Chadd Garcia - The Intersection of Returns and Morals
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[The Business Brew theme]
Ladies and gentlemen, welcome to The Business Brew. I'm your host, Bill Brewster. I hope you enjoy this episode with Chadd Garcia. Chadd is a hell of a guy. I've hung out with him a bunch. He's a great guy to talk to. I enjoyed staying at his place, hanging out with the man, the mystery, the legend known as Jerry Cap when we went out to steak, and I hope you all enjoy listening to how Chadd thinks about investing in what kind of companies he's looking for. I like the way that he looks at the world.
As always, nothing in the show is financial advice. All of the information contained in this program is for entertainment purposes only. Please consult your financial advisor before making investment decisions and do your own due diligence. Enjoy the episode.
I'm excited to be in person this time with Chadd Garcia. Thank you very much for the hospitality last night. I appreciate it.
Chadd: My pleasure.
Bill: Yeah, it was super fun.
Chadd: We owe a little thanks to Jerry Cap for providing us dinner in a nice steak restaurant.
Bill: That was fun, man. I enjoyed that steak, a little Peter Lugery and then what we got to learn how the waiter was day trading, right? So, that's always interesting.
Chadd: I'm just glad that he had his day trading account and his retirement account separated.
Bill: [laughs] Yeah. I like how he was like, “I day trade on Robinhood and I have my retirement assets at Schwab.” I thought that that was the appropriate way to do things. So, something that I've truly enjoyed talking to you about investments and investing, because you're one of those guys, one, I think enjoys to teach a lot and two, selfishly, I learn a ton from. So, thank you. I was hoping if you could talk a little bit about HEICO and what got you--? First, interested in the company and if you could talk a little bit just about building through acquisition, and what you've seen from that entity, and then maybe we can see where the conversation goes from there.
Chadd: Well, HEICO has a lot of lessons. I moved to Florida in 2006 and I heard about the company, because it's based here. But I never really spent too, too much time looking at it. When I moved to Florida, I wasn't in public markets. I was in private equity. One of the law firms that I used on ideals was the outside counsels on HEICO Steels. And so, we had a little connection there. The law firm had an event that I was invited to in May of 2014. Larry, the CEO of HEICO was one of the panelists and I got to hear the story from him on the panel, how he talked about taking the company over in 1992 and compounding earnings at a 20% CAGR since then, and compounding the stock price 20% CAGR. And so, not knowing too much about the business, I said, “Well, there's something here because this sounds pretty special.” [laughs]
Bill: Yeah. Not many businesses can do that.
Chadd: No, no. Then I did have the opportunity to meet Larry at the cocktail event afterward and talked about the challenges in this business. The first thing that came up was the accounting, because one of the things that they do is when they buy a business, they'll buy perhaps 80% of it and let the management team roll 20% of it. And so, he was complaining that, “If the company does well, then they have to go and adjust their valuation of the earnout,” which flows through and lowers their earnings, which sometimes their stock gets hit when that happens, but it's a good thing because it's performing. These're going to pay the earnout. If you're paying the earnout, then the business that you bought is doing better than you thought it would do when you bought it. So, that's a good thing. It's like, “Okay, there's going to be some interesting accounting here.”
I went back to work next week and started to look at it. That was back in the days when the first thing I would do would be to start to put a model together. I learned that this business is going to be very, very hard to model because when you model cashflows out on the business, your cashflow statements driven by your assumptions on the Income statements. But when you're acquiring assets, your income statements going to go up and you're paying for the working capital. And so, the working capital would get double counted in a lot of M&A models. Through the years, I was looking at the company, I think it's probably just easier to take a starting point of free cashflow per share and then assume some growth rate over 15 years and that's your assumption. And then, you're probably better off just doing something simple like that and [unintelligible [00:05:26] the cashflow at an assumed growth rate than just building a full model.
Bill: Yeah. If you were to do that, first of all, taking a step back for people that don't know, HEICO does parts that go into airplanes that are not highly engineered, so they can be, I guess, private label is the best way that I think about that. Is that a fair characterization?
Chadd: Yeah, they can be reverse engineered. They can make the parts. The secret sauce of HEICO is that every part an airplane has to be approved by the FAA. And so, their value add is to be able to navigate that approval process. They can get about 550 new parts a year through that approval process, which is multiples what their next largest competitors can do. Once they get that through their competitor, when they're selling to an airline would be the OE manufacturers, original equipment manufacturers.
Let's say, GE makes a part for an airplane. GE has a monopoly on that part by virtue of the FAA approval process until such time as a competitor, he gets a part through the process. And so, they ensure a position of that of a duopoly with the original equipment manufacturer and they price their products about 30% lower than the OEM and they'll capture about a third of the market, which is interesting, because they use the OE’s size against them. GE is not going to slash the prices on parts to get into a pricing with HEICO, because if they do that, they're going to kill the margin on the 70% of the business that they have left. HEICO have the 30% and then they're going to continue to make high margins on the business that they have left. And so, I think that's a really interesting competitive advantage HEICO has.
Bill: Yeah, no, it's super interesting. It's one of those or certainly appears to be one of those like win-win type relationships for HEICO and the end user. Meanwhile, the incumbent that you're attacking just simply can't respond.
Chadd: Right. They have a reasonable amount of organic growth, because their organic growth is going to be determined by miles flown. And then they take their excess cash and they buy up smaller businesses. Let's say, you worked at the OE. Let's say you work at Honeywell or a GE and you're an entrepreneurial person, and you launch your own business, and maybe you grew it to $50 million, $100 million of revenue, but that's maybe about as far as you can grow it on your own. Because you're selling to the Delta’s and American Airlines of the world, they may not want to take the risk of a small business that doesn't have a balance sheet behind him or a history behind him.
