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Stock Ideas From Investment Professionals
Welcome, subscribers!
We have a LOT of stock ideas to share today, so let’s get right into it.
Graham & Doddsville, the investment newsletter from the students of Columbia Business School, is chock full of invaluable interviews with professional investors. This Fall’s edition is no exception. We’ve highlighted the stock-specific ideas from each interview, but we strongly recommend reading the entire publication for valuable insights on position sizing, portfolio construction, and behavioral strategies.
Disclaimer: Nothing here constitutes professional and/or financial advice. You alone assume any risk with the use of any information contained herein. We may own positions in the securities listed. Please do your own due diligence.
Enjoy this one!
Nadim Rizk from PineStone Asset Management shared three ideas from their current portfolio, Novo Nordisk (NVO), Taiwan Semiconductor (TSM), and Moody’s (MCO).
G&D: That's a good transition to discussing a few positions in the portfolio. Could you discuss how you approach position sizing? Could you please highlight the thesis points that attracted you to Novo Nordisk?
Nadim Rizk (NR): We always start with a small position, usually about 1%. As the story pans out and we have more conviction, we'll increase it. Some companies are capped because of risk or business sustainability, but others have a higher max cap. Typically, a position will be anywhere between 1% to 10%. In the past, we tried to have larger positions, but we usually try to stay in that 1% to 10% range, with median sizing around 4% (25 positions on average). We are not looking for mega positions in the 15-20% range, and we don't want to have a lot of tiny positions that don't add anything. The largest positions are usually companies we bought 5 or more years ago.
Regarding Novo Nordisk, the Acquired podcast has a good episode discussing it. We purchased Novo Nordisk in 2009. When we first invested, it was predominantly an insulin company. To describe the diabetic cycle, the first stage is pre-diabetes. The number one solution is healthy eating and exercise, which most people fail. The second stage of defense is drugs from the metformin family. These metformin pills usually work up to a point, after which they're not effective. At that point, you must take insulin, and once you take insulin, you must take it for the rest of your life. Once you start taking insulin, at some point, you will have to be on dialysis.
This has historically been the pattern, and Novo was one of the biggest companies that made insulin. Now, insulin was not a protected drug under any patent, as the patents had already expired, but insulin is a difficult and costly drug to make at a consistent high quality. While anybody can make insulin, very few people can make it profitably and at a very consistent level of quality. Novo is one of the few companies that can, and once you begin using insulin, patients almost never switch providers unless there is a drastic change in price. As insulin has such an impact on your health and lifestyle, customers rarely change providers. While it is unfortunate for patients, this creates an amazing and sticky business — the foundation of our thesis. Of course, we also approve of how the management team is running the business. Management is incredibly qualified and has spent heavily on R&D, which is crucial for a pharma company. Novo rarely makes any acquisitions, which is rare in U.S. pharma.
Eventually, Novo completely disrupted the industry by creating this class of drugs called GLP-1s, which in a way hurt its own insulin business but created a much larger market opportunity. GLP-1s work such that once metformin is no longer effective, patients will use GLP-1s. GLP-1s were initially branded under the name of Victoza in the U.S. but today are branded Ozempic and Wegovy. GLP-1s are much more effective than the metformin drugs and are better than taking insulin. They effectively push your need for insulin and hence push your need for dialysis. That is a massive social benefit to humanity because if you can postpone your need for dialysis, you've massively increased your quality of life and life expectancy.
Novo began noticing that patients on GLP-1s were losing weight because GLP-1s suppress appetites. This is how the Ozempic and Wegovy weight loss business was created, which has since completely taken off. The weight loss market is much larger than even the diabetic market because, while there's a lot of people that are either diabetic or pre-diabetic, almost everybody in the Western world is obese or overweight. Our lifestyles today revolve around sitting in an office with almost unlimited access to food, which is not compatible with the way humans were biologically designed. Human beings were designed to eat as much as possible when they did find food and to store the excess as fat. That is why it's so hard to lose weight — your body is acting against you. In today's world, that's a very bad model because we have access to unlimited food, and the less income you have, the worse the food you consume, resulting in even higher calorie consumption. In addition to that, most people are not very active. This is why we think the GLP-1 drugs will be massively beneficial to society.
While GLP-1s have some side effects — and we will discover that they have more side effects as there's no drug free of side effects — the potential benefit is enormous. GLP-1s have significantly increased the value of Novo. When we bought the company, it was a good business, but it has become an incredible business over time.
G&D: You've owned the business since 2009, and while the company has done very well, it's now nearing the midpoint of your traditional holding period. It’s also not the only player in GLP-1. Could you tell us about the future opportunity for the business, how you think about barriers to entry, and why they should capture more value in that market than others?
