SPEAKERS

Chris Hohn, Simon Brewer

Simon Brewer: I’m particularly delighted to release today’s episode. In October, we held the inaugural money maze allocators Summit, and over the two days, there was fantastic discussion, debate, insights, disagreement and a lot of learning. But of all the conversations, one that particularly resonated with me was the chance to interview Sir Chris Hohn about those two topics with which he is fantastically acquainted, investing and philanthropy. And I think, as you will discover in a minute, that he perhaps stands above most mortals with the clarity of his thinking and the extraordinary generosity and effectiveness in both disciplines. Thank you. I’ve had the pleasure of interviewing Sir Chris twice before, and we are really, really appreciative of you being here today. Thank you so much. I think your investment success is probably only matched by your philanthropic generosity, and we’re going to talk about both of those today, investing and philanthropy. And I’m conscious a little bit like an earlier panel before Bernie, I would, I’d really like a couple of hours, but unfortunately, that isn’t possible. So will you come back next year? Chris, what’s made you successful?

Chris Hohn: Well, thanks for inviting me. Simon. Well, investing is all about risk and return, and vast majority of investors focus on return. That’s what you see in any asset allocator, what’s your return, that’s the only thing. But I focused actually, in my career in risk, firstly, return does matter, but to me, risk was always the first thing that mattered. And lot of people have their own definitions of risk. I love George Soros definition, which was not knowing what you’re doing. So what does that mean? You know, for me, that’s understanding what matters in investing. And it was a spiritual master once he said, very few things matter, and most things don’t matter at all. And that could also apply to investing. So what does matter? Competition matters because too much competition erodes your profits, and maybe we don’t make any money at all. So I hate competition and makes predictability and valuation impossible, and and the interesting thing, so to me, a sense, competition and disruption are the whole thing. It’s not about growth, because you can have a first move advantage growth for a period, and then a new technology or a new competitor kills you off. And fact of the matter is that most investors underestimate the forces of competition and disruption because they underestimate complexity. They look short term and and so we do two things really, we’re looking for such companies and with such high barriers to entry over the long term that we think we can have a reasonable idea that they’ll be around. Okay, can’t be precise about exactly what they’ll be worth, but they’ll be there in not in one, two or three years, which is a normal time horizon of an investor, but in 20 or 30 years, which is the time horizon where the value, if you do an NPV model, really is, And so we really, we try to get focus all our time on barriers to entry and disruption and so and the second component of the philosophy, if you like, is long termism. Now that’s fundamental. You know, our average holding period of a stock in our portfolio is eight years. We’ve held stocks for 13 years and 12 and 10, but the average is eight years, which is like. Starting to get into private equity land of duration of investment, and it’s counting eight years in counting. Now you may but it’s an interesting question. A lot of people make money with high frequency trading. The shorter the trading horizon, the better. The average stock holding period is under a year of a stock in in the US. So it’s all very well to say you’re long term, but that’s only a good thing. It’s not necessarily a good thing unless it works, and it only works if you’re right on the first point about the quality of the company and the barriers to entry. But if you’re right that this company, you find a company that is going to be a good company long term, then you should hold on to it, because there’s a persistency of these barriers to entry and the things that make it good. So in simple terms, good companies stay good and bad companies stay bad. But, and I guess there’s another point, there aren’t that many great companies, the super companies of the world, and if you find them, you should hold on to them. So that’s there’s related concepts like engagement and concentration, but those are secondary to the first points.

Simon Brewer: So let me ask you about those barriers to entry, because how is your thinking in identifying them changed in the last two decades?

Chris Hohn: we’ve enlarged the universe over time of things that we have found that are more companies, more industries, as we’ve learned, like everyone we’re always learning, if you and the so I always liked hard assets, infrastructure, the what came within that, you know, could expand beyond. We’ve owned a lot of airports and toll roads. But, you know, we found toll roads in Europe, then we found toll roads in Canada and the US through Ferrovial and cell phone towers and the so railroads and so the so. But then, beyond hard assets, infrastructure, we found other barriers to entry, such as network effects, okay and certain industries, payments is one we’ve been a shareholder of visa a long time where it has this huge, ever growing network connecting every customer and every bank to the world and the as the network grows, it becomes just ever harder to replicate. Aerospace is a sector that we’ve come to learn about and understand, and where the barriers to entry are multiple. Often you would like not just one barrier to entry, but maybe five - intellectual property. You could have its brands, hard assets, contracts, network effects, with big shareholders in aircraft engines, where you have many of those IP contracts. Installed base is another barrier to entry where customers can’t switch regulatory switching costs. And so the so we’ve expanded - rating agencies is another one. So the and one of the key sort of points of, if you, if you really do, find one of these super companies that can dominate their industries, they have something special, which is pricing power, which is a rare thing, so most companies don’t like to talk about it. And, and it’s a special thing, because it means you can grow more than your volume and, and it’s got a leveraged effect, because if it’s above inflation, so pricing power means you can price above inflation, then you there’s no cost to that. And if you have a 10% margin, might give you know, a huge every one point of real pricing guys is massive. It’s super leveraged and potent and so the but I think you world is changing so much that some of these motes of apparent moats are being just beaten down by AI and other disruption forces. So the forces of disruption, I would say, are actually rising.

Simon Brewer: So that was what I wanted, again, to disruption is around us. You got access to, you know, all sorts of very clever people, great conversations. But how are you how do you think about identifying those, those underlying weaknesses that may derail the thesis?

Chris Hohn: Well, you really want something that’s obvious. Warren Buffett used to talk about this. If you can’t put it on, and when it’s not obvious, you probably just leave it alone, because it’s probably not sustainable. So it’s sustainable barriers to entry. So if we own an airport, it’s pretty obvious in, you know, we own a company that owns all the airports in Spain. Owned it for a decade. I was on the board. No one’s ever going to rebuild those and overbuild you. And 75% is unregulated. So when you look at it, the shops and you know, so the infrastructure pieces, especially being a bit unregulated. All roads where you have 100 year duration or 60 years, like for over Al, those are, you know, people. We don’t know whether people can drive electric cars, or which brand of electric car or but it’s pretty clear they’re going to need these roads and so those are obvious things. The I’d say, when you have multiple of these barriers to entry, no alternative option. So we like aircraft engines, but will it be an alternative technology? Will they become electric? The science doesn’t really permit that, and it’s too expensive to replace the existing fleet, so you’ve probably got a pretty good visibility on 25 years. And so we think technologies that change quickly aren’t good for us. Can’t predict them. So I would say some principles would be multiple barriers to entry, and that and essential. Need something that is essential, so you’ve got to be confident of the need. So we, you know, are people still going to want to fly? You know? We believe that’s a durable need, you know. So we don’t like discretionary things, you know, I’ve never been an investor in the handbag business. Lots of people have, and they’ve made lots of money in it. But I’ve never, you know, understood what makes one handbag better than another. but it’s why it’s essential. So anyway, it may well be I don’t need to understand everything. Yeah, just say, within your sphere of competence, that’s what Buffett said.

Simon Brewer: What is fabulous about the investing business is it the quantity meets the qualitative. And you’ve written a lot about engaging with management, and I wonder when you go to meet management today, you’ve done this for a long time. What are you thinking about that conversation?

Chris Hohn: people think read about us and they say, Oh, you, you’re an activist. Well, we’ve done that. It’s sort of a tool, but we prefer always have constructive, long-term relationships with management. And the we hold an investor day in New York every year for our investors, and this year we had the CEO of GE Aerospace, the CEO of Airbus came to speak to our investors on the stage at the same time. Never, never been done before, CEO of Moody’s, CEO of Vinci, top executive from Visa. So every year we have the same. Thing it and these people come because they think we can add value to them. Our Aerospace analyst was invited by GE CEO then to speak to their top 300 managers about the company. So that’s not normal. Why do they do that? Because they think we understand the company, and we can add sometimes, some value. They find it a value-added conversation. So because we do so much, so much research on a company that and we follow the industry so we want to be, want it to be a relationship, okay? And that means and it to be a conversation. Now, of course, we weren’t always like that, but we’ve evolved. And so I’d say it’s really, really is engagement. Through engagement, you can learn something if it’s a one way conversation. You’re just speaking at someone. You don’t learn anything. We have to learn.

Simon Brewer: But along your way, there will have been some investments that didn’t work as well. And I wonder, when you reflected on those, was there something in those conversations that maybe you weren’t as sensitive to, that maybe you are today?

Chris Hohn: Ultimately, the quality of the business trumps everything. And so the I’d say does management manner, somewhat it’s not the key thing. And a great manager in a bad business, they can’t really necessarily do much, and so I think focusing on trying to assess management through conversation may miss the point. Okay, so I think you may overstate the value of the management and and sometimes management won’t even necessarily understand their own pricing power and latent pricing power. Or, you know, so, but I think, I don’t think the I think it’s if I would say something on the question, you’ve got to listen and see if you can learn and be humble if you become arrogant. That’s a killer in the investing business.

Simon Brewer: I try not to say anything, given that there are stretched valuations in all sorts of parts of the world, you have been very comfortable shorting in the past. Sort of under what circumstances might you have more shorts than you’ve had of late?

Chris Hohn: You know, I’ve never really been a significant short seller. I don’t think I’ve cumulatively made absolute money in it and and I sort of agree with what Warren Buffett told me one night. I had a dinner with him, and I asked him about shorting, and he said he didn’t do it because they - he and Charlie Munger concluded it was just too hard, too unpredictable. You know, he thought long and hard about it, because in shorting, you need to also understand investor psychology. Because when the short goes against you, you have to fund the losses. People think that’s like a costless thing, but you have to sell longs to fund the losses on shorts. And you can eventually right, be right, but can you hold your position? You know, we were. We did have a short a couple of years ago in Wirecard where we thought it was a fraud, which is, we have a very high bar run, but, and actually, I propose timing, I filed a public criminal complaint against the company in the Munich prosecutor’s office, the company wasn’t too happy. The chairman used to be the CFO Deutsche Bach. He said I was a liar and but within two weeks, it was bankrupt. Now and then the media got involved, and they went to Australia to meet a guy at Bronte capital who was one of the very first short sellers of Wirecard 20 years ago. And they said, the journalist said, Congratulations. Yeah, this must be a big day for you, but the stock could have gone up 20x and he said, I had. Cover it. After a year it was I couldn’t fund the losses. Yeah, so I wasn’t here to see the day it went bankrupt. Yeah, I lost. So it’s very hard thing, and you could be squeezed. If you watch the movie Dumb Money (2023), it’s a great movie. You’ll see that the difficulties of short selling, of being short squeezed so there’s so many technical issues that you know sometimes you just have to experience tells you it’s just too unpredictable. And the you and because of the investor psychology point

Simon Brewer: it’s interesting. I see front rows Chris Dale of Kintbury Capital, who also successfully shorted wire card for a while. And well, right to the end, actually, as it happens, and I’m an investor with them, which is why I know. What are you most excited about when you think about the investing landscape?

Chris Hohn: I like things that will just compound long term. I don’t change year to year very much. So I, you know, I things that I feel confident will be around in 30 years in a dominant position excite me, because it’s just predictable. I value predictability. You know, it’s and sometimes people under you know your very question illustrates what most investors are looking for, the next hot thing. Yep, the new thing. And sometimes I’ll say, but sarcastically, will you want to investor say, what’s new? I say, do you need to change your wife every year, difficult conversation. Family always says, don’t ask that question, because people might give them ideas. yes, we you wouldn’t ask that question because you’re happy with it. Yeah, you’re happy with what you’ve got. Yeah, and so, and it’s, you know, it’s not that easy to find, you know, there’s some truth in some of these funny examples. It’s not that easy to find the right partner. It’s not that easy to find the right investment. So why do you want to change them immediately? If you find something good, it’s going to be good long term, stick with it and don’t think that newer is always better. This is what investors think. They don’t think about sustainability. They want the next hot thing. They think growth is the thing, but new is the thing, but that, you know, we want to be, because so many people think in terms of what John Keynes actually Benjamin Graham said that in the short term, the market is a voting machine. What’s hot? It’s new, but in the long term, it’s a weighing machine, yep, so covid peloton was hot, yeah, went to $50 billion valuation. Everyone was on their peloton machine. But, you know, virtually went to zero, and so, yeah, we, I think that’s the most important question. Is just we’re more interested in question what is, what’s going to be around, rather than what’s new?

Simon Brewer: Very clearly expressed. Let’s switch to philanthropy. Why?

Chris Hohn: Why? Simon, I talked before, and you had a lot of questions on how I said there’s a book. The book, title of the book is, let’s start with why. That’s a better question to start with, and it was when, when I was 20, I went to the Philippines and saw people in poverty, and I thought living on a garbage heap, and I thought, This isn’t right. If I could do something one day, that would be a good thing to do. But then, obviously, I didn’t have any resources, and found my way to a hedge fund in New York, and after some years, I had a good year, and they paid me a bonus of $10 million and i had a couple of million dollars, I don’t remember exactly, not lots of money. And I immediately gave it away to charity. I didn’t I didn’t want it. I gave up a foundation and put it into it. I didn’t, and I couldn’t tell you that, you know, the reasoning? I just thought, This isn’t really something I should have. Yeah, and then I started doing more and more and but I I didn’t understand it. For 20 years I was doing philanthropy. Sounds strange to say, i remember sitting down with Bill Gates and asking me the same question i and it was only in recent years I sort of figured it out that why, and that actually there’s something within all of us who call it consciousness. Some people call it the soul. My son tried to explain this to him, he said to me, Dad, the soul is a myth. And actually, I don’t think so, but, and it’s this that drew me. It’s the basic urge of the soul is to to do service and and so that’s was a soul driven thing, and you it’s not of the intellect itself. Call it higher mind or intuition. So that’s the answer to the question. And also, yeah, it’s a knowing, if you like. So

Simon Brewer: there’ll be people in the room, small, large, donated to charity, regularly. How do you prioritize?

Chris Hohn: Yeah, I think there’s two answers to it. One is what you know? What is it? What do you feel passionate about? And then there’s another more analytical answer, the intellectual. You know, there’s intuition and intellect, two different ways of thinking in the intellect, you I look for high leverage and fundamental things. There are things that are back to the what, what’s most important? So one of the things I’m really passionate about is contraception in poor countries. Now, in Africa, I do most of my work, the women on average, will have nearly seven children. Now, they don’t want seven children, just to be clear, if it’s it’s not their choice. They don’t own their bodies often and for various reasons, usually economic, yep, and and so. But it’s foundational, because if a woman, let’s say, wants two children, not seven children, she’s so poor she can’t feed or they will have health for those seven children, if she has the two children instead of the seven, you see, everything is much easier. It’s sort of obvious stuff. And the other thing I’d look at is where there’s it’s unfunded or underfunded, yeah, so the, you know, contraception, it’s sort of seen as a controversial thing. For some reason, in the Millennium Development Goals, nobody put a fertility target that was deemed too controversial. They conflated it with coercion, which is stupid. And so I’m also interested in. So for $10 and it can back to value for money, you can avoid an fund, an avoided unwanted pregnancy. So the value for money is incredible. Other areas that you know passionate about very molding. Climate change is foundational. It will undermine all of development as soils dry out, drought won’t be a people will have less to eat, hunger, malnutrition. It impacts the poorest. First country is already hot, getting hotter, and so climate is really also foundational and and urgent. I’m also other areas. I love neglected tropical diseases, because impact is enormous. About seven diseases impacting 2 billion people, many of which people never heard about, like trachoma and river blindness and Lymphatic filariasis and Schistosomiasis. Anyway, these things can be eliminated. The drug companies have actually funded for fee the trucks just needs someone to do, you know, mass Drug Administration, which is very cheap, and so it’s really a crime not to do this. And trachoma surgeries is people go permanently blind for $50 surgery. Yeah, isn’t that crazy, so, but I also the other big things that are I care about that are foundational as well, like child marriage, that’s a big thing.

Simon Brewer: So when you identify that theme, terrific, but you have to choose a partner. How do you think about that?

Chris Hohn: Yeah, because we, what do I have just money? Yeah, its a commodity, and so I have to work through people and the so we, I guess we have three types of partners, governments, NGOs and companies. And if you can find, if you can do this through governments, it’s perfect as it’s more sustainable, okay? And so sometimes we will do both. We’ll fund NGOs to work through governments. What’s an example messaging to women in Ethiopia and to sorry, married couples in Ethiopia through community health workers funded by government there, about The benefits of contraception is actually free. They already found the community health worker. We found that 70% of the women who were literally the couples who were messaged to about the financial cost. Would you believe of of having lots of children, started taking contraception? Contraceptives who weren’t, and sustained it. So it’s incredible program. They’ve rolled it out through the country and and so we love we can to work through governments. You know, NGOs? Why NGOs? Well, where sometimes governments don’t have the innovation, or the interest. Okay, so child marriage in India got is something where it’s not something - requires, if there’s going to be often an NGO has to. Why do you need an NGO was an interesting question. Yeah, why can’t you just tell government the idea? Well, sometimes governments don’t care. Why do we and until the NGO tried to stop child marriages, you could just end up being killed. Yeah, in some of these places, it’s not for the faint hearted, so that they care, they’re not willing to sort of put their life in danger. And so you often find NGOs care more and and so if, especially if you can pick the right leadership. And so I do a lot with grassroots NGOs, but we’re trying to prove a concept and then get governments to scale it. So we did, and companies. I give you a couple of examples. There, may somebody says market failure. So a few years ago, 10 years ago, there was a company that patented therapeutic food for severe, acute malnourished kids, company called NutraCet, which is its bogus patent, because it wasn’t novel, but they prevented other companies producing it to make money, and I funded a company to break that monopoly. And in fact, I put in the contract that they were sued to cease and desist. They had to continue. Had funded litigation, but they couldn’t stop. And companies called manly nutrition and put $200 million into it, and now they have a capacity of $500 million of this, they’ve saved over 10 million lives. Okay? And but I, but they’re a nonprofit, so they never made any money. CEO calls it an upside down company where their performance is measured in life, save not not money, but the Why would other people, they say there’s not enough money in it? Yeah? Well, there was someone trying to patent it. So there are all sorts of reasons, but the social payoff is enormous. Yeah, so sometimes there’s stuff that philanthropy can be catalytic in a way which, so we’ll use any any partner that’s intelligent, but you really want to find people who care. See, there’s a strange thing to say. But you know, my early days, I would ask, Will, can you hire mercenaries? People just care about money. And I came to realize that it doesn’t work. You need people who it’s from the heart

Simon Brewer: and so therefore performance measurement takes on a different perspective.

Chris Hohn: Yeah, now, performance is an interesting question, okay, and because, if you don’t understand the theory of change in the you could make a big mistake, and I by measuring the wrong thing. Now, especially back to the point if you don’t know what you’re doing. So here’s an example. For 10 years, I funded this company that did contraception for adolescents. Now, what’s adolescent? In some cases, they were children, and I was brought into a slum a couple of years ago to meet these girls and dice, and I knew immediately something was very wrong, because they were so depressed. And if you looked into their eyes, there was nothing behind the eyes. Psychologists would say that they were dissociated, yeah, I would say, Soul disconnected. And I asked them, Why? Why do you need the contraceptives? They wouldn’t answer the question. I said, so the KPI was, did they get the contraceptive? On paper? Was all great. They all got the contraceptives, very low cost, I said. I asked the question, well actually, when I said, Do you have boyfriends? They said, No. I said, Do you have husbands? They said, No. They were 15, 16,17, I said, Then why the hell do you need these contraceptives? And they said, because we’re being raped all the time since we’re aged eight, and then other girls told me they were having to prostitute themselves to eat. So suddenly, the performance indicator of, did they get the contraceptive, and what was the unit cost of the contraceptive was, was missing the point - these girls had to find a way out of their their situation. Yep, so you got to understand the root cause and and rather than just working on symptoms, because the KPI may not capture the quality of life - where life isn’t about just years, yeah, the you know those girls, as is the case for many women in these. Countries. They’re living in, hell and so. But if you were just looking at numbers, you don’t see it. And the only reason I saw it is through looking at them as human beings and saying something’s wrong here. So of course, we look at cost benefit and but sometimes the and another key point is we prevention versus cure. You know, if you can prevent, you know, they’re just so many no brainers, I call them. You can test someone with a saliva test or rapid blood test for HIV, and find a positive person, put them on treatment $300 done 11 million tests with the Global Fund. So simple, so you stop that person spreading it to multiple other people for $300 yeah, so the So, but you’ve got to try to get to root cause. Why you know? Why are you know? And it’s not always obvious or simple. Why are children being married off? Is it economics. Is it consciousness? It’s actually you do need to change consciousness.

Simon Brewer: Which, of course, leads to my last question. Which is you give an example, your former example? I can’t think how AI could help. The latter is that AI might help. How are you allowing it to help?

Chris Hohn: One thinks AI is the be all and end all of humanity. World, there is one problem with AI. It doesn’t have consciousness or conscience. A friend of mine told me last week that friend of hers, her daughter, was very depressed, and she was using chatGPT to talk to she’s very isolated and and without going into the detail, she ended up committing Suicide. And the AI didn’t, obviously, do anything. Yeah, so we’re as a species, we’ve confused intelligence with you know and knowledge and and consciousness in so without, we think information and intelligence is the way all and end all. But there’s something more powerful, which is love and heart and consciousness. And without that connection, and actually, people are becoming more disconnected from that, always on their phones, always thinking that chatGPT or the latest AI can give them the answer. Will the, you know, the becoming more and more in intellect. And so I think we have to actually, we’re sort of entering, you know, a more and more dangerous point for humanity, because the we sort of have lost the plot, where we think that AI will solve All humanity’s problems. You know, couldn’t be clearer that problems are getting worse. No solution for climate change, no solution for poverty, wars, you know, you name it, and inequality, divisiveness, hatred, it’s all rising. I think you know the so I think there needs to be a new paradigm in consciousness. And it’s not about AI. It’s about love, if you and in there are foundational principles that are rather disruptive, such as ownership. Do we owe? You know, this concept that we own things and that it’s as I’ve always thought, I actually don’t own anything. I’m just a custodian. Yeah? What is that? Yeah? Which is, it’s money. Mine needs to be given away and in service to humanity. And if you go out of the intellect into intuition, which is why made me give away that money. You know, when we’re on our deathbed, we, I don’t think we think we own things. Yeah. Yeah, and why would we? Because, ultimately, everything is a gift. It’s not as it’s, you know, I didn’t make all this money because I was smart or lucky. It was, you know, I think because I’m willing to give it away. And so I think, you know, the most important thing back to what matters is consciousness and love. And if we connect to that, then we’ll find purpose. And so I think, for me, in a nutshell, philanthropy has given me purpose.

Simon Brewer: What a great place to stop. So Chris, you have given so much to the world and thank you for your time today.

Shift4 Payments Q3 2025 results were largely in line with expectations. Total Net Revenues were up 61% YoY (including Global Blue), and Gross Profits (non-GAAP) increased 62% YoY. End-to-End volumes grew 26% YoY to $55b, slightly higher than consensus. Adjusted EBITDA rose 56% YoY to $292m (49.6% margin, down 170 bps YoY). Unit economics were effectively flat, with net spreads at 62 bps. GRLNF was up 19% YoY, or 61% YoY (including Global Blue). Exhibit AA below provides a snapshot of results vs consensus and the prior year.

For FY2025, the company narrowed but reaffirmed guidance, including volume of $207-$210B (26-27% YoY growth), gross revenue less network fees of $1.98-$2.02B (46-49% YoY growth), adjusted EBITDA of $970-$985M (43-45% YoY growth), and adjusted FCF conversion of >50% (implying ~$496m in FCF this year). Management also reiterated their comfort with the 3-year “most-likely” growth targets of >30% CAGR into 2027 as shown in Exhibit AB.

Shift4 also provided a headline figure of +18% organic growth for the first time this quarter, but the key components contributing to this line item were not disclosed (e.g., same-store sales growth, net new customer wins, and conversion of acquired customers). It’s also unclear if this would include merchant-only revenues or just the uplift generated from a conversion from gateway-only to E2E. And, while it is nice to see the incremental disclosure it does appear to be below the 2025 target of ~20% organic growth for the business . All said, happy to have another data point to monitor over time.

Corporate Actions

FOUR also divested multiple small non-core assets with the largest being of acardo to Verve Group SE for proceeds of $34m. Acardo was a couponing business working largely in Germany, working with ~5,600 retail stores and branded retailer applications. This contributed to modest deleveraging in the quarter.

On the acquisition from, they acquired Worldline North America also known as Bambora. This gateway has $90b of volumes, adds one of the largest ACH/EFT providers in NA and adds 100s of software integrations. FOUR’s biggest homerun deals have been gateway acquisitions, and my understand is that this gateway skews heavily to Canadian Restaurants it seems like a great fit. Compared to the GB deal this is tried/tested playbook which should make the risk profile very low. FOUR is paying 70m EUR for the asset, an ~8.7x EV/EBITDA multiple. This adds to the cross sell funnel an attractive pipeline of ~140,000 merchants who can be converted to full E2E solution over time. The deal implies a cost of acquiring a customers at ~$580 - pretty good.

FOUR is ahead of schedule on debt repayment; they were targeting 3.3x Net Leverage by the end of 2025 but achieved 3.2x this quarter.

Global Blue

Global Blue Sales in Store (SiS) was +5% YoY driven by Europe +13% and NA offset by weaker results in Asia, where the business lapped tough comparable driven by a record low Yen last year down 11%. Exhibit AC shows trends on year over year basis. More recently though, trends in Asia recovered to be roughly flat during the month of September. Total revenues were $170m, or $156m after network fees. EBITDA contribution of $68m, and margins of ~43%.