HEICO can come in, buy the business, pay a lower than market price for that business, but then give the credibility of their reputation to that business, and then help the business grow by helping that entrepreneur navigate the FAA approval process and get more parts manufactured.
Bill: Yeah, it's like a true example of where the multiple arbitrage is warranted.
Chadd: Correct.
Bill: Yeah. So, when did you find HEICO? What years are we talking about? Because now, it's one of these compounders that has just grown to the moon and everybody knows about it.
Chadd: Like I said, I started looking at it in May of 2014. It was probably trading at a price I thought was rich at the time of maybe a five, five and a half percent free cashflow yield. It was about $3 billion market cap, which was about the size, the minimum size that the shop I was at would invest in just given our position sizes. However, I was discouraged from doing too much more work on it, because it has two classes of shares. And so, that $3 billion roll didn't really apply to them. I had it to have maybe $3 billion in the common stock before we look at it closer. So, I waited a little bit, and I went to my next shop, and it didn't have that constraint, and we started to build the position in January of 2015.
Bill: It's interesting for me to watch what HEICO has become and how often it's talked about. What I find interesting about it is, by the time that the cat is out of the bag and people have realized what you found years and years ago, now, the stock is already compounded at whatever, an insane rate and you're paying a lot for the business. The acquisition engine, almost by definition has fewer engines in front of it than it does behind it or certainly than it did in 2015, right? It's a question I ask myself a lot is, “What is the size of the business that I should be looking at to give myself the runway?” Because base rates eventually apply or alternatively like, “Do you spend your time looking for businesses where the base rates just simply don't apply?" Or, how do you think about what I just said?
Chadd: Well, I comanage two funds. The larger of the two funds has HEICO and has had it in it for a long time. I still think that there's a long runway for growth of them. Keep in mind that they do have two businesses. They have a highly engineered defense business, which is interesting. And for a long time, I thought that that was going to be where a lot of the acquisitions would come from. But if you listen to the last HEICO earnings call, they're very bullish on a lot of acquisitions coming into the flight support group. But I do spend a lot of my time looking for the earlier companies, the earlier stages, HEICO in 2014.
Bill: Right. Yeah, well, there's just a lot of return in front of you when that happens and I guess that that's a fairly-- Oh, before we move on, the question that I wanted to ask you, because I know people will love hearing about this. Do you mind talking a little bit about the nuances of acquisition accounting? If you don't mind also talking about like what makes asset heavy businesses at the accounting different there?
Chadd: HEICO is very disciplined in the price that they pay and they're focused on cash-on-cash returns, which is something that I want to see as an investor. I'm not really too concerned about GAAP earnings, accretion dilution. I'm focused on cash-on-cash returns. One of the ways that you can see if a company is focused on that is how they do acquisitions. There're three ways to buy a company. You can buy the equity of a company, in which case, you step into their shoes with respect to the tax basis of the acquired business. Tax depreciation is highly accelerated, especially in the last few years with bonus depreciation, etc. The businesses get a lot of depreciation upfront. And so, if you acquire the stock of a business, you may be in a position where you have very little to no depreciation of the assets that you acquire.
The second way to acquire a business is through an asset purchase. You buy the assets of a company that allows you to step up the valuation on a tax basis for the assets that acquired to a fair market value. And then you also get to write off some goodwill, which accountants call intangibles. But really, it's just goodwill and you write that off over a 15-year period and you get to take it against your taxes. So, that’s a free gift from the government. Sellers don't like asset purchases, because the liabilities of that business stay with the sellers. So, sellers would rather have a stock sale. The government came up with a middle ground called a 338(h)(10) election, which is stock sale that's treated for tax purposes like an asset.
Now, when the assets get stepped up, the seller has to pay the taxes on it. The seller takes a bit of a hit, but that's all negotiated in the price of a deal. For HEICO, HEICO certainly prefers to do 338(h)(10) elections and asset purchases. But it's a little less relevant to them because their businesses are very high ROIC businesses capital like. And so, that type of election will allow them to step up a little bit of the assets and then give them some of the goodwill right off, but it doesn't make too, too much difference to their cash-on-cash return. If you look at FinTwit investor favorite, GFL-
Bill: [laughs]
Chadd: -which is a waste hauler, that's a very asset intensive business. And so, I would say that a company that's doing acquisitions in that space that doesn't do an asset purchase or 338(h)(10) election, would be somewhat negligent, because they would be missing out on a massive amount of tax write offs. If you look at the history of the waste hauling space, I've heard it described as some companies are roll ups or roll ups. And so, clearly in the early days, there was a lot of optimizing for GAAP accretion, dilution as opposed to cash-on-cash returns, but I think everybody at this point has that figured out.
Bill: I just want to make sure that the people really hear what you are saying. So, do you mind just like really closing the loop on why a company like GFL should make the election? What is it the 330--?
Chadd: (h)(10) election?
Bill: Yeah.
Chadd: Well, otherwise, it would get little to no depreciation and tax write off from the assets that they purchase now. I really good case of Berkshire company and I'll think it's Warren, probably, one of the other guys but Axalta, which is a paint company. And so, Axalta was owned by, I think Dupont, and then Carlyle bought it from DuPont, and then subsequently IPO-ed it, and then Berkshire invested in it. When Carlyle bought it from DuPont they did a 338(h)(10) election. And so, you can see the assets of the business grow when the acquisition occurred, because they did the write up. So, what did that do to the financial statements in the screening ability of Axalta?
