitative stuff. And then the numbers, I’m pretty quick with, like I said, no complicated models. I think it’s hard. I think investing is really unique and really difficult in that there’s not a lot of what I would call– it’s very hard to learn anything sort of positively, I think you can learn what doesn’t work. I think it’s really hard to just say, “Oh, well, look at what’s done well recently, and I’m just going to do that,” and as you know that, can blow up on you. So, I really just try to weed stuff out first and foremost. What I don’t like, first of all, you can weed out a lot of companies by just, is that return on invested tangible capital high enough, that they’re actually creating value, that weeds out a lot.
Number two, most companies that exist don’t exist for a long time. Their profitability is competed away. The returns on capital are competed away. So, there’s got to be some sort of competitive advantage, obviously. Those are probably the two biggest ones. Can I be comfortable that this business is going to exist and be better than it is in 5 or 10 or 20 years that it is now? It’s a rare business that you can be confident in that, I think, truly confident. You can say whatever you want, but if you’re being honest with yourself, that’s a tough bar to clear. Then, I usually look for that– I think, who’s buying their products and are they solely focused on price. Obviously, you can have some price-based moats but any business where people might say, “I’m going to buy the cheapest one,” I want to stay away from. So, those two things.
And then, assuming it checks that, I think the three ways you can get yourself in trouble the most are lots of operating leverage, and there’s plenty of good businesses that their margins are going up over time because they have pricing power. And I don’t mean that. I mean like airlines. There’s a lot of operating leverage in that business and if your load factors go down just a bit, you’re not profitable. Two companies, we own TransDigm and Heico, in April, I think, rev passenger miles were down something like 90%, across the globe. And those two businesses were still profitable. EBITDA or maybe operating income was down, sure, but still free cash flow positive, so they can survive distress a lot better than something like an airline with a lot of operating leverage. So, I try to avoid that.
I personally try to avoid things that are too cyclical. I think it’s really hard if you have a really cyclical business to have any idea with earnings power is, honestly. I was looking at a Vulcan Materials other day and that’s not horribly cyclical, but they did this deal in 2007. Florida Rock was what they bought. And if you look at the graph of aggregates demand from– I think it was 1960, or something up until 2007, it’s up until the right and there’s a couple little wiggles. And so, you can read the transcript for this acquisition, and the analysts are getting on and they’re literally saying, “Hey, congratulations, this is a deal made in heaven. You guys are going to make so much money.” And management saying, thank you, thank you, thank you. And sure enough, the next year, aggregates demand was down. I don’t know the number, maybe it was a third or something. But volumes were down, EBITDA cratered. They had done a lot of debt to do the deal. And they were in some pretty serious trouble.
So, obviously, that one sort of looks not too cyclical, but when you have cyclicality, I find there’s risk obviously just in and of itself, but then it’s hard to predict what’s going to happen, I think– [crosstalk]
Tobias: What drove the cyclicality in that instance? Was it homebuilding just stopped for a period?
Kyler: Yeah, homebuilding and construction, and then there’s some public sector construction as well. We went it from really hot to not hot, and it was a problem. So, yeah. And then, I’d say the last thing, and this is sort of an obvious one, is too much financial debt. Especially, I would say– I own a couple things that have some debt on them. But if the debt’s not structured right– there’s some companies that need debt just to make it through a cycle or to operate, I really try to avoid that.
Some companies that use that to make their returns to equity holders a little better, I mostly avoid that, unless I’m really, really sure that the company’s going to be solid. And even then, I want to make sure that it’s termed out and there’s no new term maturities. And usually, that it’s a good organic grower because a good way– if you have good organic growth and then you have some debt, your debt to income ratio will drop over time. If your earnings go down, then you’ve got a problem. So, I do that in limited certain circumstances. But most of the time, I’m trying to avoid things with too much financial leverage as well.
Tobias: I like that approach. It’s like these are just the ways that you can– these are the list of things that are bad for you. And that list just grows over time as you grow in this business. But how did you start? How did you first sort of decide you wanted to be a value investor and what were you doing? Not value investor, sorry to tag you with that. You’ve never recovered from that.