Operationally, the business continues to track towards prior targets. A new 3 in 1 POS terminal with Payments, Currency Conversion and VAT Refund capabilities is in Beta Testing. What they called a “don’t screw things up acquisition” seems to be going ok outside of some macro noise.

SkyTab International Expansion

In the past, Shift4 has faced bigger-than-expected challenges in driving international growth. Localization complexity related to tax fiscalization, language support, and consumer behaviors led to a “multi-year” ramp in Germany, France, and Italy. This is in contrast to the UK market which required very little investment and as a result was one of the first markets they were able to launch in.

As the data points below suggest some momentum is building in the last 18 months. There’s a growing likelihood they will meet their target of 45,000 international locations by year-end.

Q3 2025 “Adding 1,300 international restaurant and SMB wins per month”

Q2 2025 “FOUR is installing SkyTab at a pace of ~3,000/quarter as of 2Q25”

Q1 2025 “signing up over 1,000 restaurants a month internationally”

Q4 2024 “hundreds of international restaurants across Canada, the United Kingdom, Ireland, and Central Europe, with the broad launch to Vectron’s 300-plus European dealer network yielding “hundreds of deals already signed up in January”

Quotes from the Earnings Call

Positives

“I wouldn’t be able to discuss capital allocation without the notable dislocation in our own valuation despite the continued performance of numerous opportunities we see ahead. In short, our own equity is one of the more attractive opportunities we see, and with expanding cash flows and accelerated deleveraging, we simply can’t ignore it. To that end, our Board has authorized the new $1 billion stock repurchase program, which is the largest in our history. We will be implementing a plan to purchase of what we view as highly attractive levels right away.” - Taylor Lauber (CEO)

“As you get to know me more, it should come as no surprise that I believe that the ultimate measure of business durability is compounding growth in free cash flow per share. So I’m particularly enthused by the progress of this metric, especially as a jumping-off point towards our medium-term guidance goal of exiting 2027 with $1 billion of run-rate adjusted free-cash flow.” - Christopher Cruz (New CFO)

Lastly, we agreed to acquire Bamborra, otherwise known as World Line North America. While I’m sure many of you would like to see a slowdown, the opportunity presented by a $90 billion payment gateway was something we would not ignore. A core competency of our business and team is to constantly seek out interesting technologies, great customers, and excellent talent. Those of you who know our track record of executing on gateway conversions and other synergies can appreciate why this makes so much sense. We expect that transaction to close in Q1 of ‘26 and are encouraged by our pipeline of opportunities. - Thomas McCrohan EVP, Strategy & Investor Relations

Negatives

Compared to TOST management’s Q3 2025 tone on SSS volatility, FOUR’s seemed more negative (at least relatively) as show below in Exhibit AD. If you are more skeptical about FOUR, you might interpret this as them having more discretionary exposure than Toast, but I’m not convinced it’s materially different.

Investors were focused on FY26 guidance, which implied about $240b in E2E volume, up about 13% YoY. This was light compared to the current consensus of $255b, implying +22% growth. Backlog of $35b has been stable since last quarter; while growth would have been nice, there is potential for growth in the future as they integrate Global Blue, Bambora, and SmartPay, and begin to drive cross-sell.

Lastly, Jared was renominated by the Trump Administration to run NASA. He is not required to sell any of his shares, and all indications from earlier this year is he is involved on capital allocation and strategy work. As disclosed in the ethics agreement earlier this year he will relinquish/convert the Super Voting B shares into common shares. This should clean up the perception of the corporate structure and may elicit interest from a wider range of investors.

Management clearly believes shares are undervalued and is taking action to capitalize on the opportunity with a $1B share repurchase program. They recognize that FCF per share is the north star, and this program alone could lead to the repurchase of approximately 15% of the current market cap. FOUR continues to make progress toward its medium-term financial targets and remains aggressive with M&A. At ~8x EV/EBITDA, I don’t believe I’m paying for growth or optionality from M&A. I remain positive on FOUR, but it has been a painful ride year-to-date.

Early in my investment career, I read an article about Middleby Corporation, under Selim Bassoul’s leadership, which generated a 39.7% CAGR for shareholders over 15 years (2001-2016). A popular podcast with Brian Bares also praised Selim; he said

“I would say, a 10/10 manager for better part of two decades. He’s probably the best manager that we’d ever come across. If we ever had to write the next outsiders’ book with– I’m blanking on the name even though I know him. But anyway, if we had to write chapter 1 of the next outsiders’ book, we probably put Selim Bassoul of Middleby as chapter 1. He was just phenomenal. He had the full talent stack.”

Unfortunately, things change. Since late 2016, the stock delivered an 11.79% total return over 8.5 years. This is underperforming the S&P Midcap 400 and S&P 400 Industrials Index, as shown in Figure AA below.

Investors were patient for years, but opinions changed given the data. In early 2025, activist investor Ed Garden saw an opportunity to clean up the business, perceived to try to do too much and not much of it well. Garden Investments entered into an agreement with the company and now has a board seat.

Bottom Line

The worst is behind the company after facing years of headwinds from restaurant closures, slower customer buying and weaker remodeling activity. Core equipment at the customer base is now approaching the end of life and has already been pushed out – a replacement cycle will unfold sooner than the market is expecting. The market is extrapolating lower organic growth, underappreciates SOTP math on the upcoming spin-off of the food processing segment and a dramatically different capital allocation approach going forward. At $132 share price, the risk-reward for the stock looks favorable, and a replacement cycle for the core CFS business should support growth over the next 24 months. I estimate the intrinsic value of the stock at >$160 per share, with a bull case of $220/share.

Middleby Corporation Overview

Middleby Corporation is a global leader in design, manufacturing, marketing, distribution, and service of a broad range of food equipment. They focus on three segments: Commercial Foodservice Equipment (CFS), Food Processing (FP), and Residential Kitchen (RK). Middleby owns or leases over 82 facilities globally serving thousands of customers, including McDonald’s, Burger King, Chipotle, Costco, Kroger, and Marriott. MIDD has over 110 brands. Figure AB below shows a sample from their June 2024 investor presentation. MIDD’s equipment plays an essential role in preparing food around the world. Good consumer outcomes depend on this equipment’s reliability and performance.

Figure AC illustrates the demand driver breakdown. The two biggest drivers over the past three years have been replacement and upgrade activity and new build activity. The stoves and ovens at the back of a restaurant won’t last forever, and if more locations are built, these new restaurants will typically (but not always) purchase new equipment. This activity in turn will drive sales for MIDD. On a T4Y basis, replacement has represented 37% of sales, new builds 37%, menu driven 10%, and parts ~17%. Given 64% of T4Y sales were driven by demand drivers outside of new builds, overall cyclicality should be muted in most economic scenarios.

Most of Middleby’s historical top-line and bottom-line growth was due to M&A. This was a roll-up story, one of the first serial acquirers. It started in 1888 by Joseph Middleby and John Marshall, who made custom portable ovens for Chicago area. An excerpt from the 1997 IPO filing provides a brief history.

“in the early 1980s positioned itself as a leading foodservice equipment manufacturer by introducing the conveyor oven that revolutionized the pizza market. In 1989, the Company became a broad line equipment manufacturer through the acquisition of the Foodservice Equipment Group of Hussmann Corporation, which included CTX, Southbend, SteamMaster and Toastmaster. The Company initiated its international distribution and service strategy in 1990 by acquiring a controlling interest in Asbury. In 1991, the Company established Middleby Philippines to provide custom kitchen fabrication and specialty cooking equipment to restaurant and hotel chains in the Asian, Pacific Rim and Middle Eastern markets.”

Commercial Foodservice (CFS)

Starting with the biggest segment, Commercial Foodservice (CFS). The segment’s portfolio is wide – covering ovens, ranges, fryers, ventilation equipment, fridges, ice machines, cold rooms and dessert equipment. If you’ve seen equipment in a restaurant at least some of it is likely from Middleby. Experts say MIDD’s offerings can cover 90% of a kitchen’s needs.

CFS’s customer base includes restaurants, convenience stores, supermarkets, hotels, stadiums, and cafeterias, including QSR brands like KFC and Burger King. They market this segment with 75+ brands and primarily through non-exclusive distributors. MIDD supplements this with representatives to drive sales but only with the largest multi-chain units like McDonald’s and Yum Brands. Despite some bigger customers, the largest isn’t over 10% of net sales. Companies and buying groups like Edward Don (owned by Sysco), TriMark, and Clark Associates facilitate a large number of sales using a scale-economies-shared model to help independent restaurants and smaller chains get similar discounts as larger chains.

Demand drivers for the segment are new store openings, remodeling activity (mostly new equipment), and the age of the installed base. The replacement cycle for core equipment is around 7-10 years, giving MIDD decent visibility on future demand. Mix shifts within channels like convenience stores offering more prepared food have driven incremental sales – e.g., Subway didn’t have toasters 25 years ago, now they do. Circle K or Casey’s sold less warm/hot food a decade ago but are reinvesting to expand their food & beverage offerings. Geographic expansions also drive sales – if KFC scales up in Spain, they will bias towards equipment used in the USA for a standardized global offering.

The CFS segment has Innovation Kitchens around the world, where they showcase over 150 pieces of equipment. The main value proposition is that restaurateurs can see a full range of popular equipment, experience its use, and get more hands-on learning. With sales scaling in Europe, they added a third innovation kitchen in Munich to support future growth in the region. Figure AD below shows part of the Dallas Fort Worth showroom.

Food Processing (FPS)

The next largest segment is Food Processing, which management plans to spin out in 2026. The segment sells protein processing, bread production, snack, and poultry processing equipment, typically built into automated solutions. Key considerations for choosing the equipment include processing speed, raw material waste, ownership cost, automation, and power consumption. Major verticals they sell to include protein processors, bakeries, snack producers, and poultry processors as shown in Figure AE. In contrast to CFS, aftermarket sales & service are much higher at 33% due to higher utilization (24/7) and routine maintenance. FP customers focus on maximizing ROI and understand the upfront costs for performance improvements. Their buying processes skew more sophisticated and involve RFPs in most cases.

Demand for equipment stems from upgrade or replacement cycles while end product demand grows along with increasing consumer purchasing power. The consumption of pre-cooked chicken, deli trays, frozen foods, and other ready-to-eat foods gradually grows in most places as countries industrialize, or consumer incomes grow. Figure AF below provides a sample of some of the equipment showcased early in 2025 from the segment.

Residential Kitchen (RK)

Residential Kitchen segment is the last we’ll cover. MIDD entered this market by acquiring Viking Range in 2013 and expanded the portfolio with additional M&A. This portfolio skews to premium residential products. Initially focused on indoor ranges, they now offer outdoor grilling equipment, induction stove tops, refrigeration, and ovens. Unlike other segments, sales here are (indirectly) consumer-facing, not company or small business-facing. Figure AG below shows the brands and a Viking range.

Competitive Advantage & Go to Market Approach

MIDD’s competitive position is largely driven by intangible assets (brand portfolio and R&D), and modest switching costs. Underpinning the portfolio is >80 brands which are generally market leading products and a reputation with key customers that creates some level of recurring purchases. Additionally, the installed based of +250,000 units with these key customers continues to grow providing a steady source of higher margin aftermarket parts and service revenues. Management has faced scrutiny from analysts and investors regarding the ownership benefits and true synergies of owning all three segments. I see cost or scale benefits with raw materials sourcing or R&D cost sharing but otherwise don’t see major synergies - management seems much more open to cleaning up the portfolio today than historically.

MIDD has limited customer overlap amongst the different segments, leading to different go-to-market approaches. In Commercial Foodservice, they use company-owned and indirect dealers for most of the market, but they also work directly with the largest chains. In Food Processing, regional sales managers closely consult with customers on equipment for the highest ROI. Residential Kitchen sells to retailers, distributors, designers, and home builders. Management seems to believe they are good consolidators and operators and regularly determine if they are the best owner for a particular brand or segment. In recent investor calls, they indicated that once Residential Kitchen is large enough and closer to mid/late cycle margins, there’s potential for monetization or spin-off. Ed Garden is apparently interested in seeing RK business getting sold or split off from MIDD over time. Exhibit AH below outlines the channels, and different go-to-market approaches.

Track Record

From 2009 to 2024, MIDD delivered a corporate revenue CAGR of ~12.7%. CFS grew at a 10% CAGR, and FP grew at a 17.4% CAGR – from the initial acquisition in Residential Kitchens in 2012, grew at a 10.9% CAGR into 2024. The CFS segment went from ~90% of sales in 2009 to 62% by 2024 as the other segments grew. Figure AI below shows revenue by segment and geography over this period.

To highlight the importance of M&A, I’ve broken out the contributions from M&A, Organic Growth, and Other (FX, other etc.) in Figure AJ. Organic growth (pricing, volume, mix) was +1.6%. M&A was the primary driver of sales growth contributing +8.3%, and other factors contributed 2.7%. While list pricing increased likely in the 2-4% range, after negotiations and volume discounts the 1.6% figure looks reasonable. I don’t believe they have lost material share to competitors across the portfolio, and if anything they have gained some share from Wellbilt (now owned by Ali Group) – anecdotes from executives in the space also suggest they have continued to lead with innovation which would make share losses more puzzling. But, there’s no hiding that organic trends have continued to decelerate over time – as the replacement cycle for most equipment has continued to be delayed or pushed out in the last five years.

As another way to assess the company’s organic growth, below we look at Same Store Sales (SSS) growth across about 10 customers. Data below in Figure AK shows a relatively strong relationship between at least half of these customers own SSS and the company’s Commercial Food Service segments organic growth (%) – with 5 customers including YUM, SBUX, DRI, DINE showing >70% R^2. If we index the total level of sales growth for MIDD vs this group, we can see the sales have largely been in-line with broader industry trends – from 2010 to 2024, the group saw average comp sales up from 100 to a median 150, vs MIDD which grew to 147. This indicates fair performance relative to the industry and doesn’t imply meaningful share losses.

Figure AL below shows MIDD’s gross margin history on a corporate basis and for all segments. Gross margins peaked in 2016 at 39.7%, but since then product rationalization, acquisition integration/mix, and lower sales volumes have posed challenges. Individual segment margins peaked in 2017-2019, then generally recovered by 2024, except for Residential Kitchen which struggled amidst lower housing turnover and new build activity. In 2024, Residential Kitchen reported gross margins of 30.2%, down 760 bps from the peak due to a weaker environment and a modest impact from mix changes. Management also discussed instances where poor pricing contracts on backlog and higher cost inflation led to weaker margins over the last 4 years.

Gross margins aren’t the full story. MIDD reports segment assets, goodwill, and income from operations which can be used to calculate a rough Return on Tangible Assets (Total Assets Less Goodwill). Figure AM shows CFS segment went through three periods – improving returns from 2010-2016, steady declines into 2020, then a gradual recovery. FP faced similar trends but has been more stable due to less customer disruption. The RK segment has never generated great returns on tangible assets, only rare periods reaching ~10%, then the purchase of outdoor cooking equipment near the cycle’s peak created subsequent headwinds. Adjusted EBITDA margin trends since 2017 show a similar picture.

MIDD’s economics have gradually deteriorated. Corporate ROEs were >20%, but since averaged 16%, declining to ~12% in 2024 as shown in Figure AN. The spread between their earnings and whatever reasonable hurdle rate you use for their cost of capital is much smaller today. The Return on Tangible Assets (Total Assets Less Goodwill and Other Intangible) shows a similar trend with ROTA (%) in the 21-29% from 2010 to 2018, but only ~15% in 2024. Three macro factors drove this weaker performance: uncertainty affecting restaurant or franchise owners’ reinvestment confidence which translated into lower sales volumes. Record restaurant closures during COVID-19 eliminated a large number of customers and flooded the market with used equipment. Also, broader cost inflation drove higher pricing at a time when demand was also weak - higher pricing vs low demand is a dynamic that persists today.

M&A Engine

Since 2001, MIDD was scaling up acquisitions. However, since a peak in 2018 at 8 deals including one large deal, Taylor - management has slowed the pace of acquisitions as shown in Figure AO. Most deals have been smaller with average revenues per deal in the $20-$80m range. Multiples paid averaged 1.2x on a EV/Sales basis excluding the 8 largest deals or 1.4x including them. The capital deployed relative to cash flow from operations has only been >100% in 10 of the past 24 years.

The prior roll-up strategy focused on smaller tuck-in deals leaving integration manageable in general, and avoided larger bets that could really threaten the overall performance of the company. This changed started in 2018 with Taylor a $1b deal, then in 2021 they attempted to complete a transformative merger with Wellbilt, a competitor in commercial kitchens. However, this deal didn’t go through as Ali Group emerged as a competing bidder and was willing to pay more for the asset. While walking away from the deal showed some financial discipline, and the receipt of the $110m break free was a short term win. After this deal, they have reverted to more of the smaller-mid sized deals with a large skew towards the Food Processing segment. I view this positively, given most deals were again refocusing upon niche opportunities like automation, technology and cold/beverage where the current portfolio still has some gaps.

Below in Figure AP, we show the 8 largest deals the company completed starting in 2001. By a large, margin, the acquisition of Taylor at $1b was the largest and should have had the most explanatory power in how the underlying returns of the business have deteriorated. The timing of Selim’s exit in 2019, suggests this might have been the blunder which drove his departure. Back in 2013, Selim said

“ Well, I can tell you the reasons that we don’t make an acquisition. Growth, or size, or buying a market. So all those three reasons, we will not go after an acquisition to buy a market.”

It’s hard not to consider the Taylor acquisition as buying into beverage, soft serve and frozen drinks market. Some estimates indicate they have ~18% share in global soft serve, and are by far the global leader. On the frozen drink and beverage size, Taylor is also estimated to have a mid-teens market share in the market. To me this shows some inconsistency in the execution of this strategy over time. Even the headline EV/EBITDA multiple of 15.4x, was expensive in my opinion.

In general, it looks like the deal activity has gone through better phases of returns but also weaker periods (part of which can be explained by broader industry headwinds). But, I’m inclined to believe managements previous comments that smaller deals with a focus on a niche technology or capability that can be rolled out globally or integrated into other products should generate attractive returns. Proctor & Gamble had used a similar approach of buying regional brands, then vastly improving its sales penetration with existing customers around the world – I see why that same approach could work with MIDD and generate good returns.

Industry Trends

The US Census provides data on food consumption at home and away from home. I’ll say that there are blurred lines between the categories as grocery stores may sell hot ready-to-eat food at the deli or prepared food counter, but this is a small figure overall – we can ignore it as broader trends are more meaningful. Exhibit AQ shows the trend of spending on food away from home and at home. US consumers have increasingly spent more money on food at restaurants, bars and other venues. This briefly reversed during COVID-19 when most restaurants were closed or ran at lower capacity. This trend has supported demand for commercial foodservice equipment, and this trend has been in place for over 30 years. An estimated 56% of disposable income spent on food in the US is spent on eating outside the home. The pie is growing.

Below we look at how the number of restaurants in the US has evolved over time in Figure AR. This shows a relatively stable growth rate over time – from 2005 to the peak in 2019 the data shows a 1.7% CAGR, and from 2005 to 2024 the data shows a 1% CAGR. Due to the pandemic, about 75,000 restaurants have been closed. From what I understand, the most impacted categories were full-service, luxury and food truck restaurants. Collectively, less social activity, business travel and public gatherings along with a sharp rise in operational complexity, and staffing challenges lead to closures. In general, larger chains did better on a relative basis, because of an ability to adapt their business models (staffing/takeaway), buying power and access to capital.

If we combined the two data series, we could calculate the average sales per US location as shown in Figure AS. The average store of the surviving restaurants has seen a 59% increase in sales from 2019 levels. However, I think margins are likely down due to food (raw material) costs up 27%, and labor costs up 15% from 2019. It’s hard to find lower costs – packaging, insurance, and advertising costs are up. I think most restaurants will lower margins today.

MIDD management believes they are in generally modestly growing markets – they paint a picture somewhat more optimistic that what I’ve shown above. From 2015 to 2024, the total addressable market for the CFS has grown at a 1.7% CAGR, RK grown at a 3.1% CAGR and FP at a 3.1% CAGR as show in Figure AT. Then from this data, we can calculate a very rough market share for each of the segments based on segment sales. For Both CFS and FP segments, it is clear that they have continued to penetrate markets through a combination of organic growth or M&A. Residential Kitchen (RK) on the other hand, is only up modestly from 2015 despite a number of acquisitions, but perhaps this is more of an indication of how the premium/high end market has performed over time.

The industry is seeing a long-term trend of more food being eaten away from home. I don’t see any major reasons for this to change. Preparing food is time-consuming, costly, and most people lack the skills or willingness to create a quality meal. The main negative appears to be from a health perspective, but that could be offset with GLP1s but also restaurants are shifting menus to be healthier. Make America Healthier trends could support a broader quality improvement in the food chain. Most restaurants still face cost headwinds. One lever they can pull is investing in boosting efficiency per worker – better or automated preparation equipment, and self-serve kiosks or higher digital order penetration. The best path for the industry is to invest more into automation, digital and connected solutions - all areas where MIDD is well positioned. Figure AU shows the 6 characteristics that MIDD customers want when purchasing equipment.

A long-term tailwind towards more eating away from home is likely to continue. Despite a decrease in total restaurants in the recent past, growth expectations from consultants like Technomic calling for a 0.4% CAGR into 2028 seem reasonable. Overall, MIDD is in end markets with modest organic growth, consolidation opportunities, and broader tailwinds.

What am I comfortable underwriting?

To help assess valuation, I walk through my core assumptions below. Many of these assumptions look reasonable for the company to achieve given the current outlook, and my understanding of the business.

From a topline perspective, MIDD has completely revamped its go-to-market strategy and has now better aligned sales representatives, dealers, consultants, service and digital tools on selling a full solution – I.E. capture more spend than in the past. Organic growth should be much better than we’ve just seen. The company had added +50 individuals focused on selling largely from competitors and vastly simplified the number of people going to customers. In the past, often a prior acquisition would have retained its sales team but only sold that solution – going forward, fewer representatives will sell a broader range of solutions and have incentives closely tied to higher margin products. MIDD’s more recent expansion of its cold, and beverage platforms also supports this shift in strategy, whereas before they did not have a solution for this equipment need. Multiple expert calls confirm the view that this shift is leading to faster selling cycles, better alignment with channels and incremental service wins.

To start, I assume that organic growth grows at ~2-2.5% per annum across the three segments, then gradually decelerates over the next decade. This drives total revenue CAGR of ~2.4% over the next decade, prior to any M&A. The next 12 months are expected to be soft in CFS and RK, but pent-up demand is expected to support growth over the medium term. The Food Processing segment is forecast to have the strongest organic growth, while Residential Kitchen lags. Core CFS business, has struggled with organic growth in the prior 5 years, largely due to COVID19 and the resulting restaurant closures. However, the industry will soon be approaching the end of asset life (7-10 years), which is already overdue – notably the 2010-2016 period generated organic growth which averaged 6.5%.

Margins have similarly been impacted by the weaker sales environment and remain below peak levels and below management’s longer-term targets. MIDD is targeting 25% EBITDA margins in Residential Kitchen, 25% EBITDA margins for Food Processing and 30% for Commercial Foodservice. Figure AX below outlines my EBITDA margin expectations into 2035 – with RK and CFS segments reaching then maintaining margins at targeted levels. RK margins improve but lag management’s longer expectations, and remain closer to peer levels.

Using these assumptions, along with normalized capex estimates and improvements in the company’s working capital position towards historical operating levels, I get to an EBIT CAGR of ~4.8% from 2024 to 2035, as shown in figure AX above. Also, this does not incorporate M&A, which I still expect but much more tuck-in or technology driven going forward. This scenario generates $8.6b in cumulative CFO, ~$800m in capex, leaving >$7b in cash which can be returned to shareholders via dividends or buybacks.

In the DCF model, we use an 8.5% cost of equity, a 6.5% cost of debt, and a terminal ROIC of about 13%. Using these assumptions, the terminal EV/EBITDA multiple is about 9.1x and the P/E is about 14x, which is similar to roughly 10.8x and 15x multiples, respectively, that MIDD trades at today. Figure AY below outlines a summary of my DCF output and see below for a copy of my financial model.

2025.09 Middleby Corporation (MIDD) icemancapital.com

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In an attempt to cross-reference my output, I apply conservative peer multiples for each of the segments. This acts as a check on the above output, and provides a glimpse at what these set of assets could be valued if they operated as separate entities. This means the conglomerate discount is removed in effect – CFS trades similar to SMID industrials with similar growth/margins, FP trades similar to JBT Marel and RK trades at a premium to its consumer appliance peers due to better margin profile and premium positioning. My math below suggests >$220 per share in intrinsic value.

Management and Governance

Middleby shifted their capital allocation philosophy at the beginning of the year. The following quote captures their current view:

“This framework, combined with our financial strength, positions us to be able to prioritize return of capital to shareholders, while also continuing investments in our business to drive innovation and deliver organic growth. To that end, and given our continued belief that Middleby’s current market valuation does not reflect the inherent strength of our business, we are now targeting a return of the vast majority of Middleby’s free cash flow to shareholders through share repurchases over the foreseeable future. This is an important part of advancing our efforts to drive enhanced value creation and follows our February announcement regarding the planned separation of Middleby Food Processing, which remains on track for completion in early 2026.”

“In conjunction with the increased emphasis on buyback activity, Middleby’s Board has increased the total share repurchase authorization by 7.5 million shares. The total authorized shares available to be repurchased now represents 11.4 million shares, or 21% of the company’s outstanding equity. Year to date, we have repurchased approximately $50 million of our stock in the open market.”

Now let’s contrast this to the 2019 approach – using a quote to illustrate the difference.