NR: Novo operates in a relatively fast-changing industry, so we can't say for certain that we'll own it 10 or 20 years from today. I think we will, but nobody knows because, unlike a Moody’s, Novo operates in a faster rate of change industry. Their closest competitor is a company called Eli Lilly, who has also been very successful in the GLP-1 category. Eli Lilly was previously behind, but they have largely caught up to Novo. However, the market is very large, so I think they can both win.
Eli Lilly has had a messier track record. Eli completed a few acquisitions, and the financial returns were mediocre at best. Novo, on the other hand, has consistently generated strong financial results over the past 20 years organically, which is our preference.
I think there's going to be more and more competition. The market is large, so it will certainly attract competition — that's capitalism 101. Companies see the opportunity and jump in. Amgen and some others are already attempting to compete.
As far as Dominic, our Healthcare specialist, can tell, the only company that we view as a competitive threat is Eli Lilly. It takes a while for companies to develop competing solutions. Perhaps in 5 years, the landscape might be different, but we think Novo is going to constantly innovate and move the goalposts. Ozempic is the weight-loss drug 1.0, and Wegovy is version 2.0. These drugs are injectable. Novo has been working on an oral drug, which would be very interesting, but it is quite complicated. We see Novo continuing to improve the drugs through their track record of very strong R&D.
Regardless, we will continue tracking and monitoring Novo’s performance like every business in our portfolio, and if we feel that the business has changed or the competitive environment has deteriorated, we will sell. In fact, we have taken significant profits over the last couple of years. Beginning in 2023 and during 2024, we have trimmed it multiple times on strong performance simply because we had such a large holding. We also felt there was perhaps excess excitement over the drugs with everyone talking about Ozempic. It has become a household name, which is funny because Ozempic wasn't a drug that was made for weight loss. It has weight-loss benefits, but the real weight-loss drug is actually Wegovy.
We still like the company, and the stock has corrected recently as some of the excitement has worn off. Did it make sense that the company was trading for 1,000 Danish krone? I don't know. There might have been a little excess excitement, but I think their business is very strong, and global demand will continue to be a large tailwind.
Taiwan Semiconductor Manufacturing Company (TSMC)
G&D: Can you touch on TSMC — what attracted you to the company and what is the thesis there?
NR: Taiwan Semiconductor is similar to Novo Nordisk in that when we bought the company, it was a really good business, and over time, it has become an incredible company. We first purchased TSMC in 2006. TSMC is essentially a fab company. Historically, semi companies like Intel did everything: they did design, engineering, manufacturing, etc. However, as semi businesses have become more complicated and more expensive, companies have had to specialize.
Several companies decided to specialize in design and would outsource the manufacturing of their chips to fab companies, mostly in Asia, which is how TSMC started. Over time, TSMC has become more of a dominant company because it's so well run. Today, if you look at TSMC, it's by far the best fab company in the world. TSMC manufactures every single leading-edge semi chip in the world. If you look at 5nm and below, it manufactures them for all the largest companies, including NVIDIA, Microsoft, Amazon, Google, and others. This makes TSMC a company that is very hard to replace. As I mentioned, over time, TSMC has become an incredible business, and as far as we can see, no one can compete with the company. Perhaps 10 or 20 years in the future, there will be other competitors, but as of today, they're in a league of their own.
Moody’s (MCO)
G&D: Can you touch on Moody's — what attracted you to the company and what is the thesis there?
NR: We invested in Moody's in 2001, and I personally did the research on it. Moody's is the holy grail of the types of businesses we like to own. Its industry is effectively a duopoly between them and S&P. There's another company, Fitch, that also competes against them, but it's much smaller. The industry structure is similar to that of Visa, Amex, and MasterCard, where Visa and Mastercard dominate, and Amex is much smaller. Moody's and S&P are similar sizes and effectively control the market.
This is a typical network business where the two winners take all. Similar to Facebook and Instagram with social media, the bigger you are, the easier it is to continue growing. This is what I call a benchmark business — as a company grows larger, the better its chances of continuing to grow. This happens because every client win pushes the next client to be your client. For example, in the ratings industry, most companies need two ratings to be admitted into any index or to sell bonds. Once a customer has been rated by S&P and Moody's, they have no interest being rated by a third agency — there's no additional benefit to the company.
Ratings typically cost between three to four basis points for bonds. In turn, rated bonds usually issue at anywhere between 20 to 50 basis points lower coupon versus unrated bonds. This dynamic creates a strong incentive for customers to be rated as they can save on their cost of issuance. The ROI for the client is massive — they receive 20 to 50 basis points of savings on the coupon by being rated for the cost of three or four basis points at Moody's. This creates a very sticky business. From Moody's point of view, these are very small fees, but they translate to a 50% margin. Businesses that create a very high ROI for the client at a low cost to the client are always attractive to own.
That's the Moody's business, which is the holy grail of business models and why we've owned it almost since its IPO. Moody’s has been one of the largest holdings in our funds since inception. It is not the most exciting company, it doesn't grow very quickly, and it's not super sexy. In years like this year, where technology stocks are very strong, it doesn't look like much, but it's an incredible compounder of capital.