Kyler: [laughs] Yeah. Hopefully, nobody listens to this.
Tobias: I’ll bleep it out.
Kyler: Yeah, I think I was 18, I was in high school and we did one of those stock picking competitions and so that would have been 2008 in maybe the winter, sort of February 2008, I want to make sure I’m getting my dates right, but basically– [crosstalk]
Tobias: Good time to get started– [crosstalk] Oh, before the meltdown. Okay.
Kyler: Maybe it was 2007, that age math, you’re off sometimes. Anyways, let’s say 2007, yeah, because it was right before things start to get bad. So, we did a little stock-picking contest, and you have no idea how things work, or– [crosstalk]
Tobias: What did you pick?
Kyler: That’s a good question. [crosstalk] remember. I do remember, it was with a friend of mine. And it must have been December, January, because he said, “Oh, let’s buy Coke because the Super Bowl’s in a couple months, and demand should go up.” [crosstalk] I don’t know a lot about stocks, but I don’t think it works like that. [laughs] But we probably bought a bunch of horrible companies besides that.
So, yeah, I got interested in it. And so then, when I was in college, I was wrestling in college and I’d like to look at stocks, probably to the detriment of my actual studies a little bit. So, four years– so I’m reading all the Buffett letters and I would say sort of the canonical investing books, Philip Fisher and all that stuff. I just hopefully started kept doing a little less bad over time. I was in school for fifth year, and I was done wrestling at that point. And I said, “Hey, it’d be cool if I could do this professionally.”
Tobias: The wrestling.
Kyler: No, [crosstalk] invest.
Tobias: Going to the MMA, going to the UFC.
Kyler: [laughs] Yeah, no, I had enough.
Tobias: You’d be retired by now.
Tobias: Wealthy beyond your wildest dreams.
Kyler: [chuckles] Yeah. I said, “Can I do the investing professionally?” I got licensed, and I had a year where I wasn’t wrestling, so I had some little more time. And went out to some potential investors, friends and family. I was sort of expecting, “Hey, maybe I can raise a little bit of money.” I had a place I could have maybe worked part-time. And was very lucky and blessed that after the end of that year, I had enough to sort of operate, super low expenses and everything, but I had enough to really start. And so that would have been 20– I’d been a year off, let’s say ’13. And 2012, or 2013, and have been managing money like that since.
Businesses That Can Grow Intrinsic Value
Tobias: It’s not so much a value philosophy but it’s inspired by Buffett. How do you characterize what you’re doing?
Kyler: So I would say, if I mean to own something, what I really focus on is what is my estimate of what it’s worth now, but more importantly, what is the rate of change of intrinsic value growth? If you have clients paying a lot of taxes, and you’re going to try to hold things, your return is going to be pretty close if you own it long enough to the rate of change of intrinsic value. So, I would say I have two buckets. One bucket is things I’ve owned, I think, what everybody would say, well, hopefully, sort of reasonable prices. There’s something in the business where I think that businesses can grow their intrinsic values. I use my error rate somewhere around maybe 10% to 12%, at that rate or higher, and I bought them maybe around what I think the kind of terminal value might be, so hopefully I should capture that growth. Those would be what people would call the compounders.
Then, the second group is any very free cash generative company that I think just trades too cheap for one reason or another. I really– what I want is not trades at 13 times whatever, and I think it’s worth 16 and so in two years, if the gap closes, what I might get return, but that doesn’t really work for me because of the taxes. For me, I look at it– in these cases, I actually don’t even have a target valuation. I very simply say, “Hey, if the free cash yield is 9, and I think it can grow at 3, then I’m going to make 9 plus 3, roughly 12.” And if I’m right, the valuation will probably go up because that’s too high a return obviously compared to the market. But I stopped. I used to say, “Oh, well, I’ll take the free cash yield on what I think you can grow. And then, I’ll add a little thing, because the stock should recover back to my target.” What’s tough about that, and listen, that’s how they do it in textbooks. The problem is, you’re assuming something different than the market is assuming, if the free cash yields 9, and you think it goes at 3, the market saying like, earnings are probably flat. So, if you’re right, then, great, if you’re wrong, not only do you not get the 3, but you don’t get the rebound in the valuation either, you’re in trouble twice.