I mean, acquisitions continue to remain a strategic focus and priority of Middleby. Obviously, we’ve been executing on that strategy for the better part of 20 years. And certainly, last year and this year has been no different. I think we’ve added six new great brands and technologies to Middleby this year. So we see opportunities across all three segments. We’re very focused in terms of strategic adds to the portfolio…

I mean, I think from a stock buyback – I mean other than debt paydown, that’s the other area that we think about. It is opportunistic at times and it always kind of depends on obviously where the stock is trading. But really the acquisitions are what create long-term shareholder value, as opposed to a buyback, which I’m not saying it doesn’t create long-term shareholder value, because it certainly does, but it’s a bit more of a financial buy. So that’s kind of the prioritization. And both of those are things that we think about on a regular basis.”

On base case estimates, MIDD will generate ~1.5b in free cash flow over the next three years, mainly from operating activities with some modest debt they can add on. MIDD management aims for 2-2.5x net leverage, and they should be able to re-leverage as the business returns to growth. Most deals will be small filling portfolio gaps – Frigomeccanica SPA is a good example; if bought for 1.2x sales, it implies a $45m purchase price. I think its completely off the table for them to attempt to complete a larger acquisition like Taylor, which would be considered transformational in nature.

In terms of incentives in 2024, management was primarily evaluated on EBITDA for short-term incentives. Longer-term equity incentives are 2/3rds based on performance PSUs, which are equally weighted on two metrics shown below along with management’s definition:

It’s surprising that management secured an 87% say on pay approval last year with these metrics. For a very acquisitive company, it’s too generous to add back restructuring and facility consolidation expenses and other one-time costs - especially each year. The adjusted EBITDA figure multiple by a market multiple doesn’t make sense – especially since mid-2022 Middleby traded at 9-12x while the market traded at a premium for the past 3 years as show in Figure BB. The incentive plan driven by these two metrics incentivizes deals that can boost both metrics without care on the ROIC or ultimate FCF from a deal.

By 2025, shareholder feedback has driven some changes. “the 2025 long-term equity incentive program will include Adjusted EPS Growth, Return on Invested Capital (ROIC), and TSR performance metrics.” I prefer FCF to be added but they are moving in the right direction.

Ed Garden is now on the board and has been accumulating shares since the year started. According to the cooperation agreement filed earlier this year, he owns ~643,000 shares personally and at least 2.6m shares through his firm. Ed Garden is well respected, has the capital allocation chops, and has a good investment track record from my preliminary research. The main areas for improvement are outlining a long-term growth algorithm and earnings power expectations – to date, they have only provided long-term margin guidance.

The board composition is improving. John Miller, the compensation committee chair for 47 years, has stepped down. Ed Garden brings a solid track record of public investing and capital allocation. Julie Bowerman adds strong public company and marketing experience, which could help improve organic growth. These two additions make it a total of 4 new directors in two years – a newer set of directors should help revitalize and reposition the business for future success.

Conclusion

A reset is underway at Middleby; pro-forma the spin of FP, a smaller portfolio will be more closely managed, an activist is closely watching capital allocation and a rebuilt go-to-market approach has encouraging potential - even the backdrop for the core customer base should improve over the next 24 months. At $132 per share, the risk-reward looks favorable, with intrinsic value estimated at $160 or $220 per share in a bull case. I welcome any feedback on the write up @icemancapital on X or via email at icemancapital@gmail.com

A Brief Global Blue Overview

Global Blue (GB) is the global leader in VAT tax refunds. They also offer payments, FX solutions, retail technology, post-purchase solutions, and a CRM system for merchants’ marketing activities. GB dominates the Tax-Free Shopping (TFS) vertical with an estimated >70% market share and is 3x the size of its next competitor. Figure AA shows historical revenues for all GB segments.

Starting with the biggest segment, Tax-Free Shopping Segment (TFS), which helps international shoppers obtain VAT refunds paid outside their home country. The TFS segmented generated 76% of total revenues in FY25. Figure AB shows how this works for a customer. A shopper purchases shoes for €500 at a store and pays a VAT of €100, totaling €600. At the point of sale, retailers issue a Tax-Free Form, which the customer takes to the Customs authority for authorization. This authorized form is processed by a GB Refund Agent at an airport. At the end of the day the shopper gets a €70 refund, with the remaining VAT refund split between the retailer and GB. Splitting the economics with a retailer and GB creates a strong incentive for retailers to ensure the GB service is offered on relevant transactions. Lastly, looked at it another way GB captures €15 on a gross purchase of €600, roughly 2.5% of the transaction value.

If you’re wondering if paper receipts are still used today, the answer is largely no. GB has digitized this experience for customers. Customers used to take a physical receipt to an agent, then wait for a cash, cheque, or card refund. This has been automated using software at all key stages including Issuing, Export Validation, and Refunding. GB has used the pandemic to accelerate the rollout of its digital offering. This process is now completed through a self-service kiosk or phone app. As of today, digital issuing is effectively 100%. The incremental areas of improvement through technology investments are with eligibility detection (ED) coverage ratio improving about 30% from pre-pandemic levels – allowing effective identification from the Card BIN to prompt the retail worker for a VAT Refund Form. The second major improvement is secure card capture, allowing merchants to use the same card for a refund after purchase validation. Figure AC shows trends on eligibility coverage detection ratio (%) and secured card capture as a % of Sales in Store (SiS).

Incremental progress on other TFS process parts is evident. The export validation component has been transformed with a streamlined process for TFS shoppers. Customers are now provided with transparent updates on their VAT refund status. Lastly, the company’s digital refunding process, after export validation, frees up time for GB and retail representatives - this allows them to spend more time with customers - a clear positive. Figure AD shows metrics for these KPIs.

All these components feed into two areas: the number of VAT Tax fund forms issued and the number of VAT Tax refunds completed. Multiply these figures for the “Success Ratio”. Figure AE shows out of a theoretical 100 forms, only 68% were issued and from that subset 83% were refunded. This converts into a “Success Ratio of 56% - up 4-6% points vs FY22/23 and FY19/20 largely driven by to improvements in the Issue Ratio. Compared to its largest competitor Planet, it has seen better recovery in France, Spain and Italy by 47-58% (FY23/24). These digital improvements are helping its Issue and Refund ratios over time and partly explain their market share gain in geographies like Spain, where it is up ~10% to 77% since 2019.

The Payments segment is the next largest revenue contributor, representing 18% of total revenues in FY25. This includes GB’s acquiring capabilities, dynamic currency conversion (DCC) at POS/ATMs, and multi-currency gateway for Hotels and Luxury retailers. This allows Merchant partners to let international shoppers pay in their home currency at the point of sale. GB can also offer this solution for e-commerce or ATMs, where shoppers see totals in foreign or local currencies. GB can generate revenues from FX spreads (high margin) and per transaction fees. In the DCC process, revenues are split between acquirers, merchants, and GB - in this example, GB captures 1% of the gross purchase value. Notably, this would in addition to the 2.5% illustrative fee from the VAT refund process.

The next segment, representing ~6% of revenues, is Post-Purchase Solutions (PPS). From 2020 to 2024, they completed 3 acquisitions to solve further pain points for consumers and travel merchants. ZigZag was purchased in 2021, addressed the complex issue of returns for TFS purchases, enabling merchants to add exchange and refund capabilities. ZigZag had a network of over 1,000 carriers and >200 warehouses to group shipments and reduce logistics costs – i.e. send all returns to Paris in one shipment. From GB’s perspective, this gives them another solution to sell to the merchant base and allows them to capture revenue on the subsequent return or exchange.

The second acquisition was of Yocuda, partially acquired in 2021, adding digital receipt and CRM capabilities for subsequent promotions. Yocuda’s identifying capabilities enhance merchants’ targeting, especially so if it were to be combined with ZigZag data. Yocuda merchants on the website skew away from luxury goods, including Marks & Spencer, Decathlon, and Sephora, but it’s unclear if this is important- the value proposition should still make sense. ShipUp was the last acquisition, providing merchants order status updates and real-time tracking. These bolt-on deals are additive to GB’s data moat, remove pain points for merchants and consumers, and capture post-purchase revenues (which may be less cyclical).

Competitive Advantage

GB is the leading specialty payments platform for Tax-Free Shopping with a +70% market share. GB’s competitive advantage comes from switching costs, intangible assets, and modest network effects.

Switching costs for merchant partners are high – most luxury goods retailers aren’t frequently switching retail POS platforms nor doing it in specialized verticals like TFS where competition is limited. Clients sign multi-year contracts with GB and a few competitors cited this as the biggest barrier to entry. The other contributor to stickiness is that GB individually negotiates the VAT refund split with each retailer – LVMH or Chanel might get over 50%, and this payout is a source of high margin revenues. New entrants would not only need to have a superior platform and incremental incentives to meet/beat GB’s payouts.

The next driver is that GB has invested more in intangible assets like R&D, technology, and know-how to operate with each regulatory authority. GB’s kiosks and applications offer fast refunds and clean user interfaces, creating a positive experience for shoppers. The front end is visible to shoppers, but the back end is equally important – GB’s digitization efforts translate into a superior cost structure. I mention this before considering the recent buildup of post-purchase solutions which are still penetrating their merchant base and will create further stickiness with GB’s platform.

The last major factor driving their competitive position is network effects. As the largest player in the TFS market, they generate substantially more data which can be used to promote products and drive cross-sales (e.g. Hotels or Sports & Entertainment). GB collects around 50 data points per transaction, including the purchaser’s passport information, SKU specifics, and the transaction details. After collecting this data, much like other ad-tech businesses it is enriched to identify and profile shoppers. GB is the authority on international travel luxury spending and enables ~1/3rd of category spending. If Chanel wants to determine its Abu Dhabi store’s performance, GB can show how it performs vs peers, its tourist mix as % of sales mix, basket size, and refund speed. Brands can’t replicate this information with insight into only their assets. It isn’t a surprise that GB’s net retention ratio (%) is consistently >100% as shown in Figure AG.

Vertical / Market Assessment

GB sits at the intersection of the Travel and Luxury Goods markets, both historically growing at GDP+ levels. Benefits include exposure to luxury price increases and reduced exposure to economic downturns. Figure AH shows a slide from GB’s FY23/24 presentation.

Figure AI below shows that from 1996 to 2024, the Global Personal Luxury Goods market sales grew at a 5.7% CAGR. In only 5 of the past 29 years did sales decline year-over-year, with the worst year in 2020 during COVID-19. Downturns were short, with sales recovering to prior highs in less than 2 years. From another perspective, rolling 5-year market CAGRs were positive in all but 1 period, growing at a minimum of a 2.7% CAGR. Expectations are for this market to grow >5% over the next decade according to Bain. GB has tailwinds from total market growth and pricing power of luxury brands.

GB’s exposure clearly skews towards luxury purchases. In FY2025, GB generated 41m transactions with an average value of €587. These are impressive figures relative to the pre-pandemic count of 35.2m, and especially given the UK eliminated VAT refunds in 2020/21 – which accounted for ~13-15% of transactions. Rumors suggest the UK may reverse this change, but I don’t know the probabilities. Offsetting this could be the recent addition of VAT Tax Refunds in Saudi Arabia and nine other countries which are at various stages of adopting VAT refunds policies to effectively stimulate tourism. I see more reasons why the market seems likely to grow than shrink - GB’s expectations are similar expecting a 1.5-2% tailwind from new markets over the long-term. Figure AJ below shows GB’s results from FY09-19 and Long-Term growth targets from its FY24 presentation.

So GB is a leader in an attractive market. What if a new entrant tried to enter? Many previous attempts to enter this market have failed. Uri Levine, Waze’s former founder, created Refundit to grow in this market. His business struggled, leading him to file a lawsuit with the EU competition unit in Brussels in 2021. An FT article said:

The quote shows why FOUR may have admired the business: 1) They have secured long-term agreements with luxury retailers with strong pricing power 2) limited transparency on fees – and 3) its incentive sharing approach with merchants makes it harder to dislodge as switching to an alternative would lead to an immediate loss of one source of revenue. The EU commission closed the preliminary probe in July 2023 with no fines or remedies. The list of upstarts that have attempted to dislodge GB is longer, but this was the best example to illustrate its competitive position.

Merits of Deal

Global Blue fits well into Shift4’s historical acquisition framework – it adds a hospitality gateway, relationships with many merchants not using an E2E solution, and expands their presence internationally. It adds industry-specific talent and know-how in the TFS market. The Dynamic Currency Conversion and Multi-Currency Payment are incremental capabilities and can be rolled out over time to the rest of the FOUR merchant base. GB also had a growing presence in Australia for acquiring. Pro-forma this will allow them to process payments in 75+ countries as shown below in Figure AK, compared to starting from just the USA at IPO.

The company is offering $7.50 per share in cash, or a $2.5b total purchase price. The price offered to GB shareholders was only a ~15% premium to the prior week’s price, translating into ~13.3x TTM EV/EBITDA multiple. On forward estimates (only 1 broker), a 5x P/sales or 25x F/PE on an estimated $90m net income for 2025. FOUR guided to $80m in revenue synergies and $70m in EBITDA drop through.

Breaking down GB’s customer base reveals potential underwriting synergies. Sales in Store (SiS) were split 78/22 with Global Accounts (59%) and Department Stores (19%) as the largest, followed by Accounts/Key Accounts at 11% each. These merchants contribute to the estimated $500b payments potential Shift4 could capture. Enterprise-like customers (Global Accounts + Department Stores) will be the hardest to win over, as they skew towards Adyen or Stripe. However, some customers have a split between a partner in developed and emerging markets – where FOUR’s incremental broader geographic coverage could increase odds of winning an E2E customer. The smaller accounts, accounting for 22% of sales, are more likely to convert to FOUR’s E2E solution. The $80m revenue synergies assume 10% of accounts will shift over, and 2% of enterprise-like accounts. The dynamic currency conversion and multi-currency payment gateway also have huge monetization potential across the FOUR customer base - Hotels and Sports & Entertainment Venues all seem like a great fit for this technology.

FOUR expects $80m in run-rate revenue synergies and a $70m run-rate EBITDA contribution by 2027, but that’s without “deleting the parts” and removing redundancies on the GB cost base. With just incorporation of the $70m EBITDA contribution we get to $272m in EBITDA or a synergized multiple of 9.2x - pretty good.

However, fixed operating costs were $193m, $173m and $154m over the last few years. I don’t expect FOUR to be complacent on costs here but the magnitude of potential improvement here seems up for debate - If FOUR can remove 20% of the cost base over time, the synergized deal multiple would be ~8x. That’s a bit higher than other deals, but given the size and upgrade from a vertical perspective (more pricing power exposed) it looks like a great deal. Figure AL provides an illustration of this.

Concluding Thoughts

I believe FOUR has reset its approach to setting guidance as Jared was expected to transition out of the CEO role. The new guide for +25-30% EBITDA CAGR depending on deal pace looks attractive. If FOUR can deliver on the $1b FCF Target by 2027, I believe returns will be strong.

Recent news about Jared’s NASA appointment suggests he won’t take that role, but it’s unclear if he’ll return to the CEO seat. I don’t know if it matters at this point what his specific role at FOUR is. He owns a lot of stock and will scrutinize what Taylor and the team are doing. The business has a good runway for growth and the team continues to impress with capital allocation.

I continue to own shares in FOUR.

Let me know if you have questions or feedback on this post – reach me on X at @icemancapital or icemancapital@gmail.com

SPEAKERS

Chris Hohn, Nicolai Tangen

Nicolai Tangen: Hi everyone. I'm Nicola Tangen, and today we are joined by one of the best investors of all time, actually. So Chris Hohn, not only is this fund, TCI one of the best and most successful funds that Europe has ever seen, but also the charity is one now one of the largest in the world. So Chris, you continue to have a immense positive impact on the world. Thanks for coming. Good luck. Let's start with the investment world. What makes a good investment?

Chris Hohn: I think this is something a lot of people get wrong. They let's they think it's about growth, often, okay? Or something new. Neither of them, those things in themselves, to us, matter by themselves, the most important thing and without which it's in for the let's say the types of investing that we do is high barriers to entry. The moats that Warren Buffett has talked about now can before we dig into that. Can a distressed asset of a, you know, a piece of real estate that selling at half price because of a liquidation also be a good investment. Yes. So Can there be a role for cheap average assets? Yep, let's call them low quality assets, which are trading at big discounts to replacement cost. Yes, that's the, that's the type of investing that can work. Yeah, I've done in my time, yeah, cheap average businesses or cheap bad businesses. But I don't feel that I can have any confidence in that type of investing, because the earnings power of those averages businesses is unpredictable.

Nicolai Tangen: What? So, what are good Moats?

Chris Hohn: The most important answer is ones that are sustainable. Okay, a lot of people, and ideally, you would have multiple moats, multiple pieces of defense. And there are many Moats. is basically something that means that the business is difficult to replace, difficult to compete with, yes and replace two, two substitution risk and competition risk, those long term become different, very difficult, because, why is it so important? Competition kills profits. Yep, that's as simple as that. Substitution eliminates your business. So we look at there are many, many moats, one which most people don't look at. Most investors don't really look at actually, interestingly, is irreplaceable physical assets. Okay, we're in a world where people just look at earnings. They don't look at asset value, or physical assets and so we like quite a bit of infrastructure. Airports, for example, one of our investments which has been the airport group in Spain, where they got a private ISNA. Yes, I, you know, and you just can never, they'll never build a second airport at Madrid or any other places. These are, you know, natural monopolies and so. But that also applies to toll roads and railroads and telecom towers. So there are many forms of infrastructure, transmission towers that are hard to compete with, because then natural monopolies, where, where, of course, some of these things can be overbuilt, like cable. So there's a form of infrastructure, but it's, usually you have to look at the details of case by case, very unusual to try to and usually go get the planning to build a second airport. So no economic case to it.

Nicolai Tangen: I can't remember how long they've struggled to get an extra runway at Heathrow

Chris Hohn: So planning exactly, planning and then roads is no economic case to build a second road or you don't have the land. So for different literally no. So infrastructure is physical. Assets is one a second is IP. But intellectual property, that's right, and which is so advanced, okay, that it's very difficult to replicate. Well, that's all.

Nicolai Tangen: What kind of intellectual property?

Chris Hohn: one space we like is. Is aircraft engines. And there it is a very complicated product, because the materials complexity the engines run at such high temperatures, metals melt, and so many different things have to come together. Yeah, 1000s and 1000s of complex parts. So that's one where, that's a business, where there are only two players in narrow body engines and two in wide body, and there'd be no new entrants for more than 50 years. The last new entrant was GE and so that tells you something. Yeah, there's a big industry, but it's so complex, very hard to enter. Another barrier to entry is installed base, okay, which applies to the aircraft engine business. Once those engines are there, they for various reasons. You get the spare parts business on it, and another of our barriers to entry is scale. Although that's not a guarantee of competitive moat network effects is another important barrier to entry. You can see this in assets like Visa, Meta, Yep. Two examples of network effects and brands are another barrier to entry. But I'm not saying every brand is powerful, but you know, you think about a McDonald's. It has a value. There are some brands which are powerful and sustainable, but not all. And I'll mention one more moat, which is customer switching costs. Take mission critical software once it's installed, companies are very reluctant to mess with it and switch because of the complexity.

Nicolai Tangen How important are recurring revenue streams for you? When you look at businesses?

Chris Hohn: it is important, but the predictability of when they recur is not important okay. Let me give you an example. So what's most important for us is something slightly different, which is essential, product or service. We don't like things which are discretionary. Okay, so one space we've invested in for a long time is rating agencies

Nicolai Tangen: these are the people who basically give kind of character to different type. Yeah. They say, is it good or bad?

Chris Hohn: The people who invest in bonds, they say, is it investment grade? Non-investment grade? Give for research. And if you like, bless it. And there you can actually defer an issue of pays for the rating, but they don't have to refinance their bonds, which is a big part of it. In any given year, they can delay and defer, but eventually the debt has to be refinanced and rated. And so there's an essential need is the bigger point. But usually, our companies have recurring and predictable revenue streams of essential products, yeah,

Nicolai Tangen: do they have to grow?

Chris Hohn: depending on valuation, not necessarily and or that's not necessarily at a fast rate, okay? And you and growth can cut from two forms, volume and price, so you have to break it down. Now, why isn't growth as important as people? Investors usually assume it to be because you can have profit less growth. The airline industry, over 100 years, has had a lot of growth. Airline travel has grown at 5% a year. Yep, continues to grow consistently. But airlines as a business, cumulatively and collectively have made almost, you know, minimal profits despite growth, because the very low barriers to entry and so. So I would say growth without barriers to entry is is not a combination that you want.

Nicolai Tangen: Some of these businesses are quite capital intensive, like, it's not cheap to build an airport, yeah, does that matter for you?

Chris Hohn: Well, you have to look at, like everything in detail. And some airports are all airports have a regulation on landing charges. You. Some the non-landing charges are unregulated, the shops, the advertising, the VIP lounges, the parking Yep. And the so-called jewel till regulation. One till is regulated; one till is unregulated. And those are very low capital intensity. Yep, it's in effect yep and high returns on capital, they grow because there's more and more demand for travel so on. Capital intensity by itself. It's part of the equation, okay, but it still, it tells you how valuable growth is, okay, but what Trumps, if you don't mind that expression, what trumps the all of this is

Nicolai Tangen: still a valid expression, yes,

Chris Hohn what trumps all of this is the the Barriers of Entry.

Nicolai Tangen: What about regulation? You’ve been big in things like Red Electrica

Chris Hohn: Yeah, I'll go into that, but I want to go back to the point about growth can come from two forms, price and volume. Okay? And most companies don't have pricing power. They can only price if they're lucky at inflation, and that's why people don't focus on it. They don't even look at where growth comes from. They just assume it's volume plus inflation. But there is a special group of super companies that can price above inflation, and that's, as Buffett taught, the test of whether you have the moat, okay, and this real pricing power above inflation can be very valuable, because if you can price 1% above inflation and you have a 20% profit margin, your profits will go your profits will go 5% faster than revenue, and people don't go into it or analyze it, because there's so few companies that that have it, but, this is something we have a you know, A lot of investments have

Nicolai Tangen: because incremental pricing is pretty much all profits.

Chris Hohn: That's right, and it's very potent if you have lower margins. So this is why you asked about growth. And is it how important if you ask about volume growth, but I have low volume growth, but I have a lot of pricing growth, that's actually more important because of the leveraged effect of there's no cost associated

Nicolai Tangen: Regulation. you have been invested in a lot of regulated businesses. Yeah, that's right, in airports, but you've been in Red Electrica, which is like electricity, transmission company. You've done quite a few of these things.

Chris Hohn: Yes, I have. And actually it's a general risk, because if you have barriers too low. Competition or substitution eliminates your business, and your investment barrier is too high. Regulators may come knocking on your door, yep. Every case is different, yep. And the ideal case is you that there is competition but weak competition and apparent competition.

Nicolai Tangen: Okay, so tell me what is apparent competition?

Chris Hohn: Yeah, well, it's really weak competition and rational competition. Okay, so the take some examples. Pratt and Whitney competes with GE and Safran. It has a 25% share of new orders. It can as a product, but it's not nearly as good. It's got 35% of its engines grounded multiple technical problems. It's lost a lot of trust, but it's there competing and for new engines, yeah, but price isn't the most important thing in this industry, reliability is and so you and so, as it struggles, it has to raise prices because it's got very, you know, lots of difficulties in sometimes where there is competition, that competition chooses not to compete. You know, generally speaking, not a specific industry decides to be rational, yeah, and compete on, you know, non-price based approach, okay? And then the detail matters. So you might have looked at Heathrow Airport and see, oh, that. Airport is fully regulated. Airports can't be good. But if you look into the detail of AENA, it's a different animal. It has a piece that's regulated and a much bigger piece, 70% of value, maybe more, which is unregulated, yeah. And so maybe the unregulated business, the regulated business, will give you a bond like return 7% but the unregulated give you a much higher return. Do you see?

Nicolai Tangen: another group of businesses you've been very big in has been the stock exchanges, both Deutsche Boersa, London Stock Exchange, and so on in the past? Yes, yes. Why are they? Why were they so good?

Chris Hohn: In the case of Deutsche Boerse, starting with that they had a derivative business called EUREX, which was a natural monopoly. It was a network effect. This was the barrier to entry, that liquidity of a marketplace for trading bond futures, European bond futures, the network effect of getting best prices in the most liquid market meant it became what is termed a winner takes all or natural monopoly, and once you have that liquidity, very hard to move people away price. You can never compete on best price and run the Stock Exchange has that for LCH, ClearNet business, a clearing business, and so where an exchange can CME has it on US Futures. Establish this natural monopoly by being the first mover. Okay, the winner takes all. Then these exchanges can be very good, but of course, they've changed now. Stock exchanges are in many different businesses, sells data, and half their earnings are from data, and that's nonproprietary data reselling nonproprietary data. So, it has a vulnerability on that piece. They're no longer just what they used to be. And then there was a lot of growth without capital, yep, as people came and traded more, as capital markets grew, you grew without capital, which was, was very valuable,

Nicolai Tangen: what are the type of companies you would never invest in type of industry?

Chris Hohn: Yeah, that's a good question. We have a long list of companies we don't invest in. We're very focused, and we call them risky and bad industries. And I have invested in some of these in the past, but I've learned banks sorry for that as a bank, you know, Central Banks are good, yes, Central Bank, we good, but we because we don't like, we don't like banks,

Nicolai Tangen: and why not?

Chris Hohn: Why not? the low quality of earnings, because they're very leveraged, and much more than people think, because people look at, oh, equity to risk weighted assets, but equity to total assets. Many banks have been run it 100 times and so two they're opaque. You can't look into the you can't. Yeah, you can't. I remember, pre financial crisis, I had a look at Credit Suisse, and I sat down with the then CEO, Brady Dugan and and said, Put his balance sheet in front of him from the annual accounts. And said, you have a multi trillion-dollar balance sheet. Can we walk through the line items, because I don't understand it. He said, I don't either very honest guy. I really liked him very, yeah, very honest. And

Nicolai Tangen: okay, so banks, you don't do. What else don’t you do?