G&D: How do you think about the exposure to the cyclicality of debt issuance while taking a long-term view on the company?
NR: You are right that it is a cyclical business. While it is not cyclical every year, if there's one flaw in the business, if you look at 2008, it had a very bad time. Issuance declined with the banking crisis, and Moody’s was sued by some entities. This is the period where we bought a significant holding because the stock was heavily shorted. There was a vocal short seller at the time, and we kept buying it all the way down to the bottom, eventually building a very large position.
In 2022, when rates moved up significantly, issuance also slowed down. As a shareholder, you go through these phases where issuance slows down, whether it’s due to the economy slowing down, a banking crisis, or some other reason. However, the world is addicted to borrowing, so these downturns tend not to be lasting.
Chris Waller of Plural Investing went into great depth on his firm’s positions in Watches of Switzerland (WOSG) and Seaport Entertainment Group (SEG).
G&D: Let's get to individual ideas and positions starting with Watches of Switzerland (WOSG). Can you walk us through the thesis and how you came across the opportunity?
CW: WOSG is a UK-listed company. It is about a $1.5 billion market cap. It trades at 12 times free cash flow today and will likely grow earnings at double-digit rates in most years. I think it's trading at half of its intrinsic value in three years’ time. The company is a retailer and partner to Rolex and other luxury watch brands. Most of the company's value lies in its relationship with Rolex. Rolex do not sell watches themselves. You can't buy a watch directly from Rolex or online. They only sell through authorized retailers like WOSG, which is one of their most trusted retailers and partners. The company has economics that are very different to a typical retailer and much more similar to what a subsidiary of Rolex would look like.
It benefits from qualities like long customer waitlists that sometimes run into years. There’s no price competition from other retailers, no inventory risk, and no online competition. WOSG has worked with Rolex for over 100 years. It was Rolex's first authorized retailer, and over time, Rolex has reduced the number of retailers it uses, thereby concentrating an increasingly greater share of the market in the retailers that remain. In the UK for example, there are 90 Rolex stores today, of which 41 are Watches of Switzerland stores. So WOSG has half the market in revenue terms and that number has been going up significantly. It's gone up from 35% 10 years ago when the current CEO took over. In the US, there are 280 Rolex stores and WOSG is the number one player with about 10% of the market.
A lot of the success the company has achieved has come from the current CEO, Brian Duffy. He's someone who is very competent, experienced, and wellincentivized. He owns £40 million in stock. He joined in 2014 and his idea was to invest significantly in the store base to improve customer experience, which is what Rolex really cares about. That is what has grown their market share so significantly because it has allowed WOSG to go to Rolex and say, “We can do for you in the US what we've already done in the UK.” In the US market, in some cases, you have a lot of mom and pops that have owned a watch store for generations. They cannot invest $10 million into a store like WOSG can. So WOSG is effectively becoming a vehicle for Rolex to roll up the US market, which is about 15% of the global market. That's a long runway to deploy capital. WOSG has grown 30% per annum in the US over the last five years. Still, this company trades at 12 times free cash flow. The primary reason for that is Rolex acquired another retailer late last year and the potential impact of that acquisition on the WOSG -Rolex relationship concerns investors. The other factor is cyclicality. The luxury watch market was really boosted after COVID, and that has reversed. That has impacted the secondary market, but it has not really impacted Rolex because Rolex sells off a waitlist.
G&D: Digging into this recent acquisition by Rolex, do you see any compelling reason for them to bring retail in-house? We understand Audemars Piguet did something similar as opposed to partnering with retailers like WOSG.
CW: The retailer they acquired, Bucherer, is about 5% of Rolex's sales globally, and operates primarily in Europe. They have half of the Swiss market, which is where Rolex is based, and they also have some market share in the US. From Rolex's perspective, it's important to not prioritize 5% to an extent where you end up marginalizing 95% of your distribution. When they made this acquisition, Rolex publicly stated that the acquisition was because the third-generation founder of that business, Mr. Jörg Bucherer, had no natural successor. He actually passed away quite soon after that acquisition. Rolex was in a situation where this company, which was half of their distribution in Switzerland, was going to be sold to a competitor like LVMH or a private equity firm that may not behave in the way that Rolex wants.
This was largely a defensive move. Rolex stated the importance of maintaining the Swiss heritage and protecting the transition. Rolex is a nonprofit, so that makes it very different from companies like LVMH or Swatch Group (SWGAY), for example. It is run by the Hans Wilsdorf Foundation, which is a non-profit that donates most of its cash to the district of Geneva. Per the former employees at Rolex I spoke to, Rolex has the problem of too much cash because it can only donate to this specific area. If they did want to make more money, the easiest way to do that would be to raise their prices. It would increase profits without impacting how many watches they sold.