So, I try not to do that anymore. Yeah, free cash plus the growth. With the types of companies I own, that are pretty stable, good market shares, your math is a little different if you’re growing 30% for now, or something, but I don’t own lots of stuff like that. So, you can use that simple formula.
Share Ideas With Like-Minded Investors
Tobias: When you’re thinking about finding stuff, how are you tracking down? are you screening? Are you just reading what other smart guys on Twitter are doing? Are you reading Barron’s or Wall Street Journal? What’s the search process?
Kyler: Yeah, so dual pronged. One, if you go back to all that stuff I eliminate, honestly, it does not leave a lot of companies. So, I guess right now, I have a couple investments in energy. That one’s maybe a good example of this. I own two companies, one’s Enterprise Products Partners and the other’s Magellan Midstream. I am not sure that there is another energy company I would invest in– I don’t want to say at any price, but I’m going to say almost at any price. There’s lots of operating leverage with most of those companies. A lot of them, for some reason I don’t understand, carry a lot of financial leverage. They’re not managed particularly well. The incentive schemes are sort of off. And then–
Tobias: It’s a wildcatting industry, wildcat managers, wildcat equity.
Kyler: Yes. Not a lot of people getting paid on return on invested capital in oil and gas, which you need. And then, you have the services companies and those aren’t good businesses and ss far as my eye goes, no competitive advantage there. So, if that’s your screen, there’s like two and so I follow those ones. So, if you do that across the market, you can whittle away a lot and so maybe there’s 50 or 100 things that I follow. So, that’s the first process.
And then, yeah, the second one is, I have gotten maybe 10 people on Twitter that I talk to a lot. I try to be helpful and sharing my ideas with them and they’ll share their ideas of me. Bill Brewster, I’ve had a good friend, he’s value investor three on Twitter, [unintelligible [00:24:02] and JerryCap. I’m going to forget a bunch now, and Science of Hitting is a good one. So, I talk to a bunch of people. I think the good process there is somebody comes to you and say, “Hey, I have this good idea.” And so, you look at it and make sure you know what’s going on and then you don’t buy it, and then it goes down, like 10%. And they’re like, “Wow, this is really cheap.” And you’re like, “Okay,” and you’re like “Wait.” Then at some point is going to go to another 10. They’ll be like, “Hey, can you look at this? I have no idea what’s happening, something’s clearly wrong.” [chuckles] And then, you buy it. But I think sharing ideas with like-minded investors is really important. And that’s something I did not have up until a year or two ago, and it’s been a very good change for me.
Figure Out Why Customers Use The Product
Tobias: So, that’s finding the ideas. What’s the filtering validation process like?
Kyler: Oh, if I could validate an idea, then that would be great.[laughter]
Tobias: After it goes up. A year after it’s gone up a lot.
Kyler: Yeah. I think the problem is I have a good idea maybe every couple of years, but I have, I don’t know, 10 bad ideas in that time. Yeah, it’s a good question.
Tobias: I mean are you like you want to talk to management, you want to talk to customers, you want to talk to suppliers or financial statements, industry reports, that sort of what I mean. How do you get comfortable with the idea?
Kyler: Yeah. I think I’m not always a person or often that has to talk to management. I tend to own bigger established companies. My process would be completely different if I was talking about smaller stuff or really growthy things. So, there’s some semblance of this company’s been around for a while, has it seen a couple cycles, and managed through them okay. That tells you, listen, there’s probably something here that matters and is positive. And then, on top of that, my biggest things, I like to figure out why the customers are using their product, whatever it is, who’s buying it, and why? If I can figure that out, then I can feel pretty good because you’re hoping to avoid those sort of, “Well, they sell the cheapest price,” sort of situations or host of other things.
But I would say if I can get a good moat, that’s great. There’s a lot of businesses out there that I think– the moat, to the extent that it exists, is probably not what most people talk about, which is, “Oh, well, there’s almost no reason to use a competitor.” I think there’s a lot of companies, it’s just like, maybe an oligopoly. Maybe there’s something that just prevents a ton of competition, but from there on out, it’s like we’re one of three or four or five companies. There’s nothing that says we’re going to do any better than the next company. It’s just we have to have the right people and execute. And that probably explains most businesses that are out there. That’s something I can be comfortable with, in the right circumstances.