Chris Hohn: And the other reason for banks is very important. You know that sooner or later, you may find someone without a lot of intelligence comes to run them, and then it can be toxic. Yeah, people going for growth, Anglo Irish bank, if you remember that one, and they just can destroy the shareholders, yeah, by getting bonuses. You know, Bear Stearns, you know, and non-alignment of interests with leverage and opacity. the others, oh, many. The auto industry is obviously a commodity, retail, you know, insurance, commodities, commodity manufacturing, tobacco, the truth is, yeah, anything in most things in manufacturing, okay, so industries, most industries, yeah, so.

Nicolai Tangen Of course, it doesn't leave, it doesn't leave a big universe, correct?

Chris Hohn: We say maybe there's 200 companies that we consider to be high quality and investable. And I mean, I'll list you a couple more traditional asset managers, bad businesses, yeah, speaking as one, fossil fuel, utilities, bad businesses, airlines, bad businesses, wireless, telecom, bad businesses. We think media is bad advertising agencies. You know, it's a very long list. Why? Because it's competitive and with existing players and new technologies. And the one important thing that I've learned in my time in investing is investors underestimate the forces of competition and disruption, because they just look today, maybe there's a new company which has a first mover advantage, but then competition comes in, yeah, substitution

Nicolai Tangen: where does it leave you on the big US tech companies?

Chris Hohn: yeah, so there's a lot of power of incumbency. This is another important point. So let's take a company, Microsoft, okay, which we've invested in, and one of the barriers to entry is bundling, okay, or, or maybe because it, it creates a customer switching cost. What? What do I mean by this? So the office franchise, which we're all familiar with, has many products in it, your applications, word processing, Excel, your email, security, different things, and they sell it as a bundle. They don't disaggregate it. And when a new product or a potential competitor enters, they can add it to the bundle. So Zoom came out with video conferencing, and they could have potentially, you know, added all the things Microsoft does to that. So Microsoft had to respond, and they launched Teams, and they were able to distribute it through the bundle, yeah, free to everybody. And even though Zoom, some people believe was a better product, or is it better product? Microsoft won that battle because they had the installed base, the incumbency, which we talked about, and high switching costs for because once people are using their office software, they don't want to switch. And so people started using teams, okay, something given to you free? Why? Because it was good enough. Yeah, it didn't have to be the best if it's free

Nicolai Tangen: What about the other tech companies?

Chris Hohn: We have a position in alphabet and which is maybe our most risky investment, where they're clearly the company, and it's one of our smallest investments as a result, it's and where we have some level of protection, because there are businesses like YouTube and their cloud business, which represent half the market cap today, and cash and other things. So it isn't all search, but search is critical and so can they out innovate competition? Yeah, there's a risk of search fragmenting, you know, as competitors come in and try to but it's a question mark. Well, we don't think so. We think they have a lot of advantages of their data to have, due to offer higher quality search results and but competition is increasing

Nicolai Tangen: talking of which, how do you think AI will change the investment landscape here.

Chris Hohn: It’s going to increase disruption in ways we can't even predict. But there are things like call centers will all go bankrupt, and another segment is Indian outsourcing companies who do coding and things like that? Demand for those services could collapse because AI can do coding, you know, with half the people. Yeah, yep. So. So there are, but AI will increase the productivity and lower the cost base of all, all companies. And so if you have a company with these barriers to entry, it's going to be worth more, I think, for generally competitive businesses, if you don't lead, you could become uncompetitive and be disrupted.

Nicolai Tangen: So now we have identified one of these companies. Let's say I don't know. AENA I you know, or Rolls Royce or Microsoft. How do you value these companies? What is your valuation tool like?

Chris Hohn: We don't even look at that until we get comfortable that the barriers are so strong it will be around. Now, okay, fine, fine. Be around. Yeah, we think it'll be around. We think there will continue to be an airport in Madrid.

We'll do reference checks on relevant people, okay, so and see if we're missing something. So we, when we were looking at investing in aircraft engines with we spoke to the CEO of a former CEO of one of the competitive companies, and he confirmed their thesis, and actually said the margins should be much, much higher, okay, and over time they will go there, So that that's one of the pieces of diligence, we will assess management where I think it's important, but not critical, if you have the right assets through, ideally through meeting them, the talk to competitors, get their view, and look at competitive companies, look at the track record of the company, and usually you don't understand everything, and usually the things you find out are bad things. And I think we'll discuss it with our team. And we want to hear competing views. Yeah, we have some members of team who are just inherently bearish, and they're good for testing the bear case. We always want to hear how could technology disrupt, yeah, and or just what competition and

Nicolai Tangen: are you a bearish guy?

Chris Hohn: Not particularly, no

Nicolai Tangen: What kind of valuation metrics do you look at? P/cash flows? Do you do DCFS? You have, like, 50 page spreadsheets all of those, right?

Chris Hohn: All of those. But not 50 pages. honestly, one of the things we learned is there's a really important point, is that we can have an advantage through long termism, okay, which is the average stock is held by an institutional investor by under a year, or the stock market in the US,

Nicolai Tangen: how long do you hold it?

Chris Hohn: Average holding period of our current portfolio is eight years. Eight years, yeah, that's, yeah, eight years. I'm not saying that's the limit. It's just the we've, on average, some we've held for 13 years, some new investments, like GE Aerospace, two years for the average, weighted average holding period is eight years. Yeah, so, but it could be 10. It could be 20.

Nicolai Tangen: I love long term, right? But how do you install that type of thinking into your organization? I mean, we really business school. You want to hey, I mean, you know, went to Harvard, like you did or whatever. It's just like, hey, let's do some stuff. Come on, let's do some stuff. Yeah, and it's just like, Hey, okay, let's buy something and hold it for eight years, right? You come home to your partner every day, they do nothing.

Chris Hohn: If you know, if you are in the private equity world, that's normal, yep, a private equity fund would hold an investment for their 10 year life funds, normally, yeah, or longer, 12 years, yeah, as you know, and so, we as an overused expression for some or misused we take a private equity approach, I.E that we have to hold the company forever, because you the stock market may be at very bad prices when you want to sell, yeah, if you need to sell. And so, I really think you need to have that approach and so the way we really like our long term valuations, DCF, the most important things.

Nicolai Tangen: And here's the DCF, you take the cash flow and you discount it after today.

Chris Hohn: Yeah, but here's the thing is the longer you can look out if you've got a great company, the more valuable value there is take a company we own, Moody's. Moody's. So it's been around 100 years. What do you think the average I can ask you a question. Make it fun. What do you think the average revenue growth over those 100 years has been?

Nicolai Tangen: I'm going to look like a total fool, but, 6-7%

Chris Hohn: 10%, wow, after, you know the very it's a very unusual number over a very long time period. And so investors have always underestimated its value, including myself, yeah, and I bought the stock during the financial crisis at 10 times earnings, and even bought shares Warren Buffett was selling, and reduced his stake from 25% to, I think he's got 15%.

Nicolai Tangen: the are you kind of, then, are you kind of secretly pleased having bought something cheap from Warren Buffett?

Chris Hohn: But then I sold it. I doubled, I doubled my money, and went from 10 times earnings to 20, and I sold it at $100 bought it at 50, sold it under. I thought I was clever, and then, but the earnings kept compounding, so I bought it back at $150 so now it's recently $500 now $400 so it's because, actually the intrinsic value compounding matters more than the stock price. If you have a great company, it will grow intrinsic value. Here's the thing about the multiples, they matter less than the growth when you look at it over a longer period, but most investors are unwilling or unable to invest on a long term time horizon, because either they don't know what they're doing, which interestingly, goes back to what were they think is risky, which goes back to what Warren Buffett was when he was asked what the definition of risk was. You know what? He said, not knowing what you're doing.

Nicolai Tangen: So really good nugget here is that if you buy something which is really good, it doesn't quite matter what you pay for it, because it will grow

Chris Hohn: secondary over a long while, I say the, let's just say it like this, the multiple to a point, yeah. Whether you buy it at, if it's growing, it's all math. Yep, you've got to look at the growth rate, the terminal multiple, the all the multiple things. But if it's increasing intrinsic value at a good rate, you will undervalue it if you look at it over a short horizon, yep, it can be saying it like that. And if you're, if you're willing to hold it for a long term and extract that intrinsic value growth, it'll be worth more to you than other people.

Nicolai Tangen: I've heard you say that there are more good companies in the public market than in the private market. Yes. Why do you say that?

Chris Hohn: Because the companies that that are sold by to private equity are the ones that aren't as good.

Nicolai Tangen: are you sure? How do you? what do you base that on?

Chris Hohn: lets dig into it. I know it upsets people who are in Private Equity.

Nicolai Tangen: I'm pretty pragmatic about this, but why do you? Where do get that from?

Chris Hohn: I happen to think that large companies are more likely to beat small companies in an industry, they have more money to compete and in R&D, yep, and scale. We talked earlier about scale being key and incumbency being key, and switching costs. So, yeah, we we think it's a small company that invents something new. We talked about Zoom. It can be crushed by a large company reasonably easily. They can copy. And large companies are usually, you know, too big for private equity. Private Equity can't buy Visa. No, they it's too big for them, yep. So that that size excludes private equity from large companies. And if a public company is selling something to private equity, usually they're not selling their best businesses. Yeah, and I'd say private equity, like all asset management is prone to the principal agency problem, where they are incentivized to gather assets. Let's just say, say it like this, the very best businesses in the public markets, I believe, are better than. The top 100 public companies are better than the top 100 companies in private equity,

Nicolai Tangen: okay, yep, yep. When do you sell a company?

Chris Hohn: when it's a view of intrinsic value is not as good as other things, not just value, but conviction, so philosophy, it two components to it, if you like intrinsic value, yeah, so the price still has to be at or below intrinsic value. But there's a second point which isn't really focused on by many investors, which is conviction. So it's easy to reduce faith.

Nicolai Tangen: You lose faith in them?

Chris Hohn: No, I'm saying you need to have conviction when you invest in something at all times. Yeah. And what does that mean? You could call it confidence. What does that word mean? Because there's a saying, talk is cheap. You can say this, and you can be wrong. Okay, and so one of my first investments, when I worked in New York for a hedge fund before starting TCI was in an Italian media company, and Bain Capital bought control. It was like a billion euro valuation, and it went to a 50-billion-euro valuation, and then went to zero. It was a Yellow Pages company.

Nicolai Tangen: SEAT (Società Elenco Abbonati al Telefono).

Chris Hohn: yeah, you remember it and when I first invested, the internet didn't exist, and people thought yellow pages were a monopoly, and they were and so the point is, you can be wrong, and certain industries your risk of being wrong are higher. Technology is one of those areas, absolutely. But if I own an airport, yep, that is or a toll road, let's take a toll roads that are unregulated, which there are, there are some that we own. I'm less likely to be wrong than if I own a retailer, yeah, my, my chances of being wrong are less because I have physical asset backing substitution risk. So the thesis is much more obvious, yeah, because so the and so this, this concept of conviction is very important. One investor, yeah, said to me, I have to be able to sleep at night. It has to be sufficiently obvious, which, but you always sounds contradictory to saying that you can be wrong, because what kills you as an investor is permanent loss of capital.

Nicolai Tangen: Absolutely,I got a bit of a problem with the concept of intrinsic value, as if there were some kind of objective truth

Chris Hohn: Yeah, you're right. You're right. It's, you know, we can't tell the forecast the future, so to any high degree of accuracy, you can just say, which is why you can and the longer you look out, the harder it is. And so we look at simpler tests. Sometimes, will the business be around? Yep, will we still fly airplanes in 30 years? And you know, will we want airline travel? Will there be demand for it? And so, once you know, so I agree with you. So I think that valuation is just approximate. We, you know, we can just say, in truth, with can, with confidence, we have a good or great business, okay? And as I'm saying, only a small subset of businesses can be predicted, yeah, which are the most powerful ones, but exactly how they grow? And you know, unexpected events. You're right. There's no certainty.

Nicolai Tangen: Let's move on to from companies to investors and in terms of what makes a good investor, why are you a good investor?

Chris Hohn: Well, it's your words. It's important to have humility. But there was someone I knew who took me aside once, and he said, Chris, you and I, he did reasonably well. He said, we weren't the best investors. We just took the most risk. So I just wish isn't. Not true, actually? Yeah, it was. He was. It was an interesting comment that makes you sometimes when people say a joke you or something, you wonder, is it true? But I was always willing to look at the company fundamentals and not them try to guess the stock market. Okay? And focus on macro or trading, yeah. So I was always fundamental. Most investors are not fundamental. They trade actively. They look at data points. They say, what's the catalyst? They don't really know what the company does. So I think the fundamental approach has been key. Long termism is key, Okay, another thing we've done is concentration. We've owned a few things. Yeah, we may have 10% type holdings, 10 stocks, you know, 15 stocks. We don't own 100 things. And I think another key point is intuition. We work with intuition, which is something that is, how strange. How do

Nicolai Tangen: How do you use intuition?

Chris Hohn: it's been defined as thinking without thinking, which is the Buddhist would call a Koan, something that just doesn't make sense.

Nicolai Tangen: We will come back to your Buddhist thoughts later on

Chris Hohn: but it's, it's a lot of people don't understand what intuition is. It's sort of,

Nicolai Tangen: I happen to have written my master's dissertation on this exact topic.

Chris Hohn So you're one who does, then it's sort of the opposite of intellect. And so pattern recognition, in a way, you've seen it, yeah, that's, there's a word for it, knowing, okay, it's, it's all of the opposite of intellect. So of course, we'll do analysis, but, but then I it's a higher level of intelligence than just intellect.

Nicolai Tangen: But do you, what do you have intuition about? Do you have the intuition about the people, the situation? What is it?

Chris Hohjn: All of it, okay, all of it is someone trustworthy or not trustworthy, and the patterns, another thing. And so, you know, we were, we don't do we rarely short, but we were short Wirecard, yeah, I know we're coming back to that, yeah. And, but

Nicolai Tangen: but is your intuition now better than it was when you were younger.

Chris Hohn: Yeah, it was not in intuition so much before the last five to 10 years that you've been a change, but I think I always operated with at an intuitive level, and it's not just stock picking, but I decided to start my own fund. You know, 21 years ago, I just had this intuition that I was in the wrong place and not doing what I was meant to do. And it wasn't about money or anything, but it's when, you know, when I met my wife, Kylie, you know, you just Yes, and there's a point where you just know, yeah. It isn't an intellectual thing.

Nicolai Tangen: You know, there, Chris is called, this is called love.

Chris Hohn: This is something else. Well, yeah, love is not of the mind, but love should be intuitive. Yeah, it's an example.

Nicolai Tangen: Yeah, do you? Do you believe in so if I, if I'm your colleague, so I work now for you, I'm a junior analyst. I came to I come to you, and I say, Hey, Chris, I got this intuition. I think this looks really good. Will you believe me?

Chris Hohn: I'll the because the thing is that people have to, we don't work like here's the differences. I've been a stock picker, so a lot of portfolio managers aren't portfolio managers. They're managers of managers. And they say, people like that say to me, there's only two truths, which is not the story that I hear, but the P and L and the stop loss, because they can't analyze the company themselves. So No, we never take anything from anybody at face value, and we work in a team. That's something we didn't mention earlier. But the point is, just a story is just a story. Yeah? What you have to focus on, what matters, okay? Because there was a spiritual teacher, actually, who said something that applies to investing. He said very few things matter, and most things that matter - don't matter at all. Okay, so you could and investing, it's actually similar, yeah, you can. You need to get out of the noise and just focus on the handful of things that matter.

Nicolai Tangen: Is it talent, or can it be trained to become a good investor?

Chris Hohn: I think it. And be trained? Yeah, there's a judgment element of it. I think it can be trained for sure

Nicolai Tangen: No, we have. We both have taken inspiration from some of the same people, right? One of them is John Armitage who I worked with.

Chris Hohn: yes, yeah, I love John. I love John. I consider him a friend. Yeah, I was just starting out. He really, he's a great investor, and he took me under his wing a little bit, and couldn't do anything. And we had the same couple of same stocks. The Energy Group was one, and I didn't have the experience to know and say, you, you would probably say, you know that knowing and intuition comes with experience too, but yeah, and so yeah, I'm a fan of John's,

Nicolai Tangen: yeah, because most of the things I know about investments I learned from him and his partner, Bill Bollinger. So we have some of the we have some of the same teachers here, moving on a bit. So you are, or you were, in a, perhaps more considered an activist investor. Yes, so in your, in your view, what is an activist investor doing?

Chris Hohn: It's a spectrum, and from full blown hardcore, removing boards and CEOs and demanding the sale of a company to call it soft activism, softer activism of trying to have relationship and dialog with the company at a professional level and where you understand their mindset and their thinking of the business so, so and and engage, okay? And that could mean many things. It doesn't, you know, I'd say today our relationships are very, generally, very constructive with companies so but it wasn't always that way. Yeah, it wasn't really.

Nicolai Tangen: I learned you gone from having been an aggressive tiger to becoming a bit more of a You know, big lion, yeah.

Chris Hohn: Though no one's thought like that when we started the fund, when we named it the The Children's investment fund, we thought, how are we going to compete with Tiger and Viking and more aggressive named funds? But yeah, it is true. I've learned that actually activism, hardcore activism, is not a great thing.

Nicolai Tangen: Why not?

Chris Hohn: Yeah, it's very difficult to succeed because the vast preponderance of today's investor base are passive, who don't actually to get them to vote for something is very difficult and and all the power, you know, the and so active management is dying. And so when I started, there was very little indexation, and so there was a more engaged, active shareholder base. And now indexation is limited the power of shareholders.

Nicolai Tangen: But I mean, you were one of the most feared people in Europe.

Chris Hohn: But I owned bad businesses long ago, like ABN Amro putting up for sale through putting on the AGM to sell the company. And we made a lot of money. We made a billion dollars forcing the sale of it. But in truth, the company was worthless, but was bought for 100 billion from three companies who all went bankrupt, Royal Bank of Scotland, Fortis and Donvenneter. So they didn't know what they were doing. We didn't know what we were doing. And it was all, you know, a madness. It was a, but it made money. But for those who sold, but in truth, the fundamentals were, would trump everything. So a lot of activists end up being activists in bad businesses,

Nicolai Tangen: but have you stopped being an activist because you are more attracted to good companies, because you can't control the business always

Chris Hohn: the business always wins. Yeah. Okay, so it's pointless being an activist in a B business. And that said we still engage in it, in hardcore activism. We have an investment where we went on the board and, you know, pushed out, you know, Chairman and some directors and the and the company is doing much better now and but that's an. Exception, and I'd say that was a result of a disastrous case in the company where they were on the board and they couldn't appoint a CEO. The board was divided, and it was a real mess.

Nicolai Tangen: What kind of personal toll does it take on you to be in these fights?

Chris Hohn: Let me give you an example. A few years ago we, I don't know, it was six years or so. We own shares in Safran, where we still own them. We've held them for 13 years, and it's a great company, aircraft engines and joint venture with GE aerospace, and they announced they were buying a company called Zodiac. And we felt French aerospace now, you thought that the price was ridiculous, 10 billion euros, and they wanted to pay in shares, and we thought that we believe the shares were half price, so they were paying four or five times the intrinsic value. And we undertook a very aggressive campaign and threatened the litigation and demanded a vote. And in the end, the company target was adding multiple profit warnings, and it became clear that we were right. And Safran went to Zodiac and said, we have to cut the price in half and pay in cash because TCI are forcing us okay and so. And that's what happened. The stocks doubled and but we were sued by the seller for 100 million euros, both me and my general counsel separately, he said, Chris, it's not really sleeping much at night. You can afford it. I can't. And so, yeah, I went into a Paris court and you, it's not for the faint hearted to do this.

Nicolai Tangen: And do you enjoy a good argument?

Chris Hohn: No, I don't really enjoy fighting people any more. I never really did. It was, it was a, it was a something we began with Deutsche Boersa, and now, really, I'd say what people call activism is a, is really an exception to us. So it's like, why did we get involved in that Zodiac? We were already a shareholder, and something bad came out of the blue. It's like, you walk home and someone attacks you, yeah, to try to take your wallet, and you fight back. And I say, Do you enjoy a fight Nikolai?,

Nicolai Tangen: no, but I'm not so sure. I would fight back

Chris Hohn: Should you choose to? Yeah, I would ask you that question. Is you? You would say, No, I don't enjoy fighting. It's just I had no choice. I was fighting for my life. So I put it like this, we act as owners. We always act as owners. What does that mean? We were interested. We're engaged. We think we have a right to appoint directors. We're a legal right to it. And we'll Yeah, and so we take one thing we have learned is governance does matter,

Nicolai Tangen: Which brings us to kind of the opposite wild card. It's a bad company which you short it and shorting, just for those people who don't know it's you borrow shares, you sell it. The goal is that the share price should go down and you buy them back cheaper, and hand them back, right, and make a profit. So what's the score? I mean, in a few words, Wirecard. yeah, it's a very long accomplishment.

Chris Hohn Yeah, high level, we learned that shorting isn't a great business, because you're gonna be right, but not be able to hold it or fund the losses. Okay, so, wire card, which is, if you are short and the share price goes up, you basically unlimited downside and you have to fund the losses.

This is what people don't realize you're going to be eventually, right? So the first guy to short wire card 20 years ago was a guy from Bronte Capital, and the stock went up 20-30 times and went to zero. But he was when that happened, he was interviewed by the media, and they said, Congratulations, you were right. But he said, No, I had to cover 19 years ago. I couldn't afford to fund those losses, and so it's you have to understand investor psychology. Yeah, it's tough, very tough. And I had a dinner once with Warren Buffett, and he said he and Charlie looked at shorting, you know, they studied it, and they just said it was too hard because of that point of understanding investor psychology and the asymmetric risk and reward. And so it's an exceptional thing. But we we looked at Wirecard and and all the accounting games, and then the Financial Times came out with all these articles, yeah, and I called the journalist. A good guy. And I said, you're writing all this stuff. And he said, It's all true. I said, no one will listen to you. He said, everything's true. We stand by every word. And you just you could literally read it in the paper

Nicolai Tangen: the whole German establishment went in and supported It

Chris Hohn: Yeah that’s right. That's right. In fact, the chairman was a former CFO of Deutsche Boersa and in but there was a bit of pattern recognition where I remember at Harvard Business School, an accounting course I took, and there were red flags, yeah, when you do this small auditor, yeah. No cash flow, yeah, and things like all their Asian businesses, the office was empty, yeah, absolutely so. But I think to be a good investor, you need a certain independence of thought totally and probably to be a good journalist as well. And that's why, the funny thing is that the fraud was there in plain sight. And I think I learned to be an independent investor and the and so we went to see the CEO. Actually, I sent two of my team to meet him, and they came back incredulous at this, like pathetic demonstrations of technology and that they were shown. And interestingly, there was a potential catalyst, which was the report about their accounting. And in the end, they just said, it's garbage and then the stock went up a lot. And so actually, I tried to take become an activist in this position, I filed a formal criminal complaint for fraud in the at the Munich prosecutor's office, because they said, if I didn't wasn't public about it, would be viewed as market manipulation, so we're transparent about it. And that created chaos, but it forced some action. Yeah, you know when it forced, eventually an investigation and and so, because I didn't want to be like Bronte Capital, where it just ran and ran, and so at some point it really became obvious, and it became a confidence game. I think that people trust authority too much. Okay, that sounds a strange thing, but they trusted the German establishment, that you had a board with the great and the good and they weren't willing to believe the journalists.

Nicolai Tangen: I'm really we had, we had a we had a very good team at NBIM, you know, which was on the same who were on the same side of that. So, yeah, so really good talking about trusting authority and so on. And moving on to corporate culture at TCI. What is a corporate culture like in TCI? How many people are you? You know, in the investment team?

Chris Hohn: It's, you know, seven, eight people. We have a large back office. But how do you work together? We want so small, very small, and it's collegiate. Yeah, we've known each other a long time, and there's something that we've built, which is an intangible trust.

Nicolai Tangen: Why don't you have 100 fund managers?

Chris Hohn: Good question. Firstly, my best people, you know, they would never stay. They just, they don't want to. It would be too impersonal. There's a human aspect to work. Yeah, people don't come to work. You know, the best people for money. They come to because they enjoy the environment, and so it's really important how we treat people, how everyone treats each other, and I'll never hire someone without the blessing of my senior team, and because we could destroy the culture. And so I mean

Nicolai Tangen: Ice hockey teams are five, and football teams are 11. Is there something magic with seven?

Chris Hohn: No, but it's small enough. Yeah, above 10, it would be too, too big.

Nicolai Tangen: What do you look for when you hire so now I'm applying for jobs.

Chris Hohn: Meet everybody. Meet everybody.

Nicolai Tangen: Applying for a job at TCI, you meet everybody, I share the philosophy – what kind of questions you ask me?

Chris Hoh: Yeah what makes a good business. We asked for a case study, right or two. And. Becomes immediately obvious whether you know what you're doing, yeah, whether you share the philosophy. But also, it's not enough just to be a good investor. You have to want to work in a team, not everybody wants that, and you have to be able to get on with people in a way where you have to be open minded to being wrong. You can't be too dogmatic because so the personality does matter a lot.

Nicolai Tangen: Now you have a big share of the profit of the firm goes to the charitable foundation.

Chris Hohn: Yes well actually, I give it to charities. A lot of flags would be I do have directly often I give it to the foundation or CO invest with them. So, yeah, one way or another, it goes to charity.