Well, first, the assets went up and so your denominator increase, so it's going to lower your ROIC. You are depreciating stepped up assets, and you're depreciating goodwill through the amortized intangibles, which is going to lower your earnings. Your ROIC goes down, your P/E goes up and there was no decision here from the management of the company. The management, there were the sellers. It was Carlyle, the buyer that made the decision. So, when I look at ROIC and I look at ROIC as a way to judge a company's acquisition capability. But in this case, it wasn't their decision. You really need to look at return on tangible capital, because to get a truer picture of Axalta’s ROIC, because that would exclude the effects of the 338(h)(10) election of which the company had no decision in making.
Bill: I wonder if that's an interesting screen, if you were to screen the difference between a higher return on tangible capital versus return on invested capital. I wonder if that would exploit some bias that people have against like lower ROIC businesses, but are actually high tangible return businesses.
Chadd: Yeah. I haven't looked at Axalta in several years, but I think if I go back the GAAP, if you will ROIC calc is maybe high teens, whereas the ROTC is in the 40s. So, it's not an immaterial difference.
Bill: Yeah, not at all. Do you think that that is, when I say that, I'm talking about accounting irregularities or accounting differences between what may look like reality and what's economic reality. Do you think that Buffett like that's one of his mental models that he's looking for?
Chadd: Well, I think that's the point of having his owner’s earnings. That's exactly the point of it. Then if you go deeper into the Berkshire family, if you look at Lou Simpson in the Washington Post articles in the late 80s that he gave and then talked about his investment style. Then you fast forward and you look at what was said in the Warren Buffett, CEO. He clearly made a change where he focused on free cashflow as opposed to GAAP earnings. And the free cashflow is just basically a different way to get to Buffett's owners’ earnings.
Bill: You know how dumb? In college, I majored in accounting, and I remember talking about the cashflow statement with my teacher. I was so naive. I did learn the error of my ways. But for a while, I was like, “Well, what does it really matter the cashflow, because you can stretch your working capital or whatever?” I can't believe that I ever had the thought that the cash isn't what matters, because now, I think the cash is all that matters.
Chadd: Now, getting back to HEICO. I love Larry's quote, which he says often that, “Earnings are opinion in cashflows fact.”
Bill: Yes. Cash, you can actually pay the bills with, right? [laughs] So, I want to talk a little bit about what you see in your current portfolio and the company that I think you're the most excited about is eDreams. I want to say this with the caveat of you're about to hear probably the most bullish person on eDreams in the world. But what about that idea do you like so much?
Chadd: Well, there's a couple of investment opportunities that I really like. I like, number one, advantaged business models. You see that with HEICO, its ability to use its competitor’s size against them. I like business transformation. When a business goes from one state to a better state or better competitive position. And eDreams has both of those characteristics. If you look at what eDreams is, it's an online travel agency that's based in Spain. It's the number one travel agency by far with respect to flights. And flights in the US may not be that interesting of a business because of the top four airlines control 85% of the routes. But if you look at the top four airlines in Europe, they control maybe 29% of the routes. So, Europe is highly fragmented.
There shouldn't be too many cases, where an airline can underprice an online travel agency. Because online travel agency can book you on one plane outbound or one airline outbound in a different airline inbound. It should be able to be any airline at any time. eDreams was put together through several acquisitions of private equity owned companies. They IPO-ed around 2015 and then they immediately splatted, which cause the European institutions to leave it for dead. Shortly after that they replaced the CEO-- [crosstalk]
Bill: Wait, what did you say they immediately did?
Chadd: Splatted.
Bill: Okay. Splatted. I just want to make sure that I heard that right. What does that mean?
Chadd: [laughs] They reported some bad numbers. [unintelligible [00:20:31]
Bill: Okay.
Chadd: They replaced the CEO with the CEO who's an American, guy is very sharp, Wharton capital markets at JPMorgan, McKenzie, he worked in an airline. He's got the trifecta of experience. What he sought out to do was to create a stickier relationship between eDreams and their customers and to remove Google and meta searches as a factor in their business. And so, he first started doing that by developing an app. I think they have the best app in the travel space in Europe. They will give their customers airline level customer service with respect to the ability to change your flights and get notifications if your flight’s delayed, that's something that the Americans take for granted. Gives them good customer service in Europe for flights is not the norm.
Then what he did was he started to create a subscription business. He's transforming the business from a transaction model to a subscription model. And that to me is quite interesting, because if you are a customer and you pay 55 euros a year to be in their subscription program, which they call Prime, is model after Amazon, you get immediate savings on your bookings. It usually pays back within two bookings. And so, what does that do for you if you're eDreams? Well, the customer instead of going through Kayak or going through Google when they want to fly, they just come directly to you via your app or going directly to your website. So, it locks in that customer for you and it eliminates the customer acquisition cost 75% of time. So, their Prime customers go direct 75% of the time.
Bill: On the return booking?
Chadd: On the return bookings, repeat bookings.
Bill: Yeah, that's right, that’s what I'm asking.
Chadd: It eliminates a large portion of their customer acquisition costs. They started out in flights and they're starting to move into other parts of travel. They will sell you hotels as well. And so, hotels is a fantastic business. It's even higher margin than flights and their competitors’ bookings. Here's where I see a lot of parallels between HEICO and eDreams because eDreams will sell you a package of a flight and a hotel. Who knows where the discount is coming from, if you're the customer or if you're the supplier? Bookings can't underprice their hotel suppliers. So, if booking [unintelligible [00:23:04] Marriott Hotel in London, they can't price the cheaper than Marriott can. But if you have a flight plus hotel and you get a nice sized discount, and who knows where the discounts come from.