What I found interesting is that everyone I spoke to in the watch industry was convinced that Rolex is not about to enter the direct-toconsumer market in any significant way, for some of those reasons that I've described. The margins that these retailers are making are usually about 10% or below. A smarter way for Rolex to take back some of the economics, which is something they've done over time, is to reduce the number of retailers but continue to increase production so that you have more and more watches being sold at each store. This increases operating leverage for remaining retailers and helps them generate greater profit.
This also increases Rolex's share of the economics without any big change in the business model. One thing I did push people in the industry on is, “Let's just imagine Rolex did want to really go into direct-to-consumer in a big way. Well, what could they do?” And the answer was always, “Well, in the UK, Watches of Switzerland has caught the market.” Realistically the only way to do that would be to acquire the company, which would not be what I'm looking for, but is not a terrible outcome either.
G&D: In terms of valuation, you mentioned that one of the benefits that you see is WOSG resembling more of a subsidiary than a retailer of Rolex, and that's what makes it valuable. But the market seems to be a little put off by that and the company’s concentration of suppliers with Rolex. What do you think it will take for the market to see eye-to-eye with you on this relationship that you see as so valuable?
CW: In my analysis I broke out the returns on capital for the Rolex side of the business versus everything else. The Rolex side of the business generates 40% returns on capital, which matches with multiple people in the industry saying that getting a license to sell Rolexes is like getting a license to print money. But the non -Rolex side of the business only generates returns slightly above cost of capital. I would encourage the company to continue allocating capital to where it generates the best returns rather than diversify for the sake of seeming less concentrated with Rolex.
To get the market to recognize the strong partnership it has with Rolex, WOSG should make acquisitions of mom and pops, particularly in the US, that have a Rolex license that WOSG can redevelop. Or to open stores in those markets where Rolex will essentially move the allocation of watches from the incumbent to WOSG. WOSG is opening a store on Bond Street in London, which is a three -story, 8,000 square foot store that is going to be the most impressive Rolex store in the world. When marquee stores like that get opened, it demonstrates how strong the relationship is.
G&D: WOSG has recently diversified into luxury jewelry. Do you see that as an additional sources of value?
CW: WOSG recently acquired the US license to jewelry producer Roberto Coin. Per my estimates they paid 6 times free cash flow. Jewelry is only about 10% of the business today and I don’t think it is going to become a major part of the business.
In terms of whether it adds a lot of value, if they can do a great transaction like that, that is fine. But I would go back to the point that I would prefer that the capital gets allocated to the great business, which is the Rolex business. What I would not try to do is diversify into a lot of different areas that maybe have slightly higher margins but don't generate the same returns. And I think broadly speaking, they will deploy capital to the better business over time.
G&D: Let’s switch to Seaport Entertainment Group (SEG). Can you walk us through the thesis and how you came across the idea?
CW: SEG is a spinoff from Howard Hughes (HHH), which is a real estate firm that is 38% owned by Pershing Square. As part of the spinoff, Seaport conducted a rights issue to raise capital to redevelop some of the properties. What is interesting is that Pershing Square is not only keeping its shares and subscribing to its rights, but oversubscribing and backstopping the entire rights offering. I think that tells you how attractive they think the price of this offering is.
HHH is primarily focused on master-planned communities where it has the control and can determine how those properties are designed and the speed at which they are released to the market. And its stock over the last few years has been weighed down by these assets in the Seaport district in New York. One of the reasons for this spinoff is to effectively bundle these less desirable assets into a “bad co”, which is now SEG, which transforms HHH into this pure play master-planned community business. That has led to indiscriminate selling of this stock, as investors have wanted to get rid of this for quite a while. Each SEG share is also worth about 5% of what a HHH share was worth. SEG owns a group of properties that are currently loss-making and that I think will turn around. It includes some retail and office buildings that are partially empty in the Seaport District of New York, a loss-making food court, a plot of land called 250 Water Street that is currently undeveloped, some restaurants, JVs, air rights and even a baseball team and ballpark in Las Vegas. It's a complex set of assets.
Bill Ackman was the chairman of Howard Hughes for 13 years, including when this transaction was announced, and Pershing Square is backstopping the entire rights issue at $25 a share. That means if the shares were to fall below $25 prior to the rights issue and people were not going to subscribe, Pershing Square would end up subscribing to the entire offering. And that would result in Pershing owning about 72% of the company. I think making a commitment like that means that Bill Ackman thinks this is very attractively priced at $25. The pushback is that the stake in Howard Hughes is worth six times more than the stake in Seaport for Pershing Square, even if they become a 72% holder. But there are ways they could have done this spin off without this Pershing Square backstop. Typically, a spin-off doesn't necessarily have a backstop like that. Owning 72% of a publicly traded company could also bring some regulatory and reporting complications to Pershing. I don't think this is something that they would've done lightly to support another position, which means that they must think it's cheap.