Nicolai Tangen: Do you think it's important for your colleagues that you guys fund all this?

Chris Hohn: Well, charitable, they make a lot of money too.

Nicolai Tangen: do you think it's irritating that you give away all the money

Chris Hohn: they also earn, you know, good money, and it's probably a positive thing. I don't know definitively, and you'd have to ask them. I can't say definitively, but I, yeah, I give away everything I own. I don't really care about money for because, other than its value in helping people, when

Nicolai Tangen: When did you learn about philanthropy? Who taught you?

Chris Hohn: when I was in York working for a hedge fund one point, after about three or four years, it made, I don't know, two or $3 million and they had done well, and they said you're going to get a ten million bonus. And I just, this is in intuition, said, I don't want it. I want to just give it to charity. And I created a US foundation and gave it to it, and I didn't really understand it. What was driving me for 50 years? I would meet with Bill Gates, did a lot of charitable work with him over the years, and he would ask me, I couldn't answer the question, and eventually I did understand it, and better late than never, as a soul urge that there's essence who we really are, what we really are isn't the personality or the physical body, but, you know, soul or consciousness and that, some would call it Life. Yeah, that's something that gives us life, and that and will yeah, gave you, you know, in the same way you, Nicola, had a desire, a will, a will to do something more with your life. Yeah, then just make money and that. And in the fundamental nature of that's the soul is, is service, desire to help, to help, ultimately, humanity and

Nicolai Tangen: where did that come from?

Chris Hohn: It's innate within everyone that. But you think the Yeah, yeah, for sure, everyone resonate with everyone.

Nicolai Tangen: Why? Why don't more people do it because they're they identify with their personality and less with consider that like a unit, a user interface of the soul and the personalities, basic urges, desire, possessions, glamor, like power and money and other things like that, and, and sooner or later, people realize that that doesn't really give you know, some would say happiness, but actually, there's more important things in the world, in life than happiness, purpose and meaning,

Nicolai Tangen: but not but you say that sooner or later people, but I mean, people don't.

Chris Hohn: I'm not saying in one life, they may need here many lives, and that may be a strange thing for you to hear, to realize, yeah, I don't believe this is the only time we were we here, and I. Eventually we'll learn that they the what we are and can be as a result of some crisis in your life. Yeah, and death, disease or, in my case, the third D divorce and the and it's then that they look inward and ask, well, what is their life about? What is there a purpose? Is there a meaning? And for me, I could never find any purpose or meaning in my life except service and that is clearly, you know, something you could say it comes from within, yep, and, and, so that's my origins, of my philanthropy.

Nicolai Tangen: Do you think, I mean, you came from a working-class family, right? And your father was an immigrant. Do you how do you think that shaped you?

Chris Hohn: It made me an independent thinker. You always grew up as an outsider and, and you felt different, and it gave me a work ethic, work ethic, a desire to achieve something, yeah, and so I think that that was an important piece of my history.

Nicolai Tangen: Tell me about the foundation. What are the main priorities of the foundation now? So it is now one of the largest foundations in the world, right?

Chris Hohn: We have about six and a half billion dollars and in the foundation, and I also do philanthropy outside of that. And so between us, we're giving away over $500 million a year two main areas, climate change and children's health in Africa and India on the health side, we focus on foundational issues.

Contraception is one, you know, we can't get development or lifting people out of poverty if the women are having which far more children than they want. You know, Africa, fertility is nearly seven, and in many cases it's not affordable. They don't have access and agency. Women don't have access or agency to contraception, and so for $10 cost, for avoided a pregnancy. You can help a poor woman have one less pregnancy if she wants Yeah, and that's a remarkably low return on investment. High return on investment.

Yeah, there's almost nothing Another area is severe acute malnutrition, where I funded the creation of a company and I buy product for $40 a case you can of therapeutic food. Think of it as a fortified power bar, or it's you can save a child's life. And there's 100 million children with severe or acute malnutrition. Nearly half of all child deaths under under five neglected tropical diseases like trachoma. I find trachoma surgeries where just it's not for $50 you can do a fund, a surgery which stops someone going blind irreversibly. Yeah, and there's, you know, millions of people with this so it with so little money, yeah, $10 $40 $50 you can save a life, yeah, or stop something going blind. It's remarkably you know. You know what, what you know when you go to go out for dinner, you might pay $40 for a bottle of wine. You wouldn't think, Oh, I could save someone's life with this. But that's the reality. And so the HIV aids were very involved in as well

Nicolai Tangen: So on the climate side, what are the main areas there?

Chris Hohn: We’ve been trying to create infrastructure for the climate movement and regulation advocacy, because nothing's going to be fixed if there isn't regulation. We fund that's across the board, and also technical assistance to governments who want to change but don't know how. We're very active in Asia, where, if you don't operate in India and China, that's where, and you know, Vietnam and all these countries, that's where all the emissions are growing. Tax is another thing, because if we're not advantaging through tax, new technologies and we're subsidizing fossil fuels, which is what happens, we'll never change. And methane is another one. We're founder of the methane hub and methane satellites and just many things, litigation, environmental litigation, we found that so in a sense, there's activism there.

Nicolai Tangen: And, so given all this, how do you read the backlash against ESG in financial markets?

Chris Hohn: Well, I never really got involved in the s and the G, I just the E and so here, I think it's a very dark thing that's going on where people are saying, some people are saying, in effect, burn down the Planet, as long as we can make money today, and we don't care about future generations. We don't care about poor people in poor countries dying off. We only care about our country, yep, and making money as much money as we can today, to hell with the consequences. And it's really back to what I was talking about, this distinction between soul and personality, that if it's a consciousness problem, and actually, we'll never solve any of these problems, whether it's climate or poverty or war if there isn't a change in the level of consciousness.

Nicolai Tangen: So given that, and in order to finish off on a slightly more uplifting note, what is your what is your advice to young people on a kind of spiritual

Chris Hohn: Yeah, go on a spiritual path, go on a study. And I would say the spiritual world is real. Soul is when I first mentioned this to my son, I think it was 20. He said, Dad, the soul is a myth. He doesn't think that. Now,

Nicolai Tangen: is it not?

Chris Hohn: He doesn't think that now it's definitely not. And there are many paths to connect to it, and you can connect consciously to it and whether you go the long way, the short way, the easy way, the hard way. Through suffering, you eventually come to learn that it the spiritual world is not just real, but it's the whole thing. and so the and that's the only source of real purpose and meaning and joy which the world needs. Yep, and, and I think that if you crack that, then everything else is easy.

Nicolai Tangen: Very good. Chris Hohn, we've talked a lot about purpose, meaning and joy and what really matters in life. A big thank you.

Chris Hohn: Thank You

Nicolai Tangen: Thank you.

The origins of A. O. Smith (NYSE: AOS) (AOS) go back to 1874, when Charles Smith established C. J. Smith—Machinist in Milwaukee. At inception, the company focused on producing baby carriages and other specialized hardware. Over the ensuing years, management continued to evolve the portfolio to include things like bicycle parts, auto frames, welding rods, pressure vessels, glass-lined brewery tanks, water heater tanks, electric motors, bomb casings, propellers, and landing gear.

From 1904 to 1924, the company scaled up its operations in the automotive industry. This was in large part supported by a 10,000-unit order of steel automobile frames from Henry Ford. Shortly after this, AOS honed its process for mass manufacturing these frames and soon became the largest manufacturer in the field. By 1921, the company had created the first fully automated frame assembly plant in the world and was able to create a frame every eight seconds, or about 10,000 per day.

AOS continued to develop its portfolio over time, building on arc welding expertise to create high-pressure vessels for use in oil refining. This welding expertise eventually led to the production of large-diameter steel piping that was essential in scaling the North American oil and gas industry. But most important for the future was an innovation that allowed the company to fuse glass to steel. AOS created more than 11,000 glass-lined brewery tanks over the next 30 years. This technology was subsequently used as the industry standard in home water heater tanks for consumers.

In 1948, AOS acquired Burkay Company, entering the instantaneous commercial water heater market. About five years later, it rolled out glass-lined commercial water heater products, a first for the industry. In 1953, the company launched the Harvestore Structure product, a glass-to-steel fused storage silo used for agricultural activities. Over the next 50 years, the company installed more than 50,000 of these structures on farms around the world. In 1953, AOS acquired Glascote Products, Inc., which expanded the range of vessel manufacturing. This deal made the company the largest global manufacturer of glass-coated steel products.

By 1972, AOS began to expand globally into places like the Netherlands, Canada, China, and Mexico. In 1995, the company began a multi-year process of shedding non-core operations. The first major transaction was the sale of the automotive segment, in which it sold its US and Mexico subsidiaries to Tower Automotive. In 2001, AOS acquired State Industries, Inc., which nearly doubled the size of its water heater business. Additionally, this allowed the company to enter the retail channel for the first time in over four decades. In 2006, AOS completed the largest deal in its history, acquiring GSW Inc., a Canadian water heater and building products manufacturer. AOS established itself as the industry leader in North America through this deal.

AOS entered the water purification industry as A. O. Smith (Shanghai) Water Treatment Products Co. Ltd., starting operations in 2009. The following year, it opened a 76,000-square-foot facility in India that produces water heaters for the local market. In the United States, it entered the North American tankless market by participating in a joint venture with Takagi Industrial, a Japanese conglomerate. This partnership sold products under both the Takagi and AOS brand names. Deal activity continued in 2011, when AOS acquired Lochinvar Corporation, a leading manufacturer of high-efficiency condensing residential and commercial boilers for hot water and hydronic heating applications.

In 2016, AOS acquired Aquasana, a Texas-based manufacturer of water treatment solutions. Over the next few years, effectively all the company’s incremental deals involved regional or family-owned entities that offered water treatment products to its local customer base. In 2021, it acquired Giant Factories, Inc., a Canadian water heater business based in Quebec. In mid-2024, it acquired Pureit from Hindustan Unilever, which expanded its water treatment offerings in India. In 2024, AOS celebrated 150 years of operations and planned to operate with a focus on solutions for either water heating or water treatment.

Segment Overview

AOS sells a range of products that either heat or treat water. Its portfolio of products is mostly made up of water heaters, boilers, heat pumps, and water treatment solutions (filters, softeners, or reverse osmosis systems). AOS’s portfolio includes roughly 19 brands, including Lochinvar, Giant, Reliance, and Aquasana, among others. Most of these products are sold in North America (NA), which represented 77% of sales in 2024. The remaining 23% of sales are included in the rest of the world (ROW) segment, largely generated in China and India. Figure AA below highlights the split of sales between the two segments over the past 15 years.

From 2009 to 2024, the NA segment generated a 6.6% compound annual growth rate (CAGR) in revenues, and the ROW segment generated an 8.9% CAGR. From 2009 to 2017, the ROW segment consistently outgrew the NA segment. The consistency of performance then deteriorated following a slowdown in China due to headwinds from a weaker real estate market and impacts from the COVID 19 pandemic. In US dollar terms, ROW sales peaked in 2018 at $1.17 billion and have not recovered to this level since. Figure AB below illustrates these trends.

Economics for the NA versus ROW segments are much better, as shown in Figure AC below. NA EBIT margins are consistently stronger than 23%, while the ROW segment EBIT margins have been declining since their peak in 2014. ROW capital expenditure (CapEx) intensity has historically been much higher, but since a slowdown starting in 2018, AOS management has invested much closer to maintenance levels—in line with local market growth. Looking at return on assets (ROA) between the two segments, I see a clear difference as well. Much of this can be explained by market structure, competition intensity, and product mix, all factors I’ll dig into more later.

From a distribution perspective, NA sales have been relatively equally split between wholesaler partners and retailer partners. Ferguson, the largest customer, has been the largest wholesale partner in the United States, but it doesn’t sell exclusively to AOS. They also work with First Supply, HD Supply, and Winsupply, which collectively add up to approximately 2,400 wholesale locations in North America that sell the products to contractors. On the retail side, the largest relationship AOS has is with Lowe’s—but again, AOS doesn’t sell exclusively to just Lowe’s, they also work with Ace Hardware, Do It Best, and True Value. Retail distribution accounts for roughly 2,800 locations. All told in NA, products are sold at more than 5,100 distribution points. The top five customers represented 42% of sales in 2024, a figure that has gradually increased over the prior five years, as the largest customers have generally gained market share.

From an end-customer perspective, the underlying customer usually deals with a contractor who is sourcing the product from their preferred channel. The major difference for customers is that the warranty program tends to be about twice as good when they source through retail channels at 12 years instead of six years through wholesale. At the margin, incremental pricing changes are captured more slowly through retailer partners like Lowe’s. Finally, given the complexity of installation with both plumbing, electrical, and natural gas needs, about 90% of products are installed professionally by contractors, as most consumers are far from comfortable executing this type of project (either a replacement or new installation).

Industry Trends

The water heating industry has continued to be impacted by evolving energy efficiency regulations and decarbonization efforts. Both themes play into the broader goal of reducing the environmental impact of water heating. To manage the ever-more-stringent regulatory standards, the industry has been selling an increasing share of tankless water heaters (over tank products), high-efficiency condensing boilers (over non-condensing boilers), and heat pumps. Also, in select markets like California, natural gas–powered products are being banned after a sunset date in 2029, but this trend might unfold in more geographies over time.

Ahead of these regulations, AOS and other manufacturers have been going through an investment cycle to prepare their portfolios for this new environment. By 2026, 95% efficiency will be required in gas storage tanks and 96% efficiency will be required in gas tankless products. The sale of low-efficiency commercial gas boilers will no longer be allowed, and it is expected that these regulations will impact about 55% of the commercial units that are currently sold today. Roughly three years later, in 2029, similar changes will occur in the residential market. Thermal efficiency standards are going up, lower-efficiency natural gas tank products will no longer be sold, electric water heaters will need to incorporate heat pump technology, and gas water heaters will need to incorporate condensing gas technology. Figure AD below outlines how the US Department of Energy minimum energy efficiency standards have changed since 1990. These trends will eventually stop as the industry approaches the maximum theoretical efficiency possible.

While this new generation of products will be more expensive initially, they do appear to have a net lower total cost of ownership over the life of the assets. On recent calls, AOS management has highlighted that the switch from an electric tank water heater to a heat pump–equivalent product will result in a 2x to 3x price uplift. Even for natural gas–powered products, the switch from non-condensing gas products to condensing gas products should see something in the range of a 30% uplift on price. Consumers should still come out ahead even with this uplift as longer expected asset life and lower operating costs deflate total costs of ownership. While individual factors like the local climate, the volume of consumption, and the type and cost of fuel availability will ultimately determine the payback period. Figure AE below outlines a more extreme scenario for a payback period—using a commercial operating use case and Lochinvar’s Crest fourth-generation boiler.

I believe manufacturers should also be well positioned to come out ahead—utilities will be the main losers as this plays out. If I look back at the prior rollout of NAECA 3 standards in 2015, AOS was able to capture a price uplift of about 20%. However, the full 20% uplift didn’t occur on all volume sales—only those impacted by the new regulations. Even so, a clean drop through to industry sales didn’t transpire, as the industry often utilizes workarounds such as adding multiple units (instead of one large unit), using commercial products, or pre-buying ahead of regulatory changes. All said, the expected average selling price uplift on the next generation portfolio should help from a mix perspective and drive better revenue trends than I have seen in the past five years. Based on what I’ve heard from a few industry experts the reinvestment lift required to get product portfolios to the next generation of regulation requirements is much lighter than the past – required technology already exists and just needs to be implemented rather than design & test cycle the prior generation had to go through.

Competitive Advantages and Landscape

AOS’s competitive advantages are driven by its scale and intellectual property. From a buying perspective, it can use scale to obtain procurement advantages and scale R&D spending on larger volumes. This allows it to purchase input materials or components more inexpensively than peers and generate attractive economics. The company’s scale also allows it to meet national account needs across the country—this is important for retaining and winning accounts like the Marriott or franchise restaurants.

Starting with the NA water heater market, AOS’s share has been dropping modestly over the past decade due to the loss of Sears (retail) as a customer and the increasingly faster growth in tankless volumes. As shown in Figure AF below, the big three players continue to control more than 90% market share, but this has gradually fallen from about 95% in 2014. This headwind, however, doesn’t appear to have materially changed the attractive economics of the industry—it remains an attractive oligopoly. Regulations are also supportive of this structure, as they limit the variability of most products sold—price, capacity, and technical features tend to be very similar. However, even though selling a commodity-like product, competitors have all taken different approaches to distribution. Rheem has pursued a retail-only strategy with a partnership with Home Depot, while Bradford White has pursued a wholesale-only strategy. AOS has taken a hybrid approach, which has allowed it to generate more stable volumes throughout the cycle. Going forward, any major market share shifts in this market would be surprising given brand loyalty and the built-up experience contractors have with the brands. Most contractors are unlikely to recommend a cheaper product to capture some incremental margin—especially if installation takes longer or does not go as planned. Contractors also have the potential to suffer some reputational risk if the product installed doesn’t live up to customer expectations.

The commercial water heater market is an area AOS has dominated, holding roughly 2x the market share of its next-closest peer, Rheem. Figure AG below shows market share for the US commercial market from 2014 to 2022. AOS entered the commercial water heater market with the acquisition of Lochinvar for $418 million in 2011. This implied a 2.1x sales multiple and a 9.2x EV/EBITDA (TTM) or 7.3x EV/EBITDA if it was able to meet the midpoint of targeted synergies of $10 million to $15 million . From a strategic perspective, the deal expanded AOS’s core product offerings to include high-efficiency boiler technology. The commercial boiler market was in the process of undergoing a significant shift away from lower-efficiency boilers and toward high-efficiency condensing technology, which was expected to continue gaining share. A historical five-year sales CAGR of about 8% illustrated attractive trends, and incremental distribution from AOS had the potential to increase this in the future. At the time, Lochinvar was also reselling Bradford White residential water heater products to its customer base, and these volumes were planned to be replaced with AOS products over time.

The next question could well be “Why has AOS’s market share remained so dominant in the commercial market over time?” As I understand it, Lochinvar was effectively a first mover in rolling out condensing technology and has continued to invest in the portfolio to keep it on very advantaged terms. Lochinar is effectively the industry standard in many places. It also continued to participate in a market-wide shift toward these higher-efficiency units, and the timing of the acquisition was just about perfect, as this trend was about to accelerate. This is illustrated in Figure AH.

Earlier in Lochinvar’s history, the company had its factory workers and sales representatives work aggressively to build relationships with mechanical and plumbing engineers and educate them about the benefits of its technology. As about 80% of commercial demand is driven by these indirect representatives, winning them over and retaining this reputation is very important. Figure AI below shows how this dynamic has persisted into 2023. One industry expert believed AOS’s win rate on new projects was upward of 50%, however, the magnitude of advantage seems to vary by region. As of late 2023, AOS believes it has a number one or two market position with roughly 80% of the representatives that carry the Lochinvar products. The company has also created tools like the LochSpec Selection tool to help make its partners’ selection efforts easier. Also, as most commercial sales go through wholesale, price comparisons are more limited and in turn provide better economics.

Commercial customers also tend to be much more demanding, requiring higher levels of service, maintenance, and even proactive replacements. A typical homeowner will rarely proactively replace a water heater, but a restaurant, hospital, or commercial laundry facility is going to schedule this in advance of an asset failing. Having an impaired asset like this can take out the revenue-generating capacity of a business for days or weeks if equipment can’t be easily sourced. Taking these factors into account, unit economics should be much better due to less competition, more niche needs, and higher thresholds for reliability and uptime. All these characteristics should allow for more pricing power than the residential market.

M&A and Capital Allocation

AOS’s framework and process for M&A appears to be plain vanilla compared to a number of other industrials. I don’t get the sense that any of the deals are complete blunders or huge home runs, excluding Lochinvar, which was completed over a decade ago. Figure AJ below illustrates how AOS has strategically thought about M&A—and of note, it hasn’t really changed in 15 years. Acquisitions are needed to add exposure to new geographic markets, adjacent markets, or markets that help expand or grow its core markets—water heating and water treatment.

While AOS has deployed capital into each of these categories, it is hard to call out any big successes in recent years. ROW segment sales peaked in 2018 and have continued to trend lower into 2024. The adjacent portfolio opportunities haven’t really scaled up—the air purifier products were an opportunity that had huge potential back in 2018. But since the Chinese government announced its war on pollution, this opportunity has largely evaporated. More recently, the company has called out opportunities in range hoods, dishwashers, stoves, and steam ovens. But to me the white goods market seems like a bit of a stretch. Even with a number of these introductions into China since 2019, total sales have stagnated, which indicates either little traction with recent launches or bigger problems in its core business. Not great. Midea and Haier amongst other competitors also have formidable scale, distribution and service advantages which seem difficult to compete against.

On the other hand, the only success to call out would be the scaling up of the water treatment business, which has grown at roughly a 12% CAGR on a trailing-five-years basis (including M&A contributions) to $248 million in sales in 2024. It’s a small piece, though, at only 6% of total sales or about 8% of NA segment sales. Trends are good, however, and there are no indications of a deceleration in the opportunity longer term. Management is targeting $500 million in sales by 2028 driven by organic growth of 10% to 12%, which is more than 2x annual market growth of 4% to 5%. Bolt-on acquisitions are expected to contribute another 5% to annual sales growth as it consolidates more regional players and vertically integrates the portfolio. However, as shown in Figure AK , channel complexity, number of products sold, and a more fragmented market structure may limit EBIT margins in reaching the mid-20s it has been able to achieve in North America. AOS management believes that water treatment will get to mid-teen levels by 2028, but longer term, I’m less certain where it will mature.

Figure AL below outlines all acquisitions since 2009 as well as the sole divestiture. In 2010, the sale of the electric motor business was a huge deal, as this truly cleaned up the portfolio to become a pure-play water technology business. Thematically, all the acquisitions below are of water technology businesses—either treatment or heating. The number of deals skews heavily toward water treatment in recent years, but this appears to be more of a function of the fragmented structure of the water treatment industry, where the sheer number of deals available is much higher. AOS also appears to be a favored acquirer of family-owned businesses, which I believe should be positive for the company’s longer-term reinvestment runway.

As shown above, multiples paid for either water treatment or water heating acquisitions have been in a relatively tight range of 1.0x to 2.3x sales. Not only have multiples paid been reasonable relative to AOS’s trading history and alternative options; these investments appear to have generated decent results on incremental capital deployed. Below in Figure AM , we look at return on invested capital (ROIC), including and excluding goodwill—for the trends of both measures are very clearly improving from low-double-digit/mid-teen levels to more than 30%. Drivers of this uplift were both improving net operating profit after tax (NOPAT) margins, which grew from about 5% to 15%, and improving invested capital turnover, which increased from 1.6x to 2.0x. Return on equity (ROE) trends paint a similar picture of stable-to-improving returns over the historical period. The core business continues to deliver attractive performance, and it doesn’t appear M&A has hurt trends.

Management and Governance

As of March 2025, the founding Smith family continues to control the business through its stake in the Smith Family Voting Trust. It controls approximately 97% of Class A shares, rendering the company a “controlled” company by NYSE market standards. That the firm is still in this family’s hands after 150 years of operations is remarkable. While it’s hard to quantify the impacts of this ownership culture on day-to-day operations, I ultimately believe it is positive. A longer-term owner should be willing to make more efforts to retain employees, invest in long-term projects, and take more steps to build its brand/reputation. As shown below in Figure AN , Glassdoor overall ratings and the recommendations-to-friends rating for AOS screen the best among its peers. Its CEO approval rating is effectively in line with Rheem and well ahead of Bradford White.

The incentive program AOS has set up for managers looks reasonable in the key areas. The total compensation framework is made up of base salaries, annual incentives, and longer-term incentives. Annual incentives are based on an 80% weight of EBIT and 20% of net sales relative to corporate targets. Business unit leaders have annual incentives more closely tied to the performance of their segment. Long-term incentives are paid out in restricted stock, “performance cash,” and performance stock if financial and strategic goals are met. Restricted stock units vest over a three-year period and require a minimum average ROE of 5%, which is unfortunately very low. The “performance cash” payout is tied to achieving a ROIC relative to a trailing five-year average ROIC achieved by the company. Here the targets seem much more appropriate, with a 200% payout for a 36.8% ROIC and a 100% payout for a 30.8% ROIC. This range was determined by the trailing five-year median ROIC of the S&P 500 Industrials Sector Index. The last piece is driven by water usage relative to corporate targets and historical consumption. In 2025, the major pieces of this program remain largely unchanged, with the water consumption target shifting to a landfill diversion target for the next three years. Graphs from the last proxy statement summarize the overall compensation philosophy and show a strong tie to the overall performance of the company, as shown below in Figure AO .

Strategically, I don’t have a ton of issues with how management has executed. Perhaps they could have scaled the tankless business faster, but a lack of technical expertise and a smaller current market size might make this a better opportunity down the road. The more fragmented market structure and higher levels of competition from foreign entities might make this market less attractive, but I don’t have much data to quantify this. The ROW expansion seems to have gone sideways for the most part, but that element has been largely unpredictable. AOS has restructured the ROW business for the newer low-volume environment and has been reinvesting much closer to maintenance levels, which looks like the right approach until overall visibility improves. This doesn’t scream countercyclical but seems like a reasonable rationale from what I can tell.

From a financial perspective, the biggest area for improvement AOS should consider is to run the balance sheet with some modest leverage. The company widely communicates that 80% to 85% of volumes in the NA market are replacement-driven sales, and this should drive a ton of cash flow stability over a market cycle. Running the business at 2x ND/EBITDA should hardly raise the true risk profile of the equity and implies the company could buy back more than 10% of the business today. As shown below in Figure AP , management has consistently returned capital to shareholders through buybacks and dividends—more can be done, but it’s a start. Future optionality associated with an acquisition is also good justification for keeping more cash than is needed, but the odds of getting a larger deal done in the next few years is much higher.