Bill: And the reason booking can't do that is they have an agreement with Marriott that says, “You're not going to undercut our best offered price,” right?
Chadd: Correct. But if you have a dynamic package more than one service, it obfuscates where that discount comes from.
Bill: Yeah. I guess, one of the questions that I've been thinking about is, so, I paid the Prime subscription. Why is that a stickier relationship or a lower customer acquisition cost over time than if you just like, if you are eDreams, if you just gave me the best deal all the time? Don't I have a habit that forms anyway? What incremental customer stickiness is created from Prime or is it just that once you've committed to paying 55 bucks, you're going to go back?
Chadd: It's like boot camp. It costs you a lot to join the Marines but once you've made it through the boot camp, you're gung-ho about it. So, I think having the buy in ties you to it.
Bill: Yeah, that makes sense. And then something that has been shocking to me when I've looked at the numbers is how quickly that Prime membership has ramped. What have they done to communicate that value proposition to the customer, maybe a little bit better recently or is it just that they rolled it out and people just love it so much that it just exploded?
Chadd: They have done no advertising for it, which is something that they can do. I would expect you to be in the tube in London and see an advertisement for it at some point in the future. But they haven't done any of that. What they've done is, they've bid hard for travel flights on meta search apps and Google etc., because there's another 75% number. If they get in front of a new client 75% of the time that client turns into a Prime subscriber. They can realize the lifetime value of that subscriber. They have a very low attrition rate and so there is a long life to the subscriber.
What they do is, they’ll give the customer their booking fee in the form of discount. The Prime fee of 55 euros a year, they can give some or all of that to Google the first year. And so, the first year, they're not going to see much with respect to the financial statements, earnings, and cashflow from that subscriber because they're basically given away the booking cost to the customer and the Prime fee to the lead. But when that anniversary is the second year, they keep the subscription fee. So, no matter how many trips the customer takes, the customer is always going to get the booking fee back in the form of a discount and eDreams is going to get that 55 Euros per year.
Bill: And it seems to me that the type of customer that they're looking for is a customer that takes more than one trip a year. You're really, I would think looking for the avid travel fan. Maybe I'm wrong on that. But that seems to be how you would save the most money, is like these avid travelers. The reason I'm asking is it just I wonder that customer seems super sticky to me, if you can actually save them a lot of money and they're booking often. I've just been trying to kill this idea, because we talked about it and I've been thinking about it since and it's just like, “Okay, well, I guess, how many people are you actually targeting” is one question that I have? Then the other question is, which is totally unrelated, but I'm just trying to figure out like, “What makes this business different from the OTAs that have had a lot of trouble in the past and how do you kill this idea” was the other thing that I'm thinking about?
Chadd: Well, the OTAs have had a lot of problems in the past, because they've never solved the Google issue. Doing a subscription business is not easy. I think it requires dynamic packages. Tripadvisor recently launched a subscription offering and in the end it just turned into a rebate program, which is the same thing as every other travel company has. The subscription program is unique. I think that their addressable market is every leisure traveler in Europe and presumably, ones that would travel more than twice because it pays back into bookings. Their addressable market is quite big in their largest markets, they may have a 3% market share. And so, I think they're in the early stages.
Not to mention going into hotels. They'll sell you a hotel now. I think that they believe the way that their software works right now is they're not getting full credit for how much money they're saving on hotel bookings. And so, I would expect them to rework their software, and how it looks, and how it feels to the customer, I would expect that to take a year to 18 months. Right now, if you want to book a hotel, it used to be in conjunction with a flight. I would suspect that'll change over time once they get a user interface figured out. So, yeah, it's exciting.
Bill: How do you think about a business like this that has such low market share? If it is true that all of the travelers, the leisure travelers in Europe are your TAM, how do you think about owning this kind of an entity versus selling it if it hits a price target? Would you be looking for to exit a position like this? Because it sounds to me like it's a multi, multi, multiyear ownership?
Chadd: Well, it is multiyear. Let me go through that. Their fiscal year end is in March. And so, the beginning of last fiscal year, they were still dealing with COVID. The numbers on bookings didn’t start to get to pre-COVID levels until June. The margins are lower because Europeans were taking less complex trips. They're traveling shorter distances. And so, the basket size hadn't normalized yet, still hasn't. But in my model looking at how many subscriptions will anniversary this year, which most of them will be in the latter half and I think they're going to do at least $80, $85 million of EBITDA this year. They had 3 million euros of EBITDA last year. And so, you're going to get a huge increase in earnings.
I think they're going to be compounding their top line over the next three to four years around 20%. The bottom line is going to be compounding triple digits given the little base of 3 million euros. And that's just growing out Prime numbers. That's not doing a full court press on hotels. That's not taking that model to the US. If you go on LinkedIn and look at job openings, there is a US airline relationship manager posting. So, they're going to bring that to the US, too. I think that if you have the flights and hotels, the model will work in the US just as well as it works in Europe.
Bill: Presumably, the airlines in the US are going to fight back a little bit harder. The reason that I say that is the airline industry in the US is so consolidated. Every time I check out, it says, “Hey, do you want a hotel or do you want a rental car with this?” That said, I think what you may answer is the airline is not selling a bundled package. They're selling you the ticket and then they're selling you the hotels. So, there's the same constraints on the airline that there would be on a traditional relationship with safe booking or whatever, when it comes to the hotel sale.
Chadd: I don't think I've ever booked a rental car or a [laughs] hotel via an airline. I think, Allegiant-
Bill: It’s fair.