Tobias: Providing they’re competing like gentleman rather than brass knuckle brawl in a bar.
Kyler: Yeah, exactly. That’s my biggest thing. Who are the customers? What are they buying? Do I have–? If it’s just an oligopoly situation, which most industries– well, good ones, I think, are– can I be confident that these are sort of the right people to run things? Do I like their strategy? Those kinds of things.
Tobias: Let’s talk about your portfolio a little bit. How do you think about concentration, diversification? Let’s start there and then I’ve got a few follow-up questions.
Kyler: Yeah, that’s a good question. So, this is something I’ve changed my tune on– well, even this year. I’ve always been pretty concentrated, maybe very concentrated. Most of my clients own eight or nine things, they’re not fully invested. So, those eight or nine might be 70% of their money. I invest money for individuals. Most of the time, if I do my job right, I can be investing money for them for, hopefully 30 to 60 years, a long time. If you’re taking too much risk, over those kinds of time periods, I think you blow up. And so, I don’t invest money for institutions. I don’t invest money for people generally, that say, “Hey, I want you to go out and make the highest return you can.” Most of the time, we have some money, we worked very hard to earn it and say that, “Can you keep it and not lose it, and then you know, hopefully grow it. That’s sort of what feeds into that all the quality business and avoiding all the bad things.
The first thing is, hey, we want to keep our money and hopefully grow it. I’ve seen probably more than I appreciate it is clients of mine that they don’t want a ton of risk. And by risk, I mean the possibility of having significantly less of it after inflation over time.
Tobias: After inflation, after-tax. That’s a high bar.
Kyler: Yeah, it really is. Yeah. I mean, listen, I mean, if you took a cross-section of some Americans that had saved some money up, and that had 40 or 50 years to invest, and you said, “How many of them actually beat that bar?” I think you’d be surprised at the results. And that’s even in an environment that was really conducive to making good real returns. So, going forward, I think the environment’s going to be a lot harder, frankly, just–
Tobias: Why do you say that?
Kyler: Well, where bond yields are, if you have a 60/40 portfolio on 40% of your money, you make whatever, zero or one. Stocks, I’m not one to say that you can really accurately predict the returns of stocks, but I’d feel pretty confident in saying that, if you’ve got 10 or 20 years, I don’t think we’re looking at double-digit returns. If rates are higher, and especially real rates are higher, you could be looking at a fair amount of time of returns much lower than people are used to. Obviously, the famous examples 1965, 1982, I think the DOW was flat, you got some dividends, but rates went from very low to very high. That’s always a risk. So, if you just said, you have 60%, your money-making five or six, and 40% of it making call it zero, three, three and a half percent returns. It’s the math gets a little tough.
Tobias: Plus, inflation running a little bit higher than that.
Kyler: Sure, yeah.
Tobias: It’s a negative number.
Kyler: I think for a long-term investor, assuming you own a bunch of cash generative businesses, I think that’s your biggest risk. Especially from low, I think the market in the last little while is run up a little bit on real rates are negative. And so, I think stocks are worth a lot, but if that changes, it could be trouble. At any rate, they want to make a good return after-tax, and they don’t want to have a lot of risk. I talked to a couple of my bigger clients in this April 2020. United States were shut down, markets were going kind of haywire. And due to their prudence, they had some extra money, and we’re looking to deploy it. And so I just sat him down and said, “Hey, here’s what you own,” and the first things we talked about were, are they profitable, and free cash flow positive, even in this lockdown environment? And secondly, what does debt look like? And when is any debt do who knows if we can roll it? And they weren’t so much– listen, other people have different mandates, but for me, they’re not so much, “Hey, we need to make the S&P plus one.” We’ve got money to put to work and we want to make sure that it becomes more money.