Anton Nikodemus is the new CEO coming in. He is 60 years old, relocating to New York from Las Vegas, and he's been based in Arizona and the Vegas region for most of his life. What likely drove him to make that move is the $12.4 million in stock and options he is receiving, and I don’t think he would've made this move unless he thought that these assets have a bright future and were very attractively priced today.
Lastly, SEG has a market cap of $330 million postrights issue and it's got $50 million of net cash – net of the non-recourse mortgages. The actual gross cash totals about $170 million. Howard Hughes invested at least $1.3 billion into these assets. And if you add JVs and air rights and so on into that, it's probably closer to $1.5 billion. You are getting these assets at about 20 to 25 cents on the dollars that were invested, and you have an incentivized and competent CEO coming in that is going to recover a significant portion of that value. If he does so SEG is probably worth a multiple of where the stock is trading at today.
G&D: How did you become comfortable around the $25 a share valuation of SEG?
CW: This is a turnaround. There is a wide range of outcomes, but the price you pay is an important determinant of how much risk you're taking. At $25, there are reasons to believe that most of the potential outcomes are well above that number. And the way I've tried to think primarily about the downside is to say, “Okay, as a group, this is a basket of assets that have clearly been problematic, but actually there are a few of these assets that have done very well.” One of those assets is 250 Water Street. Howard Hughes invested $180 million into this piece of land, another $60 million in terms of legal fees and preparing it for development.
It is very rare to find land like this that is ready to go, fully permitted and titled. It's a nine-minute walk from Wall Street and is fully approved for a 27-story building with 550,000 square feet of space, including apartments overlooking the Brooklyn Bridge. If you look at the economics of a developer – what it would cost for them to actually develop this and the sorts of rates they could achieve on the apartments and the retail and office space – the math works out to about $180 million. Not compensating for all the legal fees and so on that have been incurred, but still a very significant amount of value in comparison to a $330 million market cap.
The Fulton market building, also in the Seaport district, is a fairly small property, but it's fully leased up and generates $5 million in earnings per year. If you apply a 6.5% cap rate to that, that is $75 million. If you add 250 Water Street, the Fulton market building and just the net cash, that gets you not far off the current market cap, and that doesn't then include the other billion dollars that HHH invested in the remaining properties.
G&D: What are your thoughts on the re-leasing potential for the empty office space in the Pier 17 building?
CW: Pier 17 is probably the most valuable property. HHH invested $600 million into Pier 17. I think the property is roughly break-even today. It includes five restaurants on the waterfront, about 213,000 square feet of office space, and a rooftop that is a very successful venue for concerts. There is a lot of improvement potential. The office space is only half leased. COVID happened, we now have remote work and demand for office space has structurally declined in New York. Anton Nikodemus, the new CEO, has a background in entertainment and is looking to redevelop that space into an entertainment concept. This will attract a much larger number of visitors to this area, which is then going to benefit all these properties. If run well, this building could probably generate about $30 million in earnings. Depending on what cap rate you assume on the earnings, that is a very significant amount of value compared to the market cap today.
Elie Mishaan of Bryant Street Capital Management shared his thoughts on Limbach Holdings (LMB) and Vertiv (VRT).
G&D: That is a terrific example. We feel compelled to transition from the IBP case study to your position in Limbach Holdings Inc. (LMB). Can you talk through the thesis, how you originally discovered the company, and why you're so excited about the opportunity?
EJM: LMB hit our radar when they announced a new CEO. Mike McCann was the COO of the company, having spent his entire career there. He's been at the company for 20 years or so at this point. He worked his way up, became the COO and then was promoted to CEO. So, we discovered this company undergoing management transition and started doing the work. And the more we looked at it, the more it reminded me of IBP.
At the time, LMB’s market cap was about $300M, well below our portfolio’s median market cap of ~$4B. Our sweet spot tends to be the $1-$10B SMID cap space, but we’re not overly dogmatic and are happy to invest in smaller or bigger companies as we find compelling opportunities. But we focus on that SMID cap wheelhouse because we find that companies in that range can generate real strategic value on both sides of their ecosystem, beyond just their core operations. SMID cap companies are large enough to do accretive tuck-ins, which present value creation opportunities through synergies and economies of scale. Companies in this market cap range also have exit opportunities as acquisition targets for larger strategic competitors and private equity firms. Even though we do not rely on take-outs, we do like to gain conviction that our portfolio companies hold strategic value to other companies. For $1-$10B market caps, both sides of their ecosystems are available as potential levers to pull to drive value for shareholders. Limbach is on the smaller side, but it still has both elements.
The first thing that stood out was net cash on LMB’s balance sheet. There are not a lot of industrial companies with net cash on their balance sheet. A lot of value can be created with this balance sheet. The next thing we uncovered was that expectations were way too low. Consensus for 2023 was $30M of EBITDA. We couldn't get anywhere below $40M of EBITDA when we modeled it out. So it seemed like a great opportunity in the shortterm with a lot of longterm potential from allocation of capital.