What’s the Market Pricing In?

To help understand what the market is pricing in, I adjusted the model assumptions to arrive at an intrinsic value close to the current share price. Many of these assumptions look quite reasonable given the current outlook and my understanding of the business.

To start, I assume that organic revenues modestly decline in 2025, grow at more than 4% for three years after that, and then gradually decelerate. Let’s say the near-term decline is driven by a weaker housing market (new starts), with some moderate offsets into 2029 from pricing, and new regulations that help drive a better mix in NA WHs . Offsetting this could be some moderate share losses in the tankless market, where the new product launch may not scale up to management expectations. Usually end markets have grown 1% to 2%, with incremental swing factors of inventory or channel shifts and pricing power accounting for the rest. This historical algorithm should remain in place, as far as I can tell. Figure AQ below highlights revenue expectations for the business in this scenario with roughly a 3.8% CAGR.

To get to the current price, the historical trend of margin increases can’t be extrapolated forward. Recall that the NA segment margins expanded from about 10% in 2012 to 24% in 2024. During this time frame, the company successfully captured pricing on water heaters, consolidated competitors, and scaled up its higher-margin commercial business. These dynamics seem to have largely played out for the water heater/boiler market. However, a similar situation could play out over the next 10-plus years in the water treatment market—but this is a much smaller part of the business, so it is unlikely to shift overall results. However, the longer-term margin profile for water treatment is also unclear—it may be worse, or it may be better than NA WH. Through incremental modernizations of the manufacturing base and gradually increasing utilization, it feels reasonable to expect modest margin improvement in NA over the next four years.

However, there are some good reasons why margins may not expand. In the ROW segment, the economic environment in China has remained weak and doesn’t appear to be improving on the back of recent stimulus. Tariffs appear to put further pressure on region and broader consumer confidence. Prior to all this, management has communicated to the market that without a better environment, volumes aren’t likely to grow. Back in 2017, about 90% of the products sold in China were premium; this share has fallen to 45% to 60%, and even after this reset, growth expectations are just 4% to 6% going forward. This seems quite high over the near term especially as China’s real estate market continues to undergo a significant correction. This guidance implies limited volume growth even after moving down market, and pricing power is weaker in the economy/mid-sized area of the market. In addition to this, AOS has been diversifying its portfolio to include sales of more white goods (home appliances) and given the market structure (more fragmented) and more limited scale, it’s hard to envision that margins will be as attractive in this area. But regions like India, which are less than 10% of ROW segment sales, have clearer growth trends. The recent acquisition of Pureit should help the company scale the water treatment business faster in this market. If it is able to leverage technology or products from other markets, scaling up could also go much faster. But it’s currently small and may not move the results in a material way for many years to come. Overall, I believe ROW margins will recover modestly as capacity is rightsized for the new volume environment and select product lines or geographies modestly grow over the forecast period.

Using these assumptions, I get to an approximate 5% EBIT CAGR from 2024 to 2035, as shown in Figure AR above. This incorporates an EBIT margin improvement of 210 basis points to 20.7% by 2035. Also, it does not incorporate M&A, which it would have ample capacity to do. This scenario generates about $9.1 billion in cash flow from operations, of which about $1 billion is spent on CapEx, about $6 billion is returned to shareholders, and the remainder builds on the balance sheet.

In the DCF model, we use an 8.5% cost of equity, a 6.0% cost of debt, and a terminal ROIC of about 18%. Using these assumptions, the terminal EV/EBITDA multiple is about 10.1x and the P/E is about 14.1x, which is slightly below the roughly 10.7x and 16.0x multiples, respectively, that these trade at today.

I wouldn’t be too surprised if this scenario were to play out. Most of all, it’s hard to see how a ton of incremental upside can be generated without faster growth or even more margin improvement going forward. M&A activity could surprise, and that’s likely where I might be too conservative. But big deals have been hard to find, and they can carry more risks. Either way, the above scenario implies an intrinsic value-per-share estimate of about $75.00 and an IRR of about 10%. Figure AS below outlines a summary of my DCF output.

2025.04 AO Smith Model icemancapital.com

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Conclusion

While the AOS business may not be very exciting, it has generated very good ROICs in a mature industry with limited competition. The CapEx light business model combined with its NA business operating in an attractive oligopoly with pricing power has driven good historical returns. However, the reinvestment opportunities seem limited, and whether any of the newer geographies or adjacent product portfolios will be able to generate returns nearly as high is uncertain. The company has scale and intellectual property advantages that are likely to persist, but this all appears widely known and priced in.

In my view, market expectations for the key drivers implied by the current price are about right. The risk of loss should be very low given the underlying nature of the business. But I see roughly 10% returns as the highest-likelihood scenario, which feels far too low if I had cash to allocate. Given these dynamics, I don’t own AOS and have no immediate plans to add this into my portfolio.

If you have any questions or comments on anything I’ve written above I would love to discuss them with you. Please comment below or reach out on Twitter/X or via email at icemancapital@gmail.com.

I believe an investment in Fever-Tree Drinks PLC (AIM:FEVR) (Fever-Tree) represents an opportunity to buy an overlooked consumer products franchise. Fever-Tree is the dominant player globally in the premium mixer market and has the number one position in the United Kingdom, Europe, and the United States for key products. The company has been negatively impacted by decelerating alcohol volume trends, a weaker consumer environment, and substantial cost inflation. As a result, the share price has fallen approximately 70% from its peak in 2021, creating an attractive opportunity today. The business is in the process of rebuilding margins through production localization, cost optimization, and organic growth. Fever-Tree has successfully continued to adapt its portfolio away from tonics, providing evidence of the firm’s adaptability to local market preferences.

I believe long-term earnings power for the business is misunderstood by the market, and my base-case scenario underwrites more than 85% upside to intrinsic value, assuming terminal EBITDA margins of 28% and an exit multiple of roughly 10.6x EBITDA. My expectations largely differ from consensus for stronger top-line growth, and a belief that margins will revert towards historical levels over the medium term. Downside in the investment is capped by a potential sale to a strategic or financial acquirer.

History

Charles Rolls had a relatively average resumé up until the age of 40. That’s when he quit the consulting business, liquidated his life savings, and raised capital from a few parties to purchase Plymouth Gin. With no industry experience and a reliance on an instinctive gut feeling that he could turn the business around, he pushed forward. To my mind, this doesn’t belong in the calculated risk category. He just went all in, and the odds of succeeding were steep.

Rolls bought the UK company for £500,000. The firm was bleeding about £25,000 per month, while the marketing budget was approximately £100,000 per year. For that price, he got a brand, but one that was out of favour. After getting into the business, his first steps were to arrive at a major bookstore in London and begin reading everything he could about the alcohol industry—quite literally sitting on the floor reading books. What he lacked in experience, he made up for in focus and a beginner’s mindset.

Fortunately, I knew nothing . . . . Sometimes it’s an advantage not to know anything about a business. I had no relevant experience. (Charles Rolls )

With the cash burn continuing, Charles felt ample pressure to turn the business around. He began cold-calling customers and depleting inventory to raise cash. This bought Charles some incremental time and some breathing room that allowed him to experiment with a refreshed bottle design, alcohol content, and flavour recipes. With enough experimentation, he was able to develop a recipe that made the brand popular again. Sales grew 1300% over the next four years, and the business was eventually sold for £28 million—a tidy profit, I’d say.

Rolls wasn’t one to sit tight, though. In 2004, he partnered with Tim Warrilow, an industry consultant, to create a new gin to capitalize on premiumization trends. But Charles’s industry experience led to the insight that no matter how good the gin, it was always being diluted with mediocre tonics. He remembered doing taste tests in the United States in April 2000, with each tonic being “far too sweet, had far too little quinine, and they tasted of grapefruit.” As a result, they pivoted their efforts toward creating a premium mixer.

The strategy for the new product was set—create a premium mixer using natural, high-quality ingredients, and avoid the use of artificial flavours or sweeteners. They determined that sourcing the best ingredients from around the world was going to be a key differentiator. This led them to travel as far as the Democratic Republic of the Congo to source the best quinine available in the marketplace. Applying this artisanal approach and maintaining high standards for the product were how they eventually created the premium mixer category. The first tonic water was ultimately developed after working with ingredient specialists for about two years.

Fever-Tree was now born. The name originated from the chinchona tree, which is well known for producing quinine. This ingredient was historically used to treat malaria, which typically causes a fever. As quinine is very bitter, it was then mixed with sugar, water, lime, and gin to make it more palatable. Charles and Tim chose the name to emphasize its focus on high-quality ingredients and historical origins.

Business Model

Fever-Tree probably has the most simplistic business model of any company I’ve researched. They simply source and buy ingredients, market the products, and reinvest into new products. All distribution and production is outsourced to regional partners and bottlers. The business has very few tangible assets and little to no capital expenditures. The only exception to this occurs when Fever-Tree is required to purchase and own custom bottles in select markets to meet regional recycling and reuse requirements.

The company sells products through two channels: on-trade, which includes bars, restaurants, hotels, nightclubs, and cafés; and off-trade, which includes supermarkets, liquor stores, convenience stores, and online retailers. Both channels are ultimately important, although Fever-Tree has prioritized the on-trade channel, as they have found this the optimal approach to creating brand value in the minds of consumers.

In the on-trade channel, consumption is near immediate. The cocktail is prepared by professionals who usually have a full repertoire and access to ingredients that individuals are unlikely to have at home. To grow in this channel, Fever-Tree invests significantly in personnel who work with bars and restaurants to get the product onto menus. As such, tastings and industry events are the best way to find new accounts. From what I gather, once they make it onto a cocktail menu, they’re rarely displaced. The caveat is that these customers generally use only a fraction of the mixers in the portfolio, as space behind the bar is limited. Winning over key gatekeepers like chefs and bartenders is essential, as this is usually the path by which consumers discover the product.

The off-trade channel operates contrary to most of the on-trade characteristics. Here, the cocktail is prepared by an individual at home, who will normally lack the depth of ingredients otherwise available in a typical bar. This limit of ingredients at home is a huge barrier to preparing cocktails—survey s have shown that as the number of ingredients goes up, the probability that a consumer will make the actual drink goes down exponentially. This makes the time savings and quality characteristics of Fever-Tree’s product more important. In the off-trade channel, consumers will be drawn to the products that are promoted or bundled or where they have prior awareness of the brand. It seems that competition in this channel should be higher, as new brands and private-label products will increasingly emerge. So, while the off-trade market is likely many times the size of on-trade, higher competition and easier price comparisons likely make the economics in this channel modestly worse.

Segments

Fever-Tree holds the leading position in the premium carbonated mixer market globally. Given the firm’s origins, the United Kingdom represented the largest portion of their sales until 2023, when the United States grew to become the largest market. As shown below on a group basis, sales grew at a 33% compound annual growth rate (CAGR) from 2013 to 2023, a first-rate performance, in my view.

UK sales have grown at a 34% CAGR since 2013 but peaked in 2018 in value terms—coinciding with the gin boom in this market. The number of gin brands exploded during this period. Spirits Beacon, an industry publication, called it the most competitive gin market in the world. This illustrates that Fever-Tree can do well when the adjacent category is prospering too. Gin more than doubled its market share relative to other liquors over the four-year period ending 2018. Given its leading position in mixers and weaker competition from largely just Schweppes and Fentimans, Fever-Tree was able to grow roughly 12x from 2014 to 2018. Subsequently, the momentum slowed in the gin market and shifted toward other spirits. Another headwind has been the weaker consumer, which led to sales falling at a 3% CAGR from 2018 to 2023. However, the brand position has remained strong, with the Tonic value share at 48% in 2023 and Ginger Ale + Beer value share at 44%, up 9% since 2019, as shown below in Figure AB. On-trade penetration also continued to grow to over 60%, up 10 points since 2019. The consensus seems to be that this market has largely matured, and I tend to agree. While prior momentum is unlikely to be repeated, there is ample evidence that Fever-Tree is maturing with a healthy and profitable position in this market. Future growth will be mostly driven by non-tonic products and modest pricing—and that seems just fine to me.

Next up is the US market, which is by far the biggest opportunity for the company over the medium term. While US and UK sales for Fever-Tree reached a similar level of sales in 2023, the total amount of spirits consumed in the United States is approximately 12x higher. However, a much larger proportion of spirits consumed in the United States are dark spirits, which are largely consumed neat (i.e., at room temperature with no ice or mixer) or on the rocks (i.e., with ice only). This makes the market opportunity larger but far less than the 12x figure management alludes to. The premium mixer market is also much smaller in the United States, representing 10% to 12% of the category versus roughly 50% in the United Kingdom. This implies ample growth opportunity and material room for Fever-Tree and their competitors to grow over time. As shown below in Figure AC, trailing three-year and four-year trends into 2022 and 2023 highlight that Fever-Tree has been growing at attractive absolute rates and well ahead of the total mixer market.

As the data above shows, the strongest growth rates achieved for different parts of the US portfolio were mostly ex-tonic. This is critical and, in my opinion, kills one of the recurring bear theses on the stock—that the company is too skewed to tonic and won’t have success outside this category. Figure AD below shows this as largely a historical artifact when UK gin trends were supercharged for a period. As of mid-2024, 42% of the portfolio was non-tonics, and indications are that this will likely grow over time. In the United States, only about 33% of the portfolio is tonics, roughly 45% is gingers (ale and beers), 10% is sparkling (pink lemonade, etc.), and 12% is other (margarita, etc.). In the United States, Fever-Tree has built lots of momentum excluding tonic, with new launches that have included a sparkling pink grapefruit, sparkling lime and yuzu, and blood orange ginger beer. Each of these was crafted to pair with spirits other than gin. Sales from cocktail mixers like margarita and Bloody Mary have also grown from a very small base, and the market opportunity here is huge in the United States, as the margarita is the most popular drink in 40 states. From a penetration perspective, we’re still in early stages—management sees an opportunity to more than double the number of accounts selling Fever-Tree products over time, with liquor stores and on-trade accounts being the biggest opportunities going forward. Sustained innovation and new product launches to meet local market needs will be instrumental in achieving their mid-term and long-term ambitions in the United States.

The European segment generated £105 million in sales in 2023, growing at a 28% CAGR from 2013. Today it’s the third-largest segment. According to Nielsen data, Fever-Tree is the number one mixer brand in Europe. On a trailing five-year basis, they delivered an 11% CAGR—with performance driven by share gains in the premium mixer market and strong gingers product growth. Management has identified three markets where they are mature, five that are still growing attractively, and three (France, Sweden, and the Netherlands) where they are in very early stages of growth. Each country tends to have different distribution relationships, and it appears that at least a handful of the initial partners Fever-Tree found weren’t allowing the business to reach its potential. This led to distribution partner changes in markets like France and Greece in 2023. However, even with these non-optimal partners, they were able to deliver growth value share in the premium category and outgrow both tonic and ginger beer markets into 2023. Ongoing brand investments in each of these markets have continued to drive more awareness of the product as well as its artisanal, quality-ingredients positioning. Fever-Tree management had previously set a target to grow this segment 2.5x the 2020 base of £65 million over the medium term. I think this should be achievable over the next three to five years due to the brand investment and improved distribution power.

The rest of the world (ROW) segment has delivered great performance, growing at a 39% CAGR from 2013 and a 15% CAGR from 2018. As shown below, Australasia generated the bulk of sales, at 54% in 2021 and 47% in 2022. Canada was the next largest, generating sales at about half that level, at 25% to 27% of segment sales. The remaining 18% to 20% of sales account for all sales in Asia, the Middle East, and Africa, etc. Akin to its approach in many European markets, Fever-Tree is also going through an investment cycle, hiring more local talent and switching distribution partners to hopefully drive better growth and profitability. They are also aiming to localize production in Australia, which at some point in the future will help support broader Australasia growth. In Canada, trends appear solid, and a new distribution partner (Tree of Life) has added approximately 2,500 distribution points at major retailers in the country. In Canada, they dominate the mixer category, like in the United Kingdom, with 61% of value share, and they have grown at 6x the rate of the next-largest brand (The Great Gentleman). As shown below in Figure AE, they were also the number one ginger beer brand by value in Canada in 2023.

Despite a huge total addressable market (TAM) potential and a rapidly growing middle class in Asia, this opportunity is rarely discussed. I’m not sure why management hasn’t spent more time on this opportunity or, if they have, why they haven’t been able to scale up the business in this region. The only area discussed by management is the partnership with Asahi in Japan, which has helped them with distribution and a better understanding of the Japanese market. However, excluding some on-trade wins with hotels/bars in larger cities, I’ve only heard anecdata on the opportunities or challenges. It’s fair, though, as it falls very low on the materiality threshold today, but this will hopefully change over time. At this point, it appears that the premium mixer category is in its infancy in the Asia and Other segments, and substantial brand investments are likely required to grow the category in the same fashion as in the other regions.

Excluding the United Kingdom, each of the segments seems far from mature, and there is good evidence that the brand continues to mature well as the premium category grows in value in more markets around the world. This won’t happen with just any brand, but Fever-Tree has done it so far.

Industry Trends

Fever-Tree has positioned itself favourably vis-à-vis two major trends: the growth of spirits relative to other alcohol and the premiumization of alcohol. Data from the National Institute on Alcohol Abuse and Alcoholism (NIAAA) covering the US market shown below illustrates that total per capita ethanol consumption has grown at about 0.7% CAGR from 1998 to 2022. Aggregate ethanol consumption trends in the United States have been relatively stable over the longer term. However, mix shifts among the categories have led to considerably different CAGRs, with spirits at +2.7%, wine at +1.7%, and beer declining at a -0.9% CAGR. Notably, in 2022, spirits consumption in the United States exceeded beer consumption for the first time since the late 1960s. The popularity of cocktails and an increasing awareness of the calorie content of different beverages have driven more consumers to choose spirits as their choix du jour. Going for beers isn’t quite as popular as it used to be.

Historical trends have favoured spirits, and I get the sense that these will persist. However, the alcohol industry also has several overhangs today. The first is that demographics are shifting unfavourably—baby boomers are coming off peak years of consumption, and young cohorts of the population are drinking both less frequently and in less volume. The Cleveland Clinic highlighted that adults born after 1997 drank 20% less than millennials, and 28% to 30% just outright abstained from alcohol. But the definitive reasons as to why this was happening were somewhat elusive. Some theories include a greater awareness and prioritization of health, impacts on weight gain, growth/consumption of cannabis, and shifts in ethnicity mix. My take is that it’s probably a combination of all the above. Figure AG shows a Gallup poll illustrating the idea that consumer perception has outright changed too—in the early 2000s, about 25% of respondents believed that alcohol was simply bad for your health, and that figure jumped to 45% by mid-2024. Even the World Health Organization began saying in late 2022 that “when it comes to alcohol consumption, there is no safe amount that does not affect health.” Most people reading this might remember when one glass of wine per day was considered healthy, but now at least a few studies have shown a clearer link between cancer and drinking alcohol. In 2025, the bad news on this front continued, with the US Surgeon General coming out with a report reiterating this theme. However, some people believe this analysis is flawed, as it views the relationship linearly and not exponentially—the higher rates of cancer are much more skewed toward individuals who are heavy drinkers, not low or moderate drinkers (I.E less than 2 drinks), which wasn’t explained well in the initial report. Whether the analysis is 100% correct or not, it is bad press. The possibility that all alcohol will have warning labels at some point in the future seems to be growing. Given that context, it isn’t surprising that no-alcohol drink versions have continued to grow above the industry. In the United States, no-alcohol volumes grew 29% in 2023 over 2022, and even the low-alcohol category grew at 7% versus US spirits volume, which fell by 3.4% year over year in 2023. I think demographic headwinds could persist, but the above suggests that incremental growth will be just harder rather than their having to cope with an instantaneous step down in volumes.

The second threat, at least in some ways, has been the emergence of marijuana. As of August 2024, about 24 states have legalized consumption (38 for medical use), which has supported the proliferation of the variety of consumption formats, including vapes, edibles, and beverages. An IWSR report highlighted that about two-thirds of cannabis users consumed alcohol but that only one-third of cannabis users consumed alcohol. This overlap in the customer base makes it enough of a potential source of risk. Marijuana users also tend to skew younger, so impacts from this might not be entirely apparent until a few years down the road. According to a study released in 2024, from 1992 to 2022 there was a 15x increase in the per capita daily consumption of cannabis. This study also showed that daily consumption of cannabis exceeded daily alcohol consumption for the first time on record—17.7 million people used cannabis daily in 2022, but only 14.7 million people used alcohol daily. Even frequency was four to five days per month for the average drinker but 15 to 16 days per month for the median cannabis user. Overall, I believe that over time, competition for consumer spending will grow, but at this point there appears to be limited evidence that this is currently leading to a step-down in alcohol consumption.

The third threat facing the industry today is that in many regions the consumer is relatively strained. This is most evident in the United Kingdom and the United States, where food, energy, and housing costs have grown, limiting the availability of cash for more discretionary categories. Also, looking at spirits volumes in the United States, they peaked during the COVID-19 pandemic and have remained under pressure for two consecutive years. I believe 2024 has not seen much growth, and growth in 2025 seems unlikely from my perspective. Even the entire premium part of the market declined for the first time since 2009. I think the headwinds from a weaker consumer will be a cyclical and relatively short-term challenge, while the former two risks will persist over the long term.

The fourth threat facing the industry today is the emergence of GLP-1s. This medication appears to discourage appetite for alcohol. In early 2024, NIAAA and the National Institute on Drug Abuse (NIDA) as well as parties from the Scripps Research Institute found that Semaglutide reduced alcohol consumption and binge-like drinking in rodents, which sometimes, but not always, has a relationship with how humans react. My understanding is that when an individual takes GLP-1s, they feel fuller and more satiated, which translates into less food and beverage consumption. An estimated one in 10 people have alcohol use disorder (AUD) in the United States, and they likely account for a disproportionate amount of lower-priced volumes. Of all the risks, this seems to be the biggest challenge for the alcohol industry, but still in the very early stages as to how exactly this will play out. The main mitigating factor here is that while >40% of the US is obese, this figure is much lower globally at about 16%. The potential impacts will be skewed to the US market where incomes are higher, and obesity rates are higher. To tie it all together, the industry is facing some cyclical and potential secular headwinds. But it appears Fever-Tree isn’t as directly exposed and will be able to manage successfully through these challenges.

Competitive Advantage

The soft drink and alcohol industries have generated superior market returns for a long time. This is due to robust competitive advantages largely driven by scale. Figure AI below highlights that the soft drink industry generates an average return on invested capital (ROIC) of roughly 250% of the market average, and alcohol producers generate about 50% better returns than the market. This category performance is largely driven by a few giants like Coca-Cola, Pepsi, Diageo, and Brown Forman. That’s even with competition still thriving for the most part in each category. The biggest factor seems to be that once an operator can reach enough scale, they can reap benefits from operating efficiencies (higher levels of utilization), procurement, brand investments, distribution, and customer loyalty. Smaller players are unable to capture similar benefits on a global basis.

Fever-Tree benefits from all these drivers except for operating efficiencies, as they utilize an outsourced product and bottling model. They can, however, use their scale to purchase the highest-quality ingredients around the world. One example I learned of from an employee was that most/all the water for the UK-produced product is sourced from a bore hole (well) that has very low levels of minerality—which is important, as higher-minerality water interacts differently with liquors. The emphasis on quality ingredients seems very genuine to me. Ingredients for some of the ginger products they produce are sourced from the Ivory Coast, India, and Nigeria. Only lemons from Sicily are used, yielding a distinct flavour. Even the extraction of flavours and scents uses a method typically utilized only by perfumers. My guess is that most of these higher-quality ingredients aren’t as easily available from flavour laboratories used by their competitors, who therefore face a hurdle to producing the same type of high-quality product.

The company also benefits from a first-mover advantage. This is most true for on-trade relationships, where shelf space for mixers is very small. Once a product is on a menu, any product attempting to replace it needs to win over chefs/bartenders and drive either lower costs for them or provide an ability to charge more for the final cocktail. Larger scale in bigger markets also translates into an ability to partner with and fulfill the needs of national hotel or restaurant chains that are looking for a premium mixer to add to a menu. Off-trade, the benefits of scale largely allow Fever-Tree to experiment with a wider range of promotions and formats that would meet consumer needs. Prior expert interviews have also highlighted that the strength of their portfolio often leads their products to be sold in entirely different sections of a grocery store than other mixers. The ideal situation for Fever-Tree would be to be placed away from low-quality products, where price comparisons are more likely to come to mind, and close enough to the liquor section that consumers can easily see an opportunity to pair the product.

Another area where Fever-Tree derives some competitive advantage is in its ability to scale its brand and marketing spending. Historically, the business has utilized several historical partnerships with spirits companies to drive sales. For example, the partnership in the United States with Jim Beam has been mutually positive, as Fever-Tree gets leverage on Jim Beam’s regional market awareness but also expands the number of consumers who will consume the liquor (i.e., not everyone will drink Jim Beam neat or on the rocks). Whether or not #JimBeamHighball is a secular trend, I think this shows the power of working with partners who are having their own success. Fever-Tree can then adapt the portfolio to meet any areas that are cyclically strong or weak. Figure AJ below shows the consistent growth in investment in marketing on the portfolio and reasonable consistency as a percentage of sales. Fever-Tree has also invested selectively to sponsor sporting events in cricket, tennis, and golf, which are a good overlap for the target consumer. By my account, they have some competitive advantages in terms of brand, procurement, and scale, and the stability of their market share and leading market position suggests that they remain in an enviable position.