Chadd: -maybe does pretty well with it. But I've never flown Allegiant. [laughs]
Bill: Yeah, I think I did when I was long airlines. But that was motivated behavior. Yeah, it's interesting. It's a big position for you. How did you go through trying to kill this thing? Because when I hear you talk about it, I'm like, “Boy, this is one of the best ideas I've ever heard.” But it's pre-morteming, something like this is, I think, a very useful exercise. So, what does your process look for? Once you find an idea like this, how do you try to disprove it to yourself?
Chadd: I tried to kill the business model. The management's proven to be correct. They went from 1 million subscribers as of June 1st last year to 3 million subscribers June 1st this year. They're correct In the sense that Prime is highly valued. It did that without any outside marketing. And so, now, we'll see the cashflow through the financial statements this year. If the cash doesn't flow through financial statements this year, then that 75% of customers doing repeat bookings through cheap channels and REITs. And management would have lied to me, but I don't think that's the case. [laughs] So, I tried to kill the business model. If I can kill a business model and the business model is deteriorating, then it's a quick sell.
Bill: You had mentioned that one of the mental models that you have is that you like business model changes, there’re obviously business models that are morphing to higher margin businesses. One that I'm familiar with that you're also involved in is Green Plains. I was curious to hear you talk about what you saw. What I'm really trying to get at with these questions is one of the things that I find very cool about you and talking to you as an investor is, you appeared to me to be somebody that's really looking for early inflections in businesses that you can own for a very long time. I want to be that kind of investor. Selfishly, I'm looking for some mentorship through this conversation. So, if you don't mind talking a little bit about GPRE, that'd be fun for me.
Chadd: Yeah, Green Plains, I guess, 1.0 is exactly the type of company that I would not invest in. It's a legacy ethanol manufacturer. And so, it's highly capital intensive, it's very cyclical, you have commodities as an input, which is corn. You have crushed margins that you're dealing with and so it's complex. It's an industry that over promised and under delivered and so, it’s very ugly. Perhaps, maybe does $50 million EBITDA a year with a lot of variability. Some years, it's down 80, some years it's up. Yeah, not a pretty business.
But one of the byproducts of ethanol manufacturing is dried distillers’ grains, which is used in animal feed. I worked at Cargill as my first job out of college making the animal feed. And so, I know that product quite well. I know why it's used in the feed. If you look at the nutrient components of dried distillers’ grains, it has about 25% protein, which in animal feed is a middle protein and it is high in energy. Because of the fermentation process in the ethanol manufacturing and the yeast that was introduced to it in that process, it tastes good to animals. And so, you use it in animal feed for a flavor enhancer and for the energy. The value of that product is much higher than the protein level that product would say it should be worth. And so, you really don't get paid for the protein.
What Green Plains did was they bought a company that had a processing technology that allowed them to separate out the protein from the rest of the dried distillers’ grains. And so, what you ended up with was a high-protein cornmeal and the protein level right now is about 60% and then you're left with dried distillers’ grains [unintelligible [00:34:24] light. So, light protein. Now, they can still sell that dried distillers’ grains light for the same price that they would sell regular distillers’ grains because people aren't buying it for the protein. But they can take that protein that they extracted from that and sell it for a very high price per ton. And so, what they've done is they've taken a byproduct, which is the distillers’ grains and turned it into the primary product of the business.
Ethanol is now an afterthought. The primary way that they're going to be making money is through this high-protein cornmeal, which by the way, the quality of the revenue is increasing dramatically. You're going from ethanol, which the revenue is all over the place to locking in customers, such as pet food manufacturers or dog food manufacturers. What is the dog food manufacturer looking for? Well, they're looking for the nutrients that the protein is going to deliver to them. They're looking for the flavor of the product, which is coming through the brewers east and they want the product to look the same, and smell the same, and feel the same as a bag that they sell in Seattle versus a bag that they sell in Miami. And so, they're not going to be making changes to their formulations too often. When something like this comes along, which is an ingredient it's going to add immense value to eliminate that change and then it's locked in, it's like a roach motel, you get in, you don't get out.
And there's other animal nutrition industries where he had the same dynamics. They just launched a joint venture with a company that produces salmon and trout. I think it's the largest trout producer in the world, certainly, in the US. Same deal. They don't want to make changes to their formulations too often. Once they're in, there in.
Bill: How often are you rebidding an RFP on something like this? How often can they push price is really the question that I'm asking versus are they just pricing off corn and soy substitutes? How does this additive stay away from being a commoditized sale?
Chadd: Well, I think it's going to be price close to corn gluten meal, which is commoditized. But when I underwrote this, the protein prices were much cheaper than they are today. So, I'm comfortable with the low variability.
Bill: Yeah, that makes sense. Shoutout to Kyle, who we both know.
Chadd: Yes, yes. Kyle gave me a little help with that in the early days and I think I reciprocated with Archaea Energy, which has a little bit of some of the same. Green Plains, I think is going to do well with the business transformation. But there are also some tax benefits that they're going to be getting, because they can sequester the carbon that's produced in their manufacturing process, which I'm not going to underwrite it on the tax benefits. But it's real. So, and Kyle give me a lot of help with that.
Bill: The carbon sequestration stuff is pretty interesting. I started noticing it not all that long ago, but we're in an interesting time. I think I have this theory that may or may not be done, but that some industrial companies are at the center of some changes that could create a pretty interesting group of compounders.