However, an operational transformation is really what hooked us in. Historically, LMB was a general contractor for non-residential construction. The company managed buildouts of data centers, factories, warehouses, distribution centers, etc. They were active in healthcare, education, and universities as well. As a GC, salespeople were incentivized to drive revenue and backlog, with little focus on margins. The business was lumpy, and cash generation was unpredictable. Those are not the attributes of a business that we like to invest in. That was 80% of the revenue.
The other 20% was the byproduct of that business. At the conclusion of many of these buildouts, some customers would say, “Hey, any chance you can maintain or service some of the systems in the building?” The services business focused on HVAC, plumbing, electrical systems, mechanical systems, elevators, escalators, etc. That was the byproduct of the GC business, but not the focus of the company. The COO we mentioned, Mike McCann, began a transition toward inverting that 80/20 business mix a couple of years ago.
McCann looked at the business and said, “Wait a minute, 20% of our revenue is ODR (Owner Direct Relationships), where we're doing maintenance and services. That business is more predictable and has higher margins. Why are we focused on GCR (General Contractor Relationships), which is low margin and unpredictable?”
We did work on LMB in the first half of 2023, after McCann was promoted. LMB had already accomplished plenty and the stock had more than doubled by the time we were getting excited. The ODR revenue contribution had already grown from 20% a few years ago to 50% in 2023. That gave us a lot of confidence, despite the higher valuation. With proof points, we were not investing in a “pie in the sky dream;” Mike had already executed a lot of this. Now our bet is “Can he get the revenue mix to shift from 50% ODR to 80% and what would the numbers look like?”
To give you a sense of the order of magnitude, the gross margins in GCR are 10%-11%, while ODR gross margins are 25%-30%. So the mix shift alone will create step-function improvements in profitability. Beyond the mix shift to a higher margin business, there's also a halo effect from focusing on maintenance and services. Not only is LMB growing that side of the business every quarter, but it's also improving their GCR process. Now they are focusing on only the GCR projects with the highest return on invested capital. In fact, some legacy GCR projects weren’t profitable – so shrinking GCR down to its best projects and avoiding the unprofitable projects will drive even more accretion.
The other major opportunity is using the balance sheet to roll up a fragmented industry. LMB’s goal is to take their free cash flow, which is going to be $40M+ annually, and buy smaller companies. And they’re starting with no debt – so there’s even more capacity if they can find bigger targets. LMB recently announced a $20M acquisition at 5x EBITDA that we believe will be 2.5x EBITDA in 2026 post synergies. Pretty powerful use of capital.
The roll-up will also open up new regions for LMB. Currently, the business is concentrated on the eastern half of the US: New Jersey, Pennsylvania, Ohio, Michigan, Tennessee, and Florida. They have 20 branch locations, and they want to expand into other markets. So there’s plenty of white space on the map.
Now let's talk about IBP and the similarities. IBP was doing the same thing. Like LMB, IBP spends very little on CapEx. Neither of these companies holds much inventory, and if they do, it's for a matter of days. So as an investor, I'm not taking material balance sheet risk in terms of inventory and working capital.
Since I don't need to use my capital there, it can all go to M&A. That's what IBP did, and they were rolling up companies at single digit multiples. On day one of IBP owning a tuck-in, the purchase multiple was even lower just from the synergies of integrating a local service provider onto a bigger platform with economies of scale. The IBP approach was to direct free cash flow toward accretive tuckins. LMB is going to do the same thing: keep allocating free cash flow toward rolling up mom and pops for mid-single digit multiples of EBITDA that will ultimately trade at a higher multiple within consolidated LMB. I have the pattern recognition because I've seen this with IBP already. The better thing about LMB is that their balance sheet is net cash.
Starting this roll up journey with net cash is very attractive. Investors don't need to assume any leverage on the balance sheet to get to very attractive growth. When we first looked at the company, they were doing $30M of EBITDA. It has already doubled a year and a half later. And we feel that EBITDA can double again from organic growth, margin expansion, and M&A over the next three years with no debt. But I have actually encouraged Mike and the team to take on some leverage and do even more deals if they can. That would accelerate value creation.
Over the next two years, we expect LMB will reach $100M in run-rate EBITDA and have almost zero CapEx – so I'm paying 9.0x. I'm very, very comfortable buying LMB here because comps like Tetra Tech (TTEK), Comfort Systems (FIX), Trane (TT), AAON (AAON), and even SPX (SPXC) trade for 20x25x 2025 EBITDA less CapEx. While LMB stock has almost tripled since we bought it originally, we've bought more on the way up. We think that there's a lot of value here that they can create, and we have significant conviction that they'll create it. Our most recent discussion with management was very encouraging. They have built a lot of confidence in their M&A strategy now that they've done it four times.