Competitive Landscape

Schweppes has historically dominated the tonic water market. Like for many incumbents, innovation and nurturing of the brand and portfolio are secondary considerations when you are a dominant player. Looking at the Schweppes packaging below in Figure AK, one can see it hardly gives off an image of a premium or unique product. Keurig Dr Pepper, the Schweppes parent company, appears to have bigger focus areas, including coffee, soft drinks, and healthier beverages. With over US$100 million in sales coming from the Schweppes brand and the portfolio generating approximately US$15 billion in sales, it’s easy to understand how a nimbler, innovative firm was able to beat them in this area. By late 2017, they introduced a premium product branded as Schweppes 1783 to compete directly with Fever-Tree and with similar positioning—a new smaller premium bottle, new flavours, and craft-ingredient positioning. However, I don’t believe this offering has impacted Fever-Tree much, if at all—product placement in retail stores appears to be subpar, and far as I know, they have invested very little to build on trade relationships, which are hugely important in this category.

Q Mixers is the company’s main premium competitor. The founding story of Q Mixers is actually relatively similar to that of Fever-Tree—the idea was to create a better-quality tonic to mix with premium gins. Instead of going to the Democratic Republic of the Congo to source gin, they went south to Peru. The initial sales were into top-tier restaurants like Gramercy Tavern and Milk ’N Honey. On the retail side, they first sold to Dean & DeLuca and Whole Foods but eventually diversified to many large grocers and retailers like Kroger. Q Mixers’ distribution partner is Breakthru Beverages, which I believe is the second largest in the United States and has less scale than Fever-Tree’s partner Southern Glazer’s. While it’s hard to get a ton of details on the business, it appears that production is localized in the United Sttes, they have less global scale, they have invested less into on-trade channels, and they have a weaker distribution partner—all things that tip the scales in Fever-Tree’s favour. Figure AL below is an excerpt from an InPractise interview that highlights how being late to the market has been the biggest challenge for Fever-Tree.

Q Mixers has been the only real competitor for Fever-Tree in most regions around the world. However, after 17 years of running the business, they have had to tap investors for seven rounds of capital—far more than Fever-Tree. While I’m not entirely certain what they used the proceeds for, it appears that internal turmoil or financial pressures drove the need for external capital. This likely impaired their ability to reinvest to support their brand during the past few years or get into on-trade distribution. They even replaced their CEO in late 2024, indicating that some of my suspicions may be correct. The new CEO, Betsy Frost, joined in late 2024, but her experience skews toward consumer packaged goods (CPGs), and the lack of alcohol-industry experience seems like a clear negative. The risk of a future mistep or pivots in strategy seems higher—but perhaps they will finally invest more into on-trade opportunities creating incremental competitive pressure on Fever-Tree.

Despite some competition in the premium category, if I add up the combined market share of Fever-Tree and Q Mixers, it’s estimated to be about 88% to 90%. With a duopoly-like market structure and their biggest real competitors being Canada Dry and Schweppes, I don’t think competition in the category is nearly as high in reality as is feared by the market. This is most easy to envision in the on-trade market—if you are first onto a menu, you’re unlikely to get displaced, and if a premium offering isn’t on the menu yet, your real competition is the soda gun. Executives from Fever-Tree have said in the past that the true costs of a soda gun are actually much higher than most operators realize. This is due to maintenance costs, equipment costs, and syrup bags, which are rarely replaced as they hit expiry. I’m not so sure I buy into this idea, but for an upscale restaurant or hotel, I can see how these soda guns could be replaced with a premium offering

Off-trade, the market seems at least somewhat more competitive given the different dynamics—see Figure AM below showing an aisle from a specialty retailer in my neighbourhood. This shows that a handful of regional or local brands should be able to create a similar product in many cases, and I think it’s even possible that they have modest scale in their local markets. However, without the distribution power that Fever-Tree or Q Mixers has secured, I don’t think any will really be able to scale up to comparable levels, especially if they are not willing to invest into the on-trade channel. Fever-Tree’s continual investment into on-trade through pop-ups, on-trade workshops, special events, and media have differentiated their positioning. Industry sources like Drinks International’s annual brand ranking also corroborate this view—Fever-Tree ranked number one as the best-selling and best-trending mixer for the ninth year running (2023).

Financial Performance

Fever-Tree has delivered great performance in sales growth over the past five- and 10-year periods. The UK segment is an exception to this, but even including the declines from this segment, we have seen about a 7% CAGR on a group basis. From a mix perspective, the United States and United Kingdom were each at 32%, followed by Europe at 29% and ROW at 7% as shown below in Figure AN.

Gross margins historically from 2013 to 2019 were in a relatively tight range of 50% to 53%. However, starting in 2020, the company has seen margins fall each consecutive year due to a variety of contributors, as outlined in Figure AO below. Company disclosures from 2019 to 2023 provide a noisy picture of all the contributors, and some classifications by the company add noise to the analysis—in some years inflationary costs, in others cost of goods sold (COGS), in others specifically the US logistics/COGS. Regardless of attribution, here is how I’d outline the biggest drivers:

• Input costs were up meaningfully over the period. This covers sugar, specialty ingredients, labels, energy, and labour. The biggest contributor was higher energy costs in Europe, which directly translate into higher costs for bottles, which are about 30% of product costs and were 80% of total sales. Glass suppliers exacerbated these issues, as they also hedged energy costs in 2023 at elevated pricing following the invasion of Ukraine by Russia while spot pricing subsequently fell, which they didn’t benefit from.

• Logistics costs increased substantially in the US market, where demand exceeded available supply. This was due to not renewing its US west coast bottling contract and the fact that additional volumes were not expected to ramp up on the east coast until late in fiscal 2024. This led to the company shipping product from the UK system during a period when sea freight costs were elevated, port congestion or disruptions were more frequent, and driver costs continued to inflate.

• Adverse shifts in regional and channel mix represented a roughly 200-basis-point headwind to gross margin (GM). This is a function of selling more into markets with less-favourable pricing. The company also completed a 15% price reset in the United States and introduced a larger format size to increase appeal to US consumers. Fever-Tree’s acquisition of Global Drinks Partnership in Germany also negatively impacted reported margins by about 200 basis points.

• Economies of scale outside the United Kingdom were also a headwind, but I’m unsure how this was categorized. The company went from operating a sole bottling plant in 2014–15 to gradually adding a second plant in the United Kingdom for contingency purposes. By 2018, they had expanded to six bottling and canning partners across the United Kingdom and Europe. In 2021, they had a US west coast partner ramp up volumes and in late fiscal 2024 were expected to have localized production in Australia.

• The one positive area for the business globally was pricing, which they increased after an extended lag to inflationary costs. Globally they were able to capture pricing in most markets, particularly in Australia, where they shifted their route-to-market approach. The exception to this theme was in the United States, where they were priced at around 4x the level of mainstream brands, but in most other markets globally they were priced at around 2x. This led them to complete a price reset of 15% in 2020, leaving the brand at an approximate 3x premium to mainstream brands.

In Figure AP below, I show the GM and EBITDA margin waterfall back to 2013. This shows an 1800-basis-point decline in GM over the period and a 2290-basis-point decline in EBITDA margins. The company has also been shifting away from an agent model in more markets around the world, and hiring in the United States and Europe has accounted for much of the employee growth. Fever-Tree has also expanded from selling into 50 countries in 2014 to more than 85 by 2023. While they have experienced modest deleverage due to operating expense growth, they have continued to generate scale benefits from their marketing spending, which fell from 11% of sales in 2019 to 9.2% in 2023.

Next, I look at Fever-Tree’s performance relative to peers like Britvic, Monster, Keurig Dr Pepper, Pepsi, Coca-Cola, and Olivi Oyj over the prior decade. In Figure AQ below it shows that for the period from 2015 to 2019, Fever-Tree generated the strongest ROICs in its entire peer group. This was due to its relatively high margin profile and attractive invested capital turnover (high sales versus low invested capital base). However, post-2019, due to falling margins and near doubling of invested capital, they fell to the bottom of their peer group on a ROIC basis. While capital intensity remained very low vis-à-vis the peer group over this period due to the outsourced model, the operating invested capital roughly doubled because of a large increase in working capital and modest growth in property, plant, and equipment (PP&E) (including leases) and intangible assets. This suggests the possibility of generating much higher ROICs than is currently the case if margins can recover. I’ll expand on this later in our report when I review market expectations.

What Do I Think the Market Is Underwriting?

Here I look to adjust all the key drivers for the business to arrive at a fair value estimate close to the current share price. Of course, people will have different expectations than what I’ll outline below, but this is a good tool in thinking about how pessimistic or optimistic the market might be on a particular stock.

I assume that sales grow at a 2% CAGR over the next decade. This type of performance implies pricing only in line with inflation, which appears overly punitive and makes it impossible to hit management’s sales targets in either Europe or the United States. And the ROW segment remains very small, implying effectively zero success in expansion into Asia over time. The main reason this could occur is if spirits consumption begins to fall more broadly and the company’s success in soda/adjacent categories bears no meaningful sales.

On the margin front, I assume GMs will recover to 39% but will remain at this level over the forecast horizon. This means that raw materials inflation has stepped up and won’t be recaptured by optimization, pricing, or operating leverage. EBITDA margins in this scenario start at the low teens and mature at roughly 15% over the forecast period. Most other assumptions on interest (net cash b/s), CapEx intensity, and working capital changes are otherwise unchanged. In fiscal 2025, this translates into EPS of £0.30, or a P/E multiple of about 21x. On an EV/EBITDA basis, this means a multiple of 12.4x. A snapshot of the discounted cash flow (DCF) output under this scenario is outlined below in Figure AR:

What Do I Feel Comfortable Underwriting?

To start, I think it’s reasonable to assume that consumption of the product will go up on a global basis. There are many countries like the United States, Australia, Canada, and others where premium mixer consumption is still growing, and while that might not be the case in the United Kingdom, this won’t impact results on a total portfolio basis. Finally, wholesale regions like Asia are underdeveloped and should still be a fit for the company’s offerings.

On the pricing front, I do think Fever-Tree will generally be able to increase pricing at least in line with inflation of about 2%, and volume growth of 2% to 3% is very possible as penetration increases. There is some risk that pricing will be skewed to later in the forecast period if a recession occurs, but at this point they have lagged a few competitor actions, so it feels more manageable. The caveat is that many of their competitors have arguably taken price too far, leading to volume declines. I don’t believe Fever-Tree will do the same. Figure AS below shows group revenues growing to about £632 million, a 5.7% CAGR from 2024 to 2034.

Next, on gross margins I expect 600 basis points of improvement in fiscal 2024, in line with management guidance, and subsequent annual improvements driven by lapping elevated glass costs, localizing US production, and pricing. However, due to channel and mix shifts, I expect gross margins to mature at about 48.5% versus historically which averaged 52% from 2013 to 2019. Then, from the perspective of selling, general, and administration expenses (SG&A), I expect management to generate material operating leverage as they lap localization costs. SG&A (excluding D&A) will fall from 27% in 2024 to around 23.5% by 2034. As a result, EBITDA margins will recover to about 26% versus the 2013 to 2019 average of 32%.

I hold capital intensity flat at about 1% such that Fever-Tree spends only £4 million to £6 million in CapEx per year. Recall that this capital is tied to bottles that need to be owned in a few markets. Near term, I expect some work-off of inventories and materials that were built up in recent years, but longer term, net working capital (NWC) remains in line with historical levels. This eventually leads to more than £90 million in free cash flow to the firm (FCFF) in 2029. Cash builds on the balance sheet even after growing dividend payments, and special dividends could likely be issued, as management as done in the past.

I use an 8% cost of equity, a 6% cost of debt, and a 2% terminal growth rate. Despite some potential headwinds for the alcohol industry, I do think the premium mixer industry has some offsetting levers that are underappreciated. A combination of underpenetration of the category/product in major markets, growing spirits volumes, and some pricing power should create a meaningfully larger business over the next decade. Profitable growth should still occur for a very long time—even if the core alcohol market implodes, there is some chance Fever-Tree can pivot more toward premium soft drinks.

My DCF model suggests that fair value using these assumptions is roughly £12 per share, which is more than 85% higher than the current share price. Please see Figure AU for a screenshot of my DCF output.

Management and Governance

Fever-Tree has been implementing the same strategy focused on building up sales in on-trade, gradually scaling up off-trade in new geographies and creating new products to meet local market tastes. This playbook should be able to be replicated for many years. Given the strategy hasn’t changed as co-founder and CEO Tim Warrilow continues to lead the firm. Charles Rolls stepped away from the deputy chairman role in April 2020 and no longer appears to be involved in any meaningful way. They own 4.8% and 4.4% of the firm, respectively. The capital allocation process has been skewed toward just returning capital via dividends, organic investment to grow in new regions, and the rare acquisition. From a capital allocation perspective, in reviewing their history I don’t see any meaningful blunders. The regular and special dividends in the company’s past suggest they are shareholder friendly. One criticism is that they have run the business with far too much cash, and this can be optimized at some point in the future.

From a strategy perspective, the company has used a spirits-led strategy. Key leaders like Charles Gibbs, head of North America, have extensive global experience in the spirits industry, including at Belvedere, MOET Hennessy, and Diageo. The industry knowledge and relationships that individuals like him bring to the table seem to be a differentiator vis-à-vis their peers. Fever-Tree’s approach is more akin to a master distiller, as they are curating ingredients from around the world and are very prioritized on the quality and flavour of the final product. Even a decade-plus experience with a staples business, like the new CEO of Q Mixers has, would not nearly provide the depth and understanding of how particular the alcohol industry is about its ingredients, process, and craftsmanship. Depth on the team and adjacent industry knowledge appears to be at least part of the reason Fever-Tree has grown more successfully. I think this is why they have effectively created the category in multiple markets around the world and are essentially driving the “third wave” in the mixer market.

Next, the incentive plans for executives seem relatively okay. From 2014 to 2017, performance measures for annual bonuses and long-term incentives were based 75% on turnover (sales) and 25% on EBITDA as they prioritized market penetration, profitable growth, and scaling of the business. In 2016, the long-term incentive plan (LTIP) program was adjusted modestly to include malus and clawback provisions in the case of financial misstatements. In 2018, the approach remained relatively unchanged apart from boosting the salaries meaningfully, which were below market level for a company of their size. Incentives were tweaked in 2023, weighting of performance payouts was adjusted to 60% on turnover (sales), 20% on adjusted EBITDA, and 20% on strategic measures (including innovation, margin improvement, and environmental and sustainability targets). While the reinvestment rate into the business is low, a ROIC measure is not as relevant as it could be, but a future addition of return on equity/capital measure would be welcome. All told, alignment seems sufficient, and I don’t see any large red flags.

Key Risks

• Industry tailwinds have more recently favoured spirits over other types of alcohol. A reversal of this would create a small number of consumption opportunities for premium mixer brands like Fever-Tree. Consumer sentiment has changed in recent years, and the addition of warning labels could meaningfully change volume trends in the industry. A consumer shift toward marijuana and away from alcohol globally could also pressure liquor consumption.

• Expansion into adjacent areas may spark a more competitive response from large soft drink manufacturers. While Coke and Pepsi seem very unlikely to devote the resources necessary to create a premium product and invest into the on-trade channel, a new upstart could do this in select markets. Seen many times in the liquor industry is a celebrity-backed product aligned with industry trends of low calorie counts and artisan craftsmanship, which could also disrupt the business to an extent. The acquisition of Q Mixers by a more focused entity could also increase competition beyond what we’ve seen historically.

• Pricing has been a tailwind for the business since inception, but Fever-Tree’s ability to increase future pricing is going to be driven more largely by the behaviour of mainstream brands. Unfortunately, consumers view the Fever-Tree product in relation to other competing mixers and not relative to alcohol pricing. This leaves them more indexed to CPI plus or minus 1% to 3% in markets once the initial premium is established. However, the soft drink/value mixer category has worse pricing dynamics than liquor, which has historically benefited from premiumization trends.

Under a simplified pre-mortem, If I were to lose money on this investment, it would likely have to be because of a combination of all the above-mentioned factors plus an inability to recover gross margins due to more persistent inflation and weaker structural pricing. As I’ve outlined this seems overly punitive given the business’s historical performance and the fact that it is a founder-led business that should be very interested in creating value for itself.

Conclusion

Fever-Tree has continued to build on its premium position in the mixer market. The company has continued to gain or maintain value share in key markets around the world. The frequency of consumption and loyalty for the brand has continued to grow both on-trade and off-trade. However, a weaker consumer and a strategy to take lower pricing in a higher inflationary environment has weighed on the business. As the consumer rebuilds spending power in the upcoming years and Fever-Tree scales up in key markets, I expect profitability to continue to recover. The founders appear to be aligned with shareholders, and I wouldn’t rule out a potential sale of the business over time. The current P/E multiple of about 19.4x on consensus figures appears high relative to many staples, but as margins normalize, the stock will increasingly look cheap to investors—on my fiscal 2026 numbers, the stock trades at just 13.5x my estimates, and this assumes EPS up only £0.06 from 2021 levels. My base case model can be found below if interested.

As always, if you have any questions or disagree with any of the analysis/views expressed here, please fire away in the comments below. You can also reach me on X/Twitter or icemancapital@gmail.com

2025.01 Fever-Tree Drinks PLC

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Shift4 reported mixed results this past week. E2E volumes grew +56% YoY, while Gross Revenues Less Network Fees were up 48%. Gross margins fell about 100 bps YoY to 69.4%. Net spreads continued to fall modestly, to 60 bps down 5 bps YoY while offsets from a larger average merchant size allowed them to grow at a rapid clip. Like much of the company’s corporate history, cost management was strong with EBITDA margins at 54%, excluding the impact from recent M&A which added a 250 bps drag on headline figures. FCF conversion (Adjusted FCF/Adj EBITDA) was 58% in-line with expectations. All said, outside of payment volumes being a bit soft nothing too notable to call out from the reported results.

Due to this environment, the company cut E2E and Gross Revenue Less Network Fees for FY2024. EBITDA guidance was increased incorporating the GiveX acquisition. Exhibit A1 outlines the FY guidance changes. Cyclical headwinds from “higher interest rates, higher inflation and overall consumer fatigue from spending significantly more eating out and staying at hotels” were the key drivers to the de-minimis guidance reduction. Despite these headwinds, FOUR grew its contracted backlog from backlog grew from 25b last quarter to 33b, with a gross 13b added in the quarter.

With all eyes on 2025, management hinted at what guidance could look like based on annualizing the figures from Q4/2024 excluding any impacts from other growth or seasonal factors. This puts 2025 at 192b in E2E volume, 1.6b in Gross Revenues Less Network Fees and 842m in Adjusted EBITDA. About 16% higher on E2E than consensus expectations and 20% higher on Gross Revenues as shown in Exhibit A2 While EBITDA is in-line with consensus, it still implies >25% growth relative to 2024. Pretty Pretty Good. And, while I’m not 100% certain they’ll beat these hurdles next year looking back at the prior 3-year record shows very good execution and expectations management. In my mind, the management say vs execute ratio is quite good.

Hospitality Vertical

Like many other quarters, Shift4 called out a number of new customers in this vertical. This quarter it includes KSL Properties and a large Las Vegas Casino Operator (Fontainebleau?) with multiple casino locations internationally. The consistent wins are nice to see but it’s hard to always square how meaningful any individual addition is at this point. An important point to remember is that when Shift4 wins a customer at a hotel or resort they are powering all the payments including the gift shops, spas and restaurants. Like other vertical’s there is still a healthy runway to convert gateway customers and expand into Canadian and European markets. It remains difficult to see how a new entrant would be able to easily replicate the 500+ integrations that are needed to successfully compete in this area.

Restaurant Vertical

With over 55,000 Skytab installations since the beta release – Shift4 is tracking well ahead of their prior 30,000 target for installs in 2024. They are on track to complete >35,000 installations this year and management believes they have continued to take market share. Restaurants continue to have the best blended spreads of all the verticals given the customer size and relative negotiating power – I see little reason this will change materially over time. Heck there’s even some chance it goes up on a corporate basis as they expand into Europe and Internationally.

But I do have to call out how their previous target of ~10,000 international customers by YE24 isn’t going to be met. They are tracking closer to ~1,000 customers today. It seems like they ran into a few regional issues which have slowed progress. However, the company isn’t using any different playbook compared to other POS acquisitions and I’m very confident that more of the ~65,000 Vectron/Revel systems will eventually be converted to the full E2E solution over time. The playbook to convert the legacy POS customers is to waive the gateway fees, hardware costs, software costs, refresh the devices and at times offer a signing bonus to convert.

In Europe, the software plus payments opportunity has far from converged and most operators in this region aren’t offering a bundled solution like the US. I’ve yet to hear of a compelling reason as to why the European market won’t look like the US with enough time. Shift4 generated only 4% of revenues internationally in 2023, and a very large number of F&B companies are soon going to be enabled with the full capabilities that merchants have in the USA. With ~300 POS resellers and some internal sales capabilities in the region. I think the cross-sell and conversion opportunity will be captured its just a matter of when. A single throat to choke will still have its benefits in Europe.

I think number one, which shouldn't be too surprising, but it even is to us in some respects, which is just complex card-present capabilities. So if you think about the giants of Europe that, and those that have done an absolutely outstanding job, Adyen started as a Card Not Present player. You're talking more basic single software type integrations for card-present because it's a relatively new world for them. Stripe, incredible e-commerce capabilities, very basic card-present capabilities. I mean, Shop Pay, Simple Terminal.

This is why, like, from my perspective, when I ask, like, why are we even involved in all these transit systems or why are we getting, why are we winding up in all these EV operators across Europe? It's because there isn't, there isn't, there isn't like that super tech player in Europe that focused on card-present capabilities. So it's traditional old stuff. It's Barclay Cards is huge, say, in the UK worldline does a lot of volume. It is not an integrated payments player.

So I think that is, like, turning out to have some surprising benefits for us in Europe. But I mean, our main focus of going over there with card-present was our restaurant product, our hotel integrations, our stadium product. But we are clearly doing well in kind of complex integrated payments from a card-present perspective.

Sports & Entertainment Vertical

S&E trends remained strong in the quarter – this quarter included the Memphis Grizzlies, San Antonio Spurs, and the Dallas stars to name a few. One notable trend I expected in my initial report was a higher rate of ticketing included in these new wins which continues to progress very nicely. Not only are the trends remaining strong, what is under appreciated is the 4-5x uplift in payment volume they will capture if they win the Ticketing opportunity. It increasingly seems to be their partnership with Seatgeek is allowing them to win in more often. With ~66% share in major league venues they look well positioned from a scale and relationship perspective.

Giving Block and Crypto Vertical

As many of you know, Trump’s new position on Crypto has created a lot of excitement. Exhibit A3 below shows how much his view has changed over this years. This is positive for Shift4. Recall, in March 2022 they acquired The Giving Block, an integrated payment solution for non-profits and created the Crypto Innovation center to help assess related opportunities. Recently, they have integrated their offering to Give Lively, a free of charge fund raising platform that is used by ~9,000 non-profit organizations. This feels eerily like a gateway convert opportunity which adds a large list of potential E2E customers. Operating trends have also been very robust with YTD payment volumes processed by this segment up more than 2x last year’s levels.

With the market still growing, they plan to add payment capabilities starting with luxury goods merchants. This includes lodging, restaurants, special events which will be able to accept crypto or alternative currencies. The second major initiative is with Starlink/SpaceX, where customers can pay for services with crypto. The last initiative is to use crypto technology to address some ongoing fraud or merchant challenges. From my point of view, only the 1^st really seems that interesting from a use case I can really envision. But, if they roll this out to all of their Skytab locations it has the potential to really differentiate them in a marketplace where BTC acceptance is very low. I can even imagine that through stable coin or crypto conversions into local currencies cash this could also drive higher net margins than the core business.

M&A

During the quarter Shift4 acquired GiveX which added a long tail of 130,000 customers and a strong gift card and loyalty offering. Churn at this business was <3% and with the top 50 customers was less than 1%. This platform had several large blue-chip customers like 7-11, Wendy’s and Recipe Unlimited. Like lots of other M&A they have done the end customer is usually utilizing a mish mash of multiple vendor solutions to achieve their overall commerce experience. Shift4 will simplify and add on to what these customers were already getting.

GiveX should be processing >10b Gross Payment across the business today. However, if I understand reported figures correctly, this GPV figure only includes the gift card payments and loyalty rewards handled by GiveX (~2.6% of all payment flows) but not all other payment flows (~97.4% uncaptured). If FOUR increases penetration of their E2E solution for these customers by ~5%, they expect a 5% uplift on gross revenues less network fees – that’s pretty big. This is like another gateway they have just acquired which sources future low-cost customer additions. It also adds specialist talent in the gift card and loyalty space and a solution that can be cross sold to other customers around the world.

However, it seems the multiple paid is on the higher end annualizing their H1/2024 results at 2.4x sales or 27.8x EV/EBITDA. However, revenue growth seems very possible to accelerate as they convert these customers to the E2E payment solution and as cross selling efforts pay off.  And. costs should drop as duplicate functions are removed or redeployed elsewhere. As shown in Exhibit A4, If they can convert ~25% of the GTV at a 60 bps take rate, this implies an incremental 37m in EBITDA. If you then add this back to the annualized EBITDA figure I had earlier, the EV/EBITDA multiple falls to 4.6x, pretty in-line with what they’ve paid for businesses in the past. While I’m not certain I can underwrite this as a base case yet, I’m guessing management is thinking about this in a somewhat similar fashion.

As always, Shift4 took a good question from X – it’s a long response but I think it’s worth reading through.

“as someone who's followed Shift4 and its creative acquisition strategy over the past few years, I was curious about the following. One, why do you believe that another firm hasn't replicated this strategy? And two, how long do you believe you can continue to pursue this strategy?”