Chadd: Well, let's look at that. We talked about GFL earlier with respect to the tax implications of their acquisitions. But Archaea Energy, which Kyle and I both worked on and he helped me out a lot on. What do they do? They collect methane from landfills. Landfills has organic matter. As it breaks down, it produces methane for 30 or 40 years at a very slow decline rate. And so, what waste companies can do is to drill holes in their landfills, collect the methane, clean it, and either burn it on site, which in my county, they do. I've seen it. They have five power generators. The power generators burn the methane, it produces electricity and they sell into the grid. With that comes some LCFS credits, which is low carbon fuel standard credits, which some states require or what they could do with it is they could clean it and inject it into a natural gas pipeline. And so, it's all natural gas with those low carbon fuel standard credits attached to it.
When I started working on this, I asked one of the sell side analysts who supposed to be the best in the waste space about it is about a year ago, April, and he poo-pooed it. They've been working on this for years, nothing going there, and then he starts asking questions to his management teams on the Q1 call, and then followed up shortly after that by his company's main conference, and he gets positive responses. And then he keeps asking these questions. By the second quarter conference call, he asked GFL CEO about it and he said, “These are 40% plus IRR projects. It's the best use of capital in my business.” The markets that's been almost a year and the market still has even picked up on that.
Now, granted, they're just putting these projects in place and it's not flowing through the cashflow yet. But I think GFL’s quoted estimates for the free cashflow per year of these projects is $100 to $150 million a quarter. They've also said publicly that internally their cashflow projections for this is $150 to $200 million per year. And they have it separated out into its own LLC, which means if you have a hot IPO market for a “clean energy company,” what can they have on the other side?
Bill: Yeah.
Chadd: You have $200 million a year free cashflow. That's clean energy. Is it 20 times EBITDA? I don't know. But there's probably $3 to $4 billion of market cap value in this project that nobody's even looking at right now.
Bill: Yeah. Sometimes, I've heard similar idea with the carbon capture company and sometimes I wonder if I'm getting myself a little bit to Wall Streety when I start thinking about what could they spin something off versus just thinking like, “Boy, if these returns are real, which they are,” but let's say they materialize. I'd almost rather have the business continue to trade at the same multiple and just buy the shares in. Either way, you win, right?
Chadd: Well, in GFL’s case-- [crosstalk]
Bill: It assuming that it comes to fruition.
Chadd: In GFL’s case, saw $200 million dollars a year in which they can continue to roll up the waste space [crosstalk]
Bill: Yeah.
Chadd: That's not a bad outcome, either.
Bill: That's right. I'm just wondering if there's a lot of this going on in the industrial space that I don't know.
Chadd: Well, if you find some, please tell me. I think I've found one in the waste space.
Bill: It's one of the things that I really like about Kyle. Kyle [unintelligible [00:41:14] and people that may not know him. But I think he does really interesting work and I like looking at some of the stuff that he follows.
Chadd: Another fellow eDreams shareholder, I’ll just might point out for disclosure purposes.
[laughter]
Bill: Yeah, that’s right.
Chadd: Kyle is very smart. [laughs]
Bill: Yeah, there you go. Yeah, we'll have to run this bias compliance team. I'm sure he won't mind. Do you want to talk a little bit about your fund and what you are and are not focused on-
Chadd: Sure.
Bill: - like a moral aspect?
Chadd: Yeah, we can start with the investment part of it and then we'll get to the moral aspect, and then we can tie how that goes back into the investments.
Bill: Yeah, that'd be awesome.
Chadd: So, I run the Ave Maria Focused Fund. And so, we are a legal non-diversified fund. And so, within some guardrails, I can take big swings at companies. You're not going to see this fund have 30 to 50 Holdings. You'll see to have either side of 20 holdings. And so, I can take some big swings at companies that I like and as we've discussed earlier, I'm looking for companies that can compound for a long time and prefer to catch them early. But there are some larger companies that people would know. Microsoft, Adobe, Tyler would be examples. Equinix was in there for a good period of time. But the rest of it, I think, would be more obscure companies, where I think an inflection is happening, and I can hold it for a long time, and do quite well with it.
With respect to the moral component, it was founded by Catholics and was founded with the premise of allowing Catholics to invest in a way that's consistent with their moral beliefs. And so, what we have is a board of advisors that set up a list of industries or practices that companies do that we cannot participate in. And so, we have some negative screens and screens out those businesses. For example, pornography would be one. You’re not going to see us in Rix. That's an easy one, because Rix is all porn, but we have a zero-tolerance policy. And so, you won't see us in cable, for example, even though cable is an interesting space and as an investor, you might want to invest in it and the pornography might be a de minimis amount of their business, we have a zero-tolerance policy. So, we won't do that.
Bill: So, what's the difference between a cable company and Equinix, for example? Because Equinix is facilitating the transfer of pornography or what point do you draw that line?
Chadd: Well, it's like Amazon might sell you porn and UPS might deliver it. I think UPS is a step removed.
Bill: Yeah.
Chadd: They're not the ones that are distributing, producing the content or selling it, selling it.
Bill: Yeah, that makes sense.
Chadd: And so, that's where we would draw the lines in. But with respect to Equinix, they were, what was it one that was facilitating only fans or there was somebody that's facilitating child pornography like one of the websites? Was it Ackman that came out and called out the credit card processors for processing payments of it?
Bill: Yeah, I remember when he was on that kick?
Chadd: Yeah, it's June 2020.
Bill: Yeah.
Chadd: I've met people at Equinix and I found that in one data center, they hosted it and I sent that to him, I sent Ackman’s tweet and I sent MasterCard response, and didn't get a response back, but through your back channels. I've heard that they maybe, when the contract comes up for renewal, but they weren't going to be renewing it. So, hopefully, we did some good work there. As it relates to our investors, our investors invest with us for more than one reason. Number one, they want returns just like anybody else. These are private individuals that are funding their retirements. This is healthcare institutions, and universities, and other endowments. And so, they need returns to fund their operations.