LMB is a great example of what we’re looking for. We try not to focus on opportunities that are just financial engineering. We want to focus on management teams that are improving the operations of a company, which should result in stronger competitive positioning, better free cash flow and capital allocation opportunities. Mike is improving the company through a mix shift and an M&A strategy. And we have real conviction from the fact that they have already demonstrated that they can execute what they're telling me they're trying to do – and it will flow through their P&L.
G&D: That's extremely compelling. You have the mix shift that's more cash generative, you have a fact pattern that supports they're going to be able to execute that mix shift, and then you have a great use of the cash. We all had an opportunity to read your letters and LMB sounds like a really exciting opportunity. Perhaps we will transition to Vertiv (VRT). Can you run us through the thesis there, and similarly, how you found the company and got excited about it?
EJM: Vertiv is a much bigger company today than when we first looked at it. Its $50B market cap is the largest in our portfolio by a large margin. When we first got involved, it was right in our wheelhouse with a $6B market cap. Historically, Vertiv was the Network Power business inside Emerson (EMR). They sold that business in 2016 for $4B at a low teens EBITDA multiple to Platinum Equity, who then owned it privately for a few years.
In 2019, slightly before the SPAC trend became a boom, Goldman Sach’s Raanan Agus – who is a legend in the investing world (Columbia JD/MBA ’93) – teamed up with legendary executive and former Honeywell (HON) CEO Dave Cote. They set out to find a company that had a leading market share in a good industry, had margin expansion opportunities, and could create competitive advantages under Cote’s guidance. VRT would be the only pure-play in the public market and boasted the #1 market share (15% at the time, now materially higher) in power distribution and thermal management products and maintenance services to hyperscale, co-location, and enterprise data centers.
Agus and Cote scrubbed through hundreds of companies before settling on VRT. We first connected with Agus and Cote in late 2019/early 2020 and I’ll never forget the context. I was on vacation with my family in Disney World at the time. It was 3pm and I left my wife and kids stranded to find an empty booth in a Disney restaurant to join the conference call with Goldman Sachs and Dave Cote.
Cote talked about all the efficiencies he would implement in the manufacturing facilities and how the supply chain was an opportunity as well. He said he wants VRT to “grow revenues while keeping fixed costs constant.” What he accomplished previously with the celebrated Honeywell Operating System was going to be re-created at VRT. Having spoken to folks who witnessed Cote’s “genius” as he walked through facilities during the SPAC process, we got very excited.
It was certainly surprising to take notes on that call about margin opportunities knowing it had been a PE holding. We all think private equity firms maximize margin. So, what more could there be to do? The first thing we did was evaluate their competitors, including Schneider (SU FP) and Eaton (ETN), to get a sense for where margins could be. Note that VRT competes with segments within those bigger companies, segments within segments really. We estimated that the comps were operating at 15%-20% EBITDA margins as compared to VRT in the low teens. Cote’s projection that he could expand margins by 500bps seemed plausible, and we felt he was a better agent to unlock that margin than any private equity executive. Cote is a master at squeezing margins out of manufacturing, supply chains, and distribution networks.
One of the other highlights of Cote’s pitch was investing more in R&D. At the time, in 2019 and 2020, VRT was spending $175M on R&D annually on $4B of revenue. Today, VRT is spending more than $350M on R&D. Why would he want to increase expenses if he’s trying to drive margin? Because he knows from experience that innovation and higher value products create efficiencies for his customers and they’ll pay you for that innovation. Pricing power is one hallmark of a great business that has a “moat.” You hear a lot about moats in the value investing world from legends like Buffett, Einhorn, Ackman, and Greenblatt. Cote wanted VRT to not only be more efficient on the cost side, but to also innovate to achieve pricing power and to build a wider moat versus the competition.
Having gotten to know Cote very well over time, we also realized that the 500bps goal was likely a mid-term opportunity that he could probably outperform over time. He was highly confident in his ability to achieve it, having walked through dozens of VRT facilities. Factoring in more operating leverage as product innovation drives accelerating revenue growth made 20%+ EBITDA margins in the realm of possibility several years out. A lot has happened in the world since then, including inflation and an AI boom, but it remains impressive that VRT is above 20% EBITDA margins 5 years later. Impressive yes, but not surprising to us given our conviction in Cote and CEO Gio Albertazzi.
When the company debuted, the balance sheet and its 3.5x leverage was an area of concern for some. However, our conviction in demand growth and in the margin expansion opportunity at VRT made 1.5x-2.0x leverage visible as a possibility a few years down the line. Interrupting that path to deleveraging was a very synergistic acquisition in late 2021 that the market hated given the interest rate hikes that were about to start. The stock was falling because they levered to do the deal and because inflation created price/ cost issues. Fortunately, we were able to rationally analyze the long-term benefits of the acquisition and the margin expansion that would appear once the pricing issue was fixed. That process led us to add significantly to our VRT position in 2022. We knew it might hurt our short-term performance as a fund, but that in the long-term we’d be creating a ton of value for our partners.