With all that being said, you say, “Hey, Kyler, you own eight or nine things for clients.” That seems a little silly. I think there’s some truth to that. Everything that we own is on from a cash flow perspective is done okay this year, haven’t had any blow-ups. But if one big investment we had something happened, we could be having quite a bad year. So, I think the world’s very uncertain, I think business is very uncertain, and I need to do a better job of making sure that people are protected from sort of idiosyncratic risk. What makes it hard is going back to the tax thing, is you have a bunch of things you’ve owned for a long time that you’re going to have to pay some tax to diversify like that. So, I’m thinking through that as we speak. But I think the goals to own a few more things.
Tobias: Do you trim if something runs up a lot a year? Do you add if it comes back? How do you think about that sort of rebalancing? Is that something you do or you buy it one time when it gets to valuation, you gone?
Kyler: Yeah, depends.
Tobias: Because that’s hard with the tax question as well?
Kyler: Yes. So, I think there are some certain cases where I generally do not trim herself. And that is if I own something that has some optionality in it. And so what I mean by that is, if you own Berkshire Hathaway, the intrinsic value over the next 10 years might go up 6, or 8 or 10, or maybe a little bit more percent, but it’s not going to go up 15% a year. I mean, unless something insane happens, but generally, it’s big, it’s diversified. They’re so big that when they do deploy money these days, they’re not going to get humongous IRRs on it. So, there’s not a lot of risk to the upside on that. I own and have owned a company Constellation Software for a while. They deploy a lot of money into very small acquisitions at that very good IRRs. Probably last few years has been about 25% plus. So, as a holder of that company, I have some expectations on, your biggest variable first is organic growth and profitability of the base businesses, which they’re very sticky. They’re low TAM, so it’s hard for people to compete against them. They’re very oligopolistic. They’re not the growthiest, but they’re solid.
So, then the second question is, well, how much can they deploy into M&A? And maybe six or seven years ago– well, not six or seven. Few years back, they’re doing $150 million a year, at even sort of higher ROICs and it was like all their cash flow. And if you do the math, you get a lot bigger really quick. And so now this year, I think they’re in the range of 600 to 700 million a year. And so, the optionality on that is, listen, if they can deploy most or all of their free cash into acquisitions over six years, 26% ROIC, their earnings have just 4Xed. So, there’s some good optionality there. If I think it’s a little expensive, I’m going to be pretty hesitant to sell it. So far, that’s been a good idea. Will it always be a good idea? Probably not. But I think there’s a good chance that they continue to deploy a lot of money, a good rate of return and that thing works for a long time. It’s going to be really expensive for me to sell it if it runs up too much as a percentage of somebody’s portfolio, sure, I could trim it. But after taxes, it can be harder. But that’s how I look at the never sell idea.
I don’t want to get rid of optionality. If I own a normal sort of value stock, and it’s past what I think and after-tax, I think I can get a good price on it, then I’ll do a lot more susceptible to selling it.
Constellation Software’s M&A Process Up Close
Tobias: What do you think about Constellation? I’ve seen them talking about that the universe of companies that they can buy, the universe of businesses they could buy is huge and still growing. So that’s not– I don’t think that the supply side of their acquisitions is the issue. The number of people out there who’ve seen that that works and who now want to go and do that either as a search fund or– there just seemed to be a proliferation of Constellation clones. How do they go in an environment where there’s a lot more competition for the acquisitions?
Kyler: Yes. That’s a very good question and I think the most important question. I actually saw their M&A process up close a couple years ago with a– [crosstalk]
Tobias: I think I saw your tweet about it.
Kyler: Yeah. He was selling a software business.
Tobias: It’s a good story.
Kyler: I think it bears repeating. I was talking to him one day, and I knew, “Yes, software business.” He said, “Hey, I’m probably looking to sell it for a few reasons I won’t get into,” but anyway, I said, “Well, hey, we’re shareholders of this company. They buy small software companies like yours.” It was about a million dollars in pre-tax earnings, growing, maybe mid-single digits roughly. And so, I said, “Hey, I can introduce you to them, they might be interested.” And so I put them in touch and somebody reached out and they did some due diligence, and I might have the timing not exactly right, but I think it was within two or three months they had in all-cash offer, it wasn’t the highest, but an all-cash offer continue working with the company. And they said, “Well, it’s not quite enough money.” So, they went out, let’s look for other acquires.
And I just so happened, I have a good friend who had worked– he was an investment banker for software companies, and he had just gone to business school. So, they would have been well below the size that the company would have taken. And so, he ran a sales process for them, and it was a nightmare. I want to say it took two years to close.
Kyler: Yeah, a year into it, they were like, “This is horrible. This is disaster, we’re not going to close.” And frankly, if they didn’t close with who they did close with, I don’t know if they could have kept going because, my friend, he’s running the business and trying to run a sales process and he’s working two jobs. What’s the odds of maybe the one strategic actually buying them? Say, it was 10%, or something, but not high. So, in this case, you have some survivorship bias, and that the whole thing actually worked out. And you had somebody that was willing to try to sell the company, which usually it’s going to be hard to get somebody good, and not terribly expensive at that price. You had a couple other people interested that went through a lot of due diligence and then dropped out. You had a strategic that worked, but if it didn’t, now what?
Well, Constellation’s there with, again, not the most money, but a hard cash bid. And there were some other circumstances that would have made it a little tougher, I think, for them to go Constellation that wouldn’t always be there. So, I think, when you look at that, and you say, “Well, now, how many of these things get sold in a year?” It’s some humongous number, and Constellation sees really a high percentage of them. So, maybe their percent chance of getting a deal done is 2% or 3%. But they look at a lot and hard cash offers, and it’s really hard to sell these things and the capital markets are really inefficient, I think they’ve got a good runway, even with increased competition, which there certainly is.
TransDigm’s Competitive Advantage
Tobias: So, your biggest holding is TransDigm. Do you want to walk us through the TransDigm opportunity?
Kyler: Sure. That’s an interesting one. It’s an interesting time for it. It’s no longer quite the largest, but it’s close enough. So, let’s see. I found out about that company from Outsiders, the book. It’s in the first chapter, they talk about capital cities and Thorndike writes something effective. And “Oh, hey, by the way, there’s this aerospace company in Cleveland, but kind of looks like it.” So, that’s a company that a lot of people skip over immediately, and the reasons are, because there’s a lot of debt, they run net leverage, it’s six or six and a half times EBITDA. So, for a lot of people, it’s just, “We’re not going to own that.”
And then, secondly, they’re very aggressive. They run that company to make money for their shareholders and themselves. So, their pricing, everybody knows they charge higher prices than anybody else. And so, people say, well, they’ve got aftermarket aero– so let me back up. So, they make OEM parts for airplanes and then they sell the same parts in the aftermarket to their lines or same distributors. So, the FAA regulations are very stringent. Obviously, you can’t have a part fail on air because something bad could happen to the plane. So, there’s a big focus on safety. And so, once you get on to that airframe, you have the FAA certification to make that part. And in many cases, your sole source, you’re the only person that can make an aftermarket. So, you have a lot of aftermarket pricing power.
TransDigm flexes it harder than anybody else does. Their margins are very, very high. So, their EBITDA margins are in a normal year about 50%. People say, “Well, the company’s evil, it’s a zero and they’re going to blow themselves up.” They’ve been around things since the early 90s. And I wouldn’t know the number now, but they’ve compounded EBITDA by about 25% since then. So, there’s been a lot of cash distributions as well. So, you’re higher on equities meaningfully higher. And it’s been public maybe since 2005, or 2006.
All those things being said, it’s aggressive, they’ve got a really good business as long as they don’t push it too hard, but they push hard. Aerospace is a big growth industry right now, it’s in the downturn. But over time, the amount of miles that people have flown worldwide has gone up about 5%, most every year, back in since maybe the 70s. And is projected to do so until maybe 2050. If you go back to thing, you’ve got really good microeconomics, you’ve got the long-term growth story, you’ve got really good return on invested capital. On the other side of that, you’ve got a lot of debt and they push crazy hard.
And so, it’s interesting, there’s somebody in practice on Twitter, and they run– they do like expert network interviews. And they’ve interviewed some people that are involved, have been involved with TransDigm or know the space. And the person does interviews keeps asking, because I think it’s just like an interesting question to him. So, it turns out that lots of aerospace contracts, if you make a part OEM, your customer who might make the bigger part or could be Boeing. In most aerospace contracts, they write in, “Hey we get to sell for the first little while, we get to sell the aftermarket parts.” And they sell in higher prices. So, TransDigm, they go in and they say, “Well, we’re going to own our own aftermarket.” And so, part of the price increases that you see are just from that because as an outside investor, you just see, well, what are the margins went up? What did they do? They capture some of that.
And then they also in some specific cases where there’s competition, they’ll take the prices of the part itself up as well. And so, they’ll take them up, the least on sort of planes that are still in production. And they’ll take them up a lot more on planes that are out of production, and it cost a lot to make this part because you might make one part every few years. And the volumes are really low, and you need the part to fly. So, they’ll flex the pricing power where they have it. But really, I think that was– he did some really good work on that, because people just thought, well, they’re doubling and tripling their prices, and it’s like, well no, they’re getting the aftermarket pricing from some of the OEMs, which is another worry and they keep doing that. But two, then customers aren’t seeing, like 3, 4 or 5X pricing on the parts. So, the model works pretty well.
On top of all this, so now you have a lot of good things going for you, the growth, the return capital, and the microeconomics. They are also very good and lean operators. So, they remind me a decent amount of Danaher. Danaher is, of course, maybe the best run industrial company in America or the world, they’re great. They come in and they invest where they need to, for growth, they take cost out. So, TransDigm, a lot of these companies that they buy, there’s a lot of sort of mom and pop aerospace companies. And as you can imagine, if you have a monopoly, you don’t always run things the leanest. So, there’s a lot of public companies that aren’t exactly run, lean, and well, like you’d hope so. So, they can go in and take EBITDA margins from– they’ll buy something, and they’ll take EBITDA margins from– I mean, sometimes 15% up to their normal 50. And so, part of that is on price, but then a lot of it is they can take cost out and they can run their inventory leaner, which helps on cost as well.
And so, they’re just really well managed and they’re close to their customers and so they know places where, “Hey, we’ve got competition. We’ve got to run this well. We can’t take up price.” And I think they know, “Hey, in this specific part, we’re the only person that makes it and we have more pricing power.” So, I think they price to the market very well. And so when you add all this up, you’ve got a good base business, you can do acquisitions, where you buy something, they usually pay 10 or 12 times EBITDA, and after they get their improvements through, now they paid four to six, you create a lot of value like that, and then especially at the very end, they have six turns of leverage. So, when it all comes together, you can grow the intrinsic value very quickly.
So, your worries, obviously, well the aerospace market turns down and they’ve shown, their last quarter EBITDA is down 35%, again, passenger miles were down by the year or for the quarter maybe it was 80, I’m not quite sure. But positive EBITDA, positive free cash for working capital, and their debt is nice and trimmed out and they don’t have to pay anything back till 2024. So, I think that shown people, people are saying, “Well, TransDigm can be zero.” I think there’s a lot of other aerospace companies that are going to be in trouble before TransDigm is. And it’s the micro. I think, as investor, I really tried to focus on the microeconomics because that’s what drives value. And so, you could have an aerospace company with a little bit of debt. But really tough microeconomics and the stocks are down 95% this year, like you sort of imagined. So, it’s an interesting company and it’s been a long-term winner and see how it goes.
Tobias: Yeah, absolutely fascinating. Kyler, we’re coming up on time. If folks want to follow along with what you’re doing or get in contact with you, what’s the best way of doing that?
Kyler: I’m on Twitter, maybe too much, @KylerHasson. So, my direct messages are open. If you want to contact me there, send me direct message. My email address is email@example.com, and you can reach me there as well.
Tobias: And you have a site, hassoninvestments.com.
Kyler: I have a blog now. That was an old sort of long story, concentratedcompounding.com, I haven’t written on it in a while, but it’s there. So, I have some old annual reports on there. And if you email me, I can also send you anything you want to read.
Tobias: That’s great. Kyler Hasson, thank you very much.
Kyler: Thank you. Thank you for having me.
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