But there's also the moral component. That's important to them. What I've noticed is that it tends to make our customers, our clients stickier, which is good for me as a portfolio manager. But it's also good for them, too, because nothing is going to destroy wealth like interrupting, compounding, and trading too much. If they're redeeming on me, when you have a period of performance, then it makes it harder for me to do my job. But in the end, they're not serving themselves well and doing that. And so, what I've seen is that it tends to make them very sticky, which is good for both of us.
Bill: Yeah, that would be. It's hard to find somebody that's aligned. So, if you have that kind of mission alignment, that's a nice filter.
Chadd: I'm pretty suspect to have a lot of ESG. I think it's marketing. But in our case, we have [unintelligible [00:45:53]. And so, if a company, we call them offenders. If company is not an offender, but subsequently when it becomes one like, it's a quick sell. It's nearly sold. We've done that on several occasions. Consequently, if the company was an offender and ceases to be one, because they changed their business practices, then that opens it up. We're thinking like Adobe at one point was an offender, because of some of the corporate contributions that they made, and they stopped making those contributions to funding organizations, and it opened it up for us.
Bill: No, that's interesting. You may find some things change with the recent Supreme Court decision, but you just monitor, right?
Chadd: Mm-hmm.
Bill: Yeah.
Chadd: We do have some outside organizations that do some screens for us. But a lot of it is internal as well. Diligence in companies, no one outside screening service should know my portfolio of the companies better than I do. And so, we often find or not often, but it's not uncommon to find a company that a screening service would say is an offender but when you dig into it, they're not and sometimes, they'll miss things. And so, it's incumbent upon us as we're doing our financial due diligence to also do the diligence on our moral screens.
Bill: I guess, the only way that I know how to ask this question is to ask you directly. So, are you going to call people and say like, “Are you guys funding travel for abortions or is that not something--?”
Chadd: I think that that is a question-- [crosstalk]
Bill: That's almost a privacy issue, potentially. I don't know.
Chadd: Well, companies are very public about this right now. I think that is a question for--
Bill: The big ones are.
Chadd: Yeah. Well, actually, I've seen some small ones, too.
Bill: Oh, really?
Chadd: I think that's a question for our advisory board, if the travel aspect is a violation or not. I think it's something that they're going to be thinking about and discussing at their next meeting.
Bill: Yeah. It makes sense. It's an issue that we haven't had to think about for a while. Now, it's an issue that people are going to think about.
Chadd: But certainly, corporate contributions to Planned Parenthood was one of our screens and we went looked for it. If it was there, we would invest in that company.
Bill: Yeah. I guess. If I were on your advisory board, I would say that, “Corporate contributions to Planned Parenthood are almost a corporate endorsement of Planned Parenthood.” Whereas supporting an employee may not be as much of a corporate endorsement. It may be more of facilitating the employees.
Chadd: A benefit.
Bill: Yeah. I don't know. I would-- [crosstalk]
Chadd: You would draw the distinction with respect to like, “If there's a matching contribution.” The company has a matching contribution and employee donated to Planned Parenthood in the company matching. We historically have viewed that as a benefit to the employee and employee’s choice as opposed to a direct corporate contribution.
Bill: Yes, that makes sense to me. Yeah, because the corporation is not saying, “Go out and do this.” It's saying, “I will match whatever you choose to do.” Yeah, that makes sense. That's an interesting distinction.
Chadd: To get back into how the financial due diligence can be done when you do or how the moral screens, diligence in how you do financials, probably summer of 2015, I was looking at Jordan, and Jordan didn't come up. But in one sentence in their annual report, they talked about buying this company in Germany that was an offender and it was just a one line. And the financials of that company are probably de minimis to Jordan, but I found it. I'm like, “Okay, well, I can do that.”
Bill: Yeah. Well, that's what some people are hiring you for. So, it's nice to know that you're looking out for those interests.
Chadd: Yeah, the whole role doesn't need to be Catholic, but it is nice to have a place for Catholics to invest and do it in a way that's alignment with their values.
Bill: Yeah, I would posit that there are some other religions that may have some overlap with Catholic beliefs. I've always associated it with somebody that wants to feel morally clean in some way, shape, or form. This is a reasonably good product for them to take a look at.
Chadd: Right.
Bill: Yeah. It never frustrates you or you're on a good idea like Jordan, for example.
Chadd: Well--
Bill: I guess, you start with it now.
Chadd: Well, look at the benefits that I have. The benefits I have as a stickier investor base. And so, the moat of our business is the adherence to our values. And so, that moat is way more important in finding another good investment idea. I co-run two funds. The focus fund is 20 names. But even the more diversified fund, it’s around 30. So, like, “We don't have to find too many good ideas to buy and hold for a long time.”
Bill: Yep. And you'll go global, obviously.
Chadd: Right.
Bill: eDreams of Spain.
Chadd: eDreams of Spain.
Bill: GFL’s Canada.
Chadd: More operations in the US. But yes, Canada.
Bill: Yeah, okay. I was thinking where it's listed, but interesting.
Chadd: Brookfield. Brookfield’s dual.
Bill: Yeah. What did you think of the recent Equinix short?
Chadd: I think that the thesis has been around for a long time and it was the challenges that I got when I first presented as a best opportunity. Fair enough. But if I would have listened to that I had been much for. [laughs]
Bill: What? You're the one that recommended Tubes to me, I think, right?
Chadd: Right. Yeah. I really learned and then Tubes talked about how these network engineers go to find access points to various websites and shrew that. I was able to find all the access points for the largest software and website companies, cloud companies in the world and saw that Equinix may have 30% access share to Amazon Web Services access points.