The original thesis was that the great management team would deliver excellent operational execution and margin expansion, creating a ton of value in the business and free cash flow, which can be used to de-leverage the balance sheet. Once the balance sheet is healthier, you can lean into buying companies and buying back stock. Longer-term – and remember VRT was a $6B market cap back then – perhaps you have a bigger industrial company come in and buy the business, yielding a great exit for shareholders. Now the market cap is much bigger, around $50B, so some of that takeout potential has been limited, but it’s only because management has done such a great job creating value for shareholders.
Finally, David Baron updated his thesis on Spotify (SPOT) and On Holding (ONON).
G&D: For the next position, could you talk about Spotify and your thesis for the company?
DB: At its core, Spotify is a great platform. The company has a wellknown brand and it continues to invest in improving the platform through adding new services, podcasts, and audiobooks. Spotify’s goal is to make the platform the best that it can be. People are concerned that while Spotify has approximately 30% share of the market today, their product is a commodity given Apple and Amazon also have offerings. However, in our view Apple and Amazon have many other offerings to worry about than music. Their music businesses are secondary to their respective businesses, whereas with Spotify, music is their core business. As previously mentioned, Spotify has 30% of the market with 600 million subscribers; however, only 200 million of those subscribers pay for the platform. In other words, there are 400 million that don't, and there's an opportunity to upgrade them away from the free offering. Furthermore, as Spotify improves the service, more people will be willing to pay for it.
As we have established, Spotify has a huge base of subscribers, and the company believes that in the next four to five years, it can grow from 600 million to a billion subscribers. Spotify is also raising prices and all of the price increase falls right to the bottom line. Spotify is able to raise prices without experiencing significant churn, which is similar to Netflix. Customers are willing to pay $14, $15, or even $16 a month as they are listening to music daily whether in the car or when they work out. There is leverage in the business model, and Spotify continues to grow at a 20% plus rate, given the subscriber growth and price increases. Spotify is able to generate strong gross margins that we think can continue to increase with price hikes and decreasing churn.
Spotify also has a strong cash flow profile. The company generates significant cash with strong free cash conversion and low capital intensity. Its balance sheet is solid, with a net cash position, and over the next six to 12 months, we anticipate a capital return program, either through dividends or buybacks, which would benefit investors. A potential dividend could attract dividend-focused investors to the stock. Furthermore, Spotify is founder-led, with Dan Ek holding a 15% ownership stake, aligning his interests closely with ours.
We expect Spotify to continue achieving 20% + revenue growth as the business performs well. While some view Spotify as operating in a commoditized market, we believe that the record labels need Spotify as much as Spotify needs them. Labels rely on Spotify for distribution, which helps drive demand for new songs. Eventually, customers might even be able to purchase concert tickets through Spotify.
Finally, Spotify’s AI is going to be a gamechanger. Their AI is designed to help customers create personalized podcasts, music, and playlists. Though it’s still early, this AI initiative has the potential to drive substantial growth for Spotify in the future.
G&D: For the last position, what is your thesis for On Holding, and how do you view the growth potential in the athletic footwear and apparel market?
DB: Like the other businesses we invest in, On Holding operates in a large market with immense potential. While Nike has been investing less in recent years, On has seized the opportunity to create a better sneaker. They’ve focused on enhancing athletic performance, especially for marathon running, and are now branching out into other activities, such as tennis. They recently signed athletes Ben Shelton and Iga Świątek, using this marketing momentum to expand into apparel. Historically, On’s growth has been primarily domestic, but there are substantial opportunities in Europe and China. Although they’re based in Switzerland, they’re still gaining market share even there. In addition to Switzerland, they see a global market opportunity, and with On being only 10% the size of Nike, there’s considerable room for growth.
In comparison, Nike is seeing flat or declining growth, down 5-10% this year, while still trading above a 20x EBITDA multiple. If On’s business can double its earnings over the next two to three years, we believe it should trade at a much higher multiple than Nike. Last year, On generated $2 billion in revenue. We anticipate this to increase to $4 billion by 2026, with the potential to raise their margins from 15% to 20%, meaning EBITDA could go from $600 million to approximately $800 million.
I mean, what's that worth? If Nike is trading at 21 times earnings while its business is shrinking 5-10% annually, and On is growing 25-30% annually, we believe On should be valued at 30- 35x EBITDA.
Those numbers would imply a $25 billion business that today is trading at $15-16x EBITDA? I think that sets up for attractive returns, partially due to On still being founderled and all the founders still owning about 30% of the business. On’s management is not selling, even though the stock has almost doubled over the past 18 months. We at Baron expect to still see further gains in the industry.
On is also expanding into apparel. Their focus isn’t solely on sneakers and footwear; they’re targeting the significant opportunity in apparel as well. On has been seeing strong attachment rates from customers who buy their sneakers, and we believe these rates will continue to improve as they grow.
Until next time! — EP