So John, thanks. A lot of companies are reasonably active at M&A. I mean, across all sectors. I think within payment specifically, Adyen is probably the only example of a scaled payments company that has not done an acquisition. i mean, even Stripe has laid square, they've all done deals. So I would say when an industry is in transition and there's opportunity, deploying capital intelligently to take advantage of it is a pretty obvious strategy. In fact, last quarter I gave examples of like Palo Alto Networks, Apple, Amazon, all of which have taken advantage of different transitions within their respective industries.

So look, the issues are, are you doing a deal to take advantage of an opportunity or are you doing deals to fix problems? And I think many examples of late from people are trying to fix problems versus actually having a pretty solid strategy and then using capital intelligently to pull it forward.

So, I think where people make mistakes, they don't have good conviction around their synergies, they become afraid to burn the ships and focus on the future, and that's scary for some. But failing to see it through is when all those worst fears are realized, lots of tech debt, then your synergies start coming up short. You don't actually start delivering on your margin goals or free cash flow, I think that's where people make mistakes.

We're good at it because we've been doing it for 10 years, since we started our own organic integrated payment strategy back to Harbortouch. We saw the success from it and then moved to pull forward the opportunity by believing it was really our best use of capital, and we did this using our capital, not others. And then we've since learned how to do it even better.

Now the question of can this keep going on? Look, it's very early days of software post payment. So if you think we're going to run out of good ideas taking advantage of this convergence, then you have to believe that Adyen and Stripe will as well, since they are essentially chasing the same opportunity of software post payments coming together.

So, we think that there is no shortage of opportunities ahead, this has been a particularly busy year in 2024, but it was also because there was a lot of opportunity, I mean we didn't do much in 2021 when valuation expectations were in a different zip code. So we like our pipeline, I wouldn't worry about us coming up short on things that could move the needle.

Closing

Generally, I was happy with the feedback on my initial report. My initial write-up had generally a very positive view on their M&A capabilities but there is at least one exception that people brought to my attention where the investment hasn’t as obviously worked out. That was 3D Cart, an eCommerce platform which more directly competed with the Shopify’s of the world. At acquisition they renamed this business to Shift4Shop and the strategy they used was to eliminate fees as an attempt to onboard clients. However, after meaningful customer growth about 12 months after to ~70k (vs 14k at acquisition). Jared touched on how this area wasn’t a great area to invest in and how they had subsequently reduced the size of the team. This sort of ties back to how Jared talks about strengths in card present environment and this acquisition was a bit of a step away from what I believe the company’s competitive advantages and management circle of competence.

I certainly won’t be posting quarterly about all prior write ups, but I may increasingly do a follow up on a prior post to better demonstrate how some of my thinking has evolved on a particular name. With the stock at 12.8x 2025 EV/EBITDA and a long runway to reinvestment/growth I can’t help but think that Shift4 will generate very attractive returns in the years to come.

Introduction to Shift4 (FOUR)

Who doesn’t love going to a great restaurant. Great food, friendly wait staff and bartenders, good music and ambience. But, at the end of the meal the restaurant needs to be paid, and, if you’re like me, the end of an experience really matters. That means having a seamless transaction before you leave. Shift4 exists to create that dynamic in the most complex and demanding payment situations.

Paying for a meal with a credit card at your favorite restaurant might not feel so novel today, but in the 1990s only larger stores and restaurant chains were widely accepting credit cards, while smaller businesses were left behind. At the time, adding payment acceptance capabilities was a tedious, complex, and expensive processes; it involved hundreds of pages of paperwork and high upfront costs to obtain the hardware and terminals. Jared Isaacman entered the industry in 1999 and saw an opportunity to stream line this and help all merchants add electronic payment acceptance. He didn’t wait long after dropping out of high school to create the United Bank Card Company (UBC), and with their simple onboarding process, as well as free terminals and hardware, UBC’s customer base grew at a rapid pace. UBC Merchants, in return, would pay for software and payment processing through the company. After multiple years of attractive growth and returns, growth decelerated as the benefits from this superior conversion approach and broader penetrations gains approached their natural limits.

Jared then pivoted and focused on adding more technology to the platform. After rebranding as HarborTouch Jared expanded into related markets including hardware, software, and payments. The new strategy led to another decade of profitable growth, and the creation of a more formalized M&A strategy. Then, to accelerate this transition the company received its first outside investment in March 2014 from Prospect Capital Corp. Acquisitions continued to ramp up during the following two years, with HarborTouch reaching ~$10 billion in annual payments volume by the end of 2016.

In the following years, the company continued their acquisition streak, adding Point of Sale Systems (POS) such as Restaurant Manager, POSitouch, and Future POS; CurvePay (sales organization serving the Taxi/Transportation market); and finally, Shift4 Corp, the world’s largest independent payment gateway at the time. With this latest acquisition in January 2018, the company changed their name to Shift4 Payments.

Shift4 Payments was a homerun. The company processed more than $60 billion in payments. Shift4 was the industry leader in PCI-validated point-to-point encryption (P2PE) and had 100% gateway uptime since 2008 due to its redundant and diversified datacenter footprint. After the deal, the combined entity was processing more than $100 billion in payments, and the addition of PCI secure payment processing capabilities made the company stand out in a time when cybersecurity incidents continued to ramp up and the risks of technical debt were increasing within the industry.

By June 2020, Shift4 Payments completed an IPO on the NYSE under the ticker symbol FOUR at $23 per share. Since then, M&A has continued to be a core strategic pillar for the company. Notable deals over the past few years include: VenueNext, a payment solution for stadiums, arenas, amusement parks, and universities; Finaro, a European cross-border ecommerce payments provider; Giving Block, a cryptocurrency fundraising platform; FOCUS POS, a restaurant point-of-sale system; SpotOn’s Appetize which was well known for expertise in the sports and entertainment industries; and Vectron and Revel in 2024, which added many clients in Europe and significant under-monetized payments revenue potential. Lastly in August 2024, they acquired Givex Corp, a global provider of gift cards, loyalty programs and POS solutions.

Value Proposition

To complete a credit or debit transaction there are about four major components required: A POS System, a Payment Interface, Merchant Acquirer and Payment Network. Exhibit AA illustrates this general process and key components. Shift4’s positioning is unique because it acquired capabilities in the first three components and has >500 integrations that allow them to work with a wide range of systems. Shift4 does not operate a payment network but instead partners companies like Visa, MasterCard, American Express and Discover.

Shift4’s value proposition is that they offer merchants an integrated payment solution that is higher quality, more reliable, and has lower total costs than competing solutions.

Most merchants execute with a piece meal approach to having a full payment solution. A terminal from Joe hardware, payments processing through Bob Payments, integrations offered by Larry Information Technology Corp, and delivery capabilities from John’s application corp. This can make sense given the path dependency: as a merchant you might not need certain capabilities today. Exhibit AB below illustrates how the payment flow would look like if assembled through multiple solution providers.

This piece meal approach is still relatively prevalent in many places and is significantly less reliable than a single integrated solution. For example, most employees working at a restaurant or hotel are far from experts on any of these individual components, and a failure may be more difficult to be rectified or even identify – perhaps the terminal isn’t sending the payment processor the information or perhaps the issue is the payment gateway. Hard to identify problems are hard to solve quickly.

Shift4 positions itself counter to this situation, providing a one-stop solution (Exhibit AC illustrates their simplified payment flow relative to Exhibit AB). Instead of having individual partners for pieces of the payment problem, they do it all. FOUR believes that this bundled solution creates a superior experience for merchants through improved convenience, system efficiency, and reliability; one throat to choke has its benefits. Exhibit AC from reformingretail.com shows the contrast between a piecemeal solution and Shift4’s Skytab POS System which has equivalent or more capabilities, illustrating the improved quality and usability.  

This dynamic is even more extreme if the payments solution for a customer is across multiple locations like on a resort or hotel. For example, there might be reservation systems for the restaurants, a separate system for booking excursions, and for the gift shop. Guests don’t want to see or understand the complexity of how these systems need to interact and reconcile – they just want a single itemized bill with clear line items on what they are being charged for. This is where the company’s software integration capabilities really help and has results in Shift4 winning at a rapid clip in the hospitality market. About 8 years ago they had zero customers in this vertical and now they regularly talk about having >40% of all hotels in the USA using at least one of their solutions. Similar dynamics exist in both stadiums, theme parks and special event venues.

The company charges their merchants much lower upfront hardware/software costs, as well as lower monthly fees than their most direct competitor, Toast (Exhibit AD). Over five years, this results in customers spending 72% less with Shift4 than their direct competitor: $18,000 versus the $65,000 estimate for the Toast alternative. This demonstrates the value proposition for its customers and why Shift4 has been able to drive market share gains. Shift4 is able to charge less than peers as their strategy focuses on locking into customers into their integrated payment solution instead of just selling either hardware, software or payments processing. Through bundling they can capture higher returns. Shift4 can act as both an acquirer and a gateway for customers they can act more competitively on pricing for each component.

Business Model

There are three major pillars to the company’s business model: technology solutions (hardware, software & integrations), a payments platform (Gateway and E2E payments), and partner-centric distribution (VARs and ISOs as partners). Shift4 generates revenues through two main categories: End-to-End (E2E) and Gateway. E2E customers utilize the integrated platform for payment acceptance, devices, POS software, and business intelligence tools.

E2E customers generate fees based on the number of transactions processed. Also, a percentage of processed volumes. And monthly fees for equipment, hardware, data, or analytics. Gateway-only customers are limited to paying per-transaction fees. Fees are low, about 3-5 cents. These customers benefit from being able to route payments to the preferred third-party payment processor. In contrast, a full E2E customer would pay 30-100 bps of the payment volumes. As of last quarter, Shift4 customers paid a blended rate of 62 bps. They would also pay 4-5 cents per transaction and monthly fees for the point-of-sale system, software, and hardware. Both potential options pass on interchange fees and network fees to customers. In Exhibit AE below, we display gross revenues by category and net revenues from 2018 to 2023, which grew at a ~30% CAGR.

Exhibit AF below provides an illustration of what an individual restaurant’s economics look if they convert from the gateway only option. As an incentive to convert, they have often waived gateway fees, upgraded hardware in return for securing the merchant acquiring payment flows. So, there are some reasonable incentives for merchants to complete a conversion If the discount rate is similar enough. However, they do have hurdles to overcome – most merchants aren’t really prioritizing optimizing payment processes and instead tend to prioritize managing and optimizing restaurant operations. Merchants can also sometimes loyal to their banking partners who offer merchant acquiring as part of a bundled financial services solution. From an industry perspective, it appears that a lot more customers are shifting to an E2E solution and away from Aloha/Micros which have historically been the legacy solution in place.

E2E payment volumes have grown at a T5Y CAGR of 47% to $107 billion, which has been the largest driver in revenue growth. Offsetting this has been gradual pressure on the net take rate which declined from 88bps in 2018 to 65 bps in 2023. FOUR’s ability to scale into new verticals, such as hotels and stadiums, has allowed growth to persist, but has come at the expense of the take rate. I think Shift4’s growth will continue as they have expanded into non-profit, retail, gaming, and e-commerce markets. Exhibit AG below shows the trend in E2E payment volumes and the company’s net take rate on these volumes.

FOUR believes they can still convert over time under-monetized E2E volumes worth >$500 billion. While I’m not sure all of these will necessarily convert, the TAM is estimated at >$3.5T so the runway seems sufficiently large. I’m relatively comfortable that they will continue to growth as they expand into new regions around the world. Recall, the Finaro acquisition will enable them to offer the same value proposition to European customers, where integrated payments solution is far underpenetrated compared to US markets. The SpaceX Starlink-Shift4 partnership also seems very valuable in supporting their going global strategy. At the time of announcement, they estimated $100b in subscription payment revenue potential and this also opens a larger pool of global ecommerce opportunities. Exhibit AH from a recent investor letter from the Shift4 highlights the current areas where they process payments, but this also shows the ample white space they have the potential to expand into over the long run.

The SkyTab POS distribution strategy also appears superior to competitors who use a blanket approach across regions. Shift4 took a different approach, separating the key markets into areas which had low-density and high-density customer bases. Exhibit AJ below shows Shift4’s position as of Q3/2022. For the higher density markets, they consolidated the distribution partners eliminating the residual payments that would have been paid out to them. This approach allowed them to lower their overall distribution costs but still maintain capabilities in both lower/higher density markets. This should add up to better economics vs peers over time.

Economics of the Business

Shift4 strategy of converting gateway-only customers to full E2E customers drives much better economics. Due to the nature of the integrated nature of their payments capabilities, they can capture a higher share of the economics of the Merchant Discount Rate (MDR). Some experts think this allows them to capture 20-30 bps more of the Merchant Discount Rate (MDR) which tends to range from 1-3%. The company’s consolidation strategy has also allowed it to grow the potential E2E conversion TAM at an attractive rate and grow its customer base in a capital efficient manner. They’ve done this despite providing better on-site customer service and support which customers in their core verticals highly value.

But, first let’s look at the total investment FOUR and a few peers have made over the past 4 years (2019-2023). Exhibit AK shows FOUR invested $836m, TOST invested $1,858m and LSPD invested $1,858m. So, peers invested about 2x the level FOUR did, with the vast majority being much higher spending on sales and marketing. From what I understand this means heavily advertising online on Google/Facebook and offline with sales representatives aggressively knocking on doors. TOST for example completed ~48% of it spend on S&M while LSPD did 35%. FOUR was the outlier spending only ~8% of its investment here.

On the right-hand graph above, we can see the relative growth rates in payment volumes and gross profits. On this basis, FOUR sort of looks mixed – 2^nd ranked volume growth, and lowest gross profit growth. However, to evaluate them we have to look at the total investment relative to the incremental Gross Profits they were able to capture. On this basis, as shown in Exhibit AL below, FOUR stands out as by far the most efficient with a 61% GP conversion rate on investment vs peers at 17-42%. Shift4 uses a strategy unlike the others and is generating better incremental economics – what’s not to like.

The next question, would be well that nice and all but will this persist? I think it’s very likely to persist, because they’ve trained themselves culturally as an organization to be efficient with cash and manage expenses tightly. This is due to their history, where they didn’t take any outside capital for something like the first 15 years of the company’s life. Other Fintech peers had quite the contrary approach, taking multiple rounds of venture capital investment to allow cash burn and scaling up to sustain for a few more years. Exhibit AM is a tweet from Jared emphasizing this dynamic.

Taking things a bit further, if we look at the CAC and estimated paybacks for this group. FOUR still looks the best as shown on Exhibit AN. To calculate paybacks, we look at net hardware and professional losses plus S&M spending. Then we look at the incremental GP based on the take rate of a particular year to get a payback estimate. Here we can see, FOUR ranks by far the best with consistent payback consistently less than 8 months. This was while TOST and LSPD delivered deteriorating metrics – which seems to suggest their strategy/execution isn’t necessarily going as planned. FOUR was able to deliver these results while its net take rate fell from 82 bps in 2020 to 65 bps in 2023. Peers on the other hand had modestly increasing take rates which makes the result that much more impressive.

M&A Machine

Shift4’s strategy is ultimately to deliver a superior commerce experience – they do this through a build, buy and partner approach. Focusing on the Buy piece, the company’s acquisitions can generally be classified in two major categories. Deals need to add additional technology capabilities that can expand what they can do or that benefit the current customer base. The second is deals that expand the number of customers – usually this means POS Systems which have a large base of payments that could be converted to the E2E solution.

Shift4 has prioritized the roll up of a number of POS systems. These systems collectively enable the managers of restaurants to assess performance, productivity and adjacent functions like inventory controls and back-office reports. They are effectively the restaurants “brain” allowing employees to “place orders and display in a kitchen, manage table seating and reservations, combine orders placed with bartenders and waitstaff into a single bill, add mandatory gratuity, track and control inventory, manage deliveries, record employee entry and exit times, measure employee productivity, assist with financial management, and sometimes, track customer loyalty programs.” Each of these POS System acquisitions adds 1,000s of potential E2E customers. Post-acquisition, they require these customers to either use their payment interfaces (Shift4/Dollars on the net/MerchantLink) and their merchant acquiring capabilities or often face a range of higher fees to maintain. Prior lawsuits outlined high expectations for this strategy to drive market share in the payment interface market for restaurants from <10% in January 2018 to >40%. Exhibit AO, shows an excerpt from the Payment Logistics Limited case from April 2018. From an industry perspective, as volumes roll away from the independent payment interfaces (towards Shift4), this creates profitability headwinds for competitors in the PI market. Over time this results in a consolidated market in both POS systems but also Payment Interface market, creating a future opportunity for Shift4 to execute on pricing increases.   

Shift4 also takes a very radical approach with its POS system acquisitions. Jared calls it blowing up the prior economic model and replacing it with a payment-oriented model. Their ability to do this allows them to capture both revenue and cost synergies. As shown below in Exhibit AP, for FocusPOS, under the prior owner the going to market generating much of its revenue from one-time sales. As FOUR integrated this deal, they immediately deprioritized this one-time sales model which led to revenue falling ~54% post acquisition. But then as they shifted the model towards a bundled payments and SaaS revenue model revenues grew to 5x the post acquisition low and >3x the level achieved prior as customers converted to the E2E solution. Through this transition the revenue quality has also drastically improved with >95% the revenue today largely recurring in nature. Costs for these types of deals are usually quick to fall too, as acquired entities tend have their own hardware, software and integration teams which can be reduced in size/scope. Far as I can tell, they’ve replicated this playbook many times and going forward will execute this on the recently announced Vectron and Revel deals. Some nuances will change depending on the footprint in a specific region and localization dynamics, but I don’t think they are material in terms of the overall approach to elaborate on.

One example of a particularly successful deal was of VenueNext in 2021 for $72m. Similar to the prior mentioned approach Shift4 executed the same playbook but in a new vertical as VenueNext had relationships and expertise in stadiums, arenas, amusement parks and corporate campuses. On its own I think the VenueNext solution was quite attractive. The value-proposition for attendees to these venues is that you could have your tickets, parking payments and food ordering centralized in one place.  Similar to the POS System deal category, instead of keeping the legacy model for monetization they began to transition more of the customer base to a bundled payments and SaaS revenue model. In my opinion, this deal looks a way better than the typical POS deal as penetration of the solution into stadiums around the world is still low and that there are two major areas where upside could surprise. The first is that ticketing sales are still in many cases handled by companies like Ticketmaster. However, Shift4 has increasingly been able to convert them over the subsequent ~2 years after winning the initial F&B contract. Experts have also touched on how this can be huge win for the Arena owner or operator as revenue capture on Ticketing increases from ~95% with Ticketmaster to ~98% with Shift4 and SeatGeek Partnership. For a venue that has a full calendar of concerts, and other special events I think this translates into millions of dollars of savings. Remember for most operators, having fewer vendors leads to less complexity and allows them to focus on core aspects of their business. Given the average ticket price is something like 4-6x, what a customer might spend on concessions, merchandise and parking, the potential step up in revenues as this is captured looks very significant. Second, sports betting continues to be legalized in many markets globally, and those wagers whatever the size can increasingly be completed through the same applications. But, even if it isn’t in the same applications, Shift4 can capture revenue from payments processing for BetMGM which has ~13% GGR share and ~22% share in iGaming. Post acquisition after the same blow up of the prior economic model, VenueNext is generating 7x the revenue and it is much higher quality with ~90% recurring in nature. Each quarter, we continue to hear of more stadiums that are selecting Shift4, with an increasingly skew of wins in Europe. If I had to guess, this deal was probably amongst the top 5 value creating deals done in its history.

To round it out, I think their M&A strategy has allowed them to expand the customer list efficiently and expand into new verticals building on prior capabilities. An excerpted below from FOUR’s Q2/2024 Letter summarizes the playbook.

1. We don’t win banker auctions; we find overlooked and attractively priced assets through our own proprietary process.

2. We confidently underwrite revenue synergies by cross selling or bundling payments.

3. We blow-up the existing revenue model (one-time software, hardware sales, etc.), often taking steps backwards, to run far forward leading with an integrated payments offering.

4. We aggressively delete parts. Parts can be legacy products, internal systems and other costly expenses that don’t fit within our plan.

5. We align the talent and distribution with our strategy, enhance the value proposition with payments and win without delay.

Competitive Advantage

In my opinion, Shift4 benefits from multiple factors including Switching Costs, Distribution, Economies of Scale and Scope and Network Effects.

Customers face high switching costs for systems once installed because the employees need to be retrained and build experience working with them. Outside of the initial fixed charge that competitors would charge, the more meaningful cost for employees is the retraining and integrations that need to be completed when a new system is put in place. This ties into the habits of employees too. If they had a certain process to complete a tip-out at the end of a night or compiling a customer’s various charges across multiple sales points, then any system changes can result in lower dollar throughput at a location until they can get back to a certain level of efficiency.

If we revert to the company’s history, they also benefit from distribution advantages. This goes back to the company’s gateway capabilities which are a middleware like business in the payments industry. They can source customers from this area or through third party sales organizations. But, despite these advantages they don’t use a blanket distribution approach which highlights the thoughtfulness of the strategy. Back in Q2/2022, Shift4 acquired a number of independent sales organizations who used to sell their payments solutions but also previously sold competitor solutions. By acquiring these partners, they cut off a large variable compensation which was near 40% of variable revenues that they would typically pay. Management estimated an <1 year payback period on these investments. They only did this in select regions where they had confidence that these recently converted employees could be redeployed to continue selling to customers. Exhibit AQ below outlines the impact on Skytab unit economics because of this change.

From an efficiency advantage, the consolidation activity they have driven for POS systems has allowed them to consolidate multiple individual R&D, integrations and relationship management activity into fewer areas. Now Shift4’s POS system Skytab, appears to have just about every feature that could be required from customers. The second piece that drives efficiencies is the >500 integrations they have with other software like Quickbooks, MS Dynamics, SAP etc. Once these integrations are implemented for one customer into Skytab, the second, third and fourth are much more seamless. This piece might be underappreciated, as >500 integrations also mean regular updates from each of these software vendors which might need its own modifications to work effectively. As this activity can be centralized, it should drive a lower cost per transaction for the average customer.

Competitive Landscape

Shift4’s origins are in the Full-Service restaurant (FSR) market and over time it has expanded into adjacent card present markets like hotels, stadiums and theme parks. If we look at split between the segments using the Global Foodservice market as the TAM, FSR markets represent about 46% followed by Quick Service restaurants at 33%, Cafes at 15% and Street food at 6%. Exhibit AR separates the market size by classification over time, for 2022 and by country.

I think each of these sub segments operate with varying levels of customer risk, payment acceptance problems, and complexity in needs. At a smaller scale, I think lots of the restaurants with less than 20 locations (Street Food + Cafes) can be satisfied with a solution from Square or Clover, where payment acceptance problem is solved, contracts are limited in nature and implementation is relatively easy. In the QSR market, Par Technology, Xenial and Qu seems to be one the go-to companies in the space, and competition appears quite high even from the legacy acquirers who tend to compete on price. Here I think loyalty programs, software integrations and operational complexity move quite a bit higher. Lastly, in the FSR market it is a duopoly between Toast and Shift4. And while they both compete in restaurants – Exhibit AS below, outlines how Shift4 has exposure to many other verticals where they are also winning.

Toast’s growth strategy in the FSR market is very aggressive. It involves the deployment of many employees to generate relationships and increase penetration of its solution in the FSR market. Shift4 takes a different approach having only dedicated staff in select regions but otherwise leaning on independent sales organizations (ISOs) to go to market. Prior organic growth campaigns having included a $2k referral bonus to anyone who successfully refers their local restaurant or bar - which is cheaper than the average CAC to obtain a customer in the industry.  Jared was asked in a recent call what’s the biggest reason why a customer might pick Toast over them? It came down to who was able to reach the customer first. This suggests that either POS isn’t materially better or worse, and having a system with a similar enough capability is just table stakes. Even from the restaurant customer perspective that makes sense, food isn’t going to taste any better or worse through payment partner than another.

But, that’s not the only thing that might matter. Restaurants are going to have issues with payments and TOST appears to have skewed its employee base towards sales rather than service. If a TOST terminal is down or receipt printer isn’t working, a merchant needs to dig through the “knowledge base” aka support forums. If that doesn’t solve the issue a customer service agent accessible on 1-800 number attempts to troubleshoot. FOUR on the other hand will have representative come on-site to service or replace equipment on site when required. So, at the margin, it seems like the customer experience is at least somewhat better, but I couldn’t get a great sense if its 10% or 100% better.

Once either of these companies secure a relationship, relative churn matters too but neither provide any clear data on what that could look like. However, we can look back at prior company action with how they treat their restaurant partners to get a qualitative sense for how they think and manage that relationship. Back in 2023, Toast was caught up in a flurry of negative headlines for charging online ordering fees to its customer base. For all orders above $10 or more they began to charge an online ordering fee of 99 cents directly to customers. Exhibit AT below, shows an example of how this fee is communicated to the end customers. But, worst of all the fee would go directly to TOST. These fees were tagged onto online orders, but also those through aggregators like DoorDash, and Ubereats. This led to widespread discontent from both restaurant customers and restaurant owners, with the former seeing higher prices and the latter not getting any capture of this fee that was tacked onto customer bills. Media reports indicated that the fee was added without the consent of the restaurant owner, but I’m not sure that’s necessarily the case, it was probably just fine print in the documents they signed which they never read.

Another anecdote to consider, is that back in August 2021, TSYS which runs the front end of some of Shift4’s payment volumes suffered a multiple hour outage. FOUR immediately communicated to its partners that while they were not responsible for the outage but that they would compensate the merchants for this issue. Exhibit AU shows the notification from FOUR. This sounds and feels like swift action in the event of bad outcome for clients. While anecdata, it seