Arlington Value 2013 Letter

Inspiring read. 

Thoughts on Aggregators

The following is an excerpt of my diary notes in September 2013. It contains extracts from an email conversation I had with another investor whose opinions I admired. The central part of this excerpt concerns the issue of aggregators, namely companies that grow by acquiring others.  I call them the Pac-Mans. 

24 September 2013

Aggregators

Thought of the day: aggregators versus organic growers. Spending on acquisitions are capitalised whereas spending on organic growth is expensed.

Buffett has previously warned of the "sleight of hand" with the accounting treatment for acquisitions. He pointed out that post acquisition, the acquirer gets a free kick with margins and earnings as the target usually comes with accounts receivables and contracts in progress for which the costs of sales has already been expensed.  Since the acquirer capitalises all acquisition costs, the metrics such as cashflow, earnings and margins are boosted in the operating section.

Your point that organic growth spending is usually expensed is an excellent point. Although in cases of heavy R & D, this may need to be revised.  CSL provides an excellent support for your point, as they expensed all their R & D every year.  The value of their IP does not show up on the balance sheet.

On the subject of aggregators (or roll-ups as they call it in the US), various anecdotes and studies I have read appears to suggest these fail more often than not.  Neptune Marine Service (NMS) was an example.  AMA was another failed example which got turned around. ABC Learning, MFS and Allco are the well-known bad-boys in the aftermath of the GFC. Nevertheless, early investors can make a lot of money on those who execute correctly.  I am thinking ONT ran by the excellent ex-army Daryl Holmes, CPU in the days of Morris, QBE in the mad days of Frank, and Navitas.

Here is a quick list with my current thoughts:

SGH- I still believe this will implode, but may survive implosion. Dislike management intensely.

AMA- made good money on this when Malone turned it around.  Very close to implosion before Malone.

ONT- this is a keeper, but not at current prices.

GXL- the debt load is getting scary, not as compelling as ONT.  Not sure whether retailing business has any relevance to the core vet business.

VEI- another one which nearly imploded. I dont think it will do well, as the specialist doctors have too much bargaining power.  Very different to ONT.

TRG- interesting but have not had a close look.

IVC- very good run, but I have questions about how they manage their prepaid book.

One quite common theme is that many of these aggregators have a strong run-up before they implode. The ones that don’t implode are runaway successes.  The ones that do implode can do well if they are turned around. A good specialist in this field can make decent money.

Cross post on SRV

The serviced office business has no barriers to entry. It is also difficult to get any meaningful advantages by being the lowest cost player via economies of scale. As stated by others, these businesses have large operating leverage due to high level of fixed costs and low variable costs. 

The way I see it, SRV is a play on very good and shareholder friendly management. Just like the insurance industry, you want management which is disciplined and focused on the bottom line for the long term future, as the industry is prone to be buffeted by economic cycles.  Management of SRV is savvy in that they pick their spots carefully in the market instead of trying to be everywhere and everything for everybody, a strategy used by Regus. Focusing on great service, great locations and innovative business solutions allow them to attract and keep high margin customers. As a contra reference, just Google "Regus Complaints" and you will see the point of distinction with SRV.

Due to the inherent cyclical nature of the industry, one needs to fully understand the boom and bust economic cycle (something I really need help on), to watch carefully what management does in good times and in bad times, and as always, to pick a good price for entry.  A lack of understanding will result in ruin, because it is precisely when things are all hairy and ugly that one should start buying, and precisely when things are going gangbusters that one should be selling. For SRV, it is in the midst of both economic downturns post tech crash and post GFC crash, when things are looking bleak and financials are weak that presented great buying opportunities. 

Over the very long term of say 10 to 20 years, I would venture to suggest that SRV under current management will increase intrinsic value quite steadily plus a respectable dividend return, however the ride will be very bumpy like a rollercoaster.

On a side note, plays such as HUB and other hipster plays are probably in a different market segment. For example, if a corporation needs to send over a specific team to implement a project in a specific location, serviced offices provide the ideal short term solution. No such team would want to work in a HUB or a hipster work environment. As we move more towards an information based economy, the need for segregated and quiet space for concentrated uninterrupted work increases.  As such I see no systemic risk to the underlying demand for serviced offices.