Bill: That's a moat.
Chadd: That's a moat that's not going anywhere. These access points are part of the critical infrastructure of the internet. If you want access to AWS, that's where you go. You don't go to Amazon's Hyperscale Data Center to access AWS. You go to an interconnected data center. That in part is what he's missing.
Bill: Yeah, so, the short thesis is that you could go directly to AWS or that AWS will disintermediate the system.
Chadd: Right.
Bill: Yeah.
Chadd: Which sounds to me like he's probably long Microsoft, and Amazon, and Google, because maybe they're compelling valuations right now and he wants to pair it with something.
Bill: Yeah. I don't know. That'd be interesting. Whenever I hear somebody talking about a short position, I always like to know, “What are they long, what are they saying, what are they offsetting, what are they hedging?” But financial reporting doesn't really do things that way.
Chadd: No.
Bill: So, we never know.
Chadd: Yeah, the GFL short was really interesting one.
Bill: Oh, we should-- Yeah, do you mind-- [crosstalk]
Chadd: [crosstalk] Spruce Point one.
Bill: Yeah.
Chadd: The Spruce Point put together this 80, 100-page slide deck on GFL, where they basically call the CFO mafioso and all kinds of nasty things. Whenever a short report comes out, I respect the short. So, I want to learn about it, and read it, and consider it. But the one thing that tipped me off was they sent the report where they alleged fraud and all kinds of stuff, and just send it to the SEC. If you think there's fraud going on, you sent to the SEC. But they sent it to the Department of Justice, which regulates anti-competitive and competitive behaviors like the FTC. And so, why would you send it to the FTC? Well, what was going on in the industry? What was going on in industry was that waste management was vying advanced disposal. For whatever reason, the FTC said, “We want you to divest a certain amount of assets for competitive purposes.”
For whatever reason known only to the government, they only wanted that sale to happen to one company. They didn't want them to piece it out for whatever reason. I don't know why. It's the government's prerogative on how to run the process and that's what they chose. Well, the only company of size that wouldn't have any other competitive issues was GFL. The reason why they sent that report to the FTC was to get that purchase stopped. I believe that Spruce Point had a short on GFL as they said, they did. But I also believe that the bigger short was advanced disposal because that deal got killed, that stock was going to plummet.
Bill: Hmm. Interesting. See, old why am I reading this now and why did they send it here?
Chadd: Right.
Bill: Yeah. You and I've talked about in the past ubiquity and I think that's another one where I think reality of the situation was that the motive behind the short report had to do with a basketball team. I don't actually think the short report turned out to have as much merit as they maybe would like.
Chadd: We spent a lot of time is to write it. But I think the only thing that he got right, he being left got right, there was an error in the number of users in their community.
Bill: Yeah, they had to restate that eventually.
Chadd: Yeah, they had to restate that. But I don't think that was material to any of the investors. Again, look at what was going on. There was a put call scenario that was coming due the following November, the report came out in September. The CEO of ubiquity was the controlling shareholder of the Memphis Grizzlies, the number two shareholder publicly stated he wanted to buy and own a basketball team. And so, if you're a CEO that doesn't take your salary and your wealth is tied up in the equity of the company that you found it and in run, if that stock price goes down, you're going to have less ability to borrow against or sell those shares in order to cash out a partner in another business.
Bill: Yeah. I don't know, man. The older I get, the more I ask, “Why is someone leaking this?” It's funny. I read the newspaper. We were actually talking about this last night. I read the news and if I know about something, I'll be like, “Ah, I don't think this is right.” But then the next article, I'll be like, “Well, this is right.” It's like once I realized that logical fallacy, I almost stopped reading the news a little bit too much and I need to get back to reading it and saying like, “Okay, well, who's trying to leak this?” I'm just skim it that way.
Chadd: I have the opposite view, because if you know something well and you know the news is getting wrong and you're like, “Well, if the news is getting wrong, that can sound really convincing.” Does that mean everything else is just as wrong?
Bill: Yeah, that's right. And it got me to stop reading a fair amount of news for a while. I think I need to balance the competing thoughts in my head.
Chadd: Right.
Bill: But it's why I've actually been reading the actual Supreme Court cases. Because I've said to myself like, “I'm certain that the coverage of these is not going to be accurate. So, there's an app that you can listen to some of them and like the really highly political ones" I'm forcing myself to listen to.
Chadd: They're entertaining to read.
Bill: Yeah, they're quite good.
Chadd: I'm not a lawyer, but I have read several of them including the recent ones.
Bill: Yeah, I think the only frustration that I have with the Supreme Court and I've always had this with con law, I didn't do very well, because I came to realize that at the end of the day, it's usually an outcome and then really smart people figure out how to argue to the outcome. But I think it's important to look at source documents and everything. I actually think one of the best, TransDigm, for example. When I was researching that, reading their testimony to Congress, I think it is one of the greatest sources of due diligence, right?
Chadd: Right.
Bill: I just think that Buffett says a lot that he only operates on public information. I think now with Berkshire’s dataset it's probably more private information than public. But there's a lot of very valid public information out there that no one else is looking at. Well, do you want to talk about anything else, man? I've really enjoyed. I came over to your hometown, you'd put me up, I've got coffee. Thank you very much. This has been great.
Chadd: My adopted hometown.
Bill: Yeah. Well, that's fair.
Chadd: I'm not a [unintelligible [00:57:43] by birth.
Bill: Well, very few are. But I think we're all happy to be here now. So, thank you very much for your time, man.
Chadd: Great, great. Yeah, I was happy to be on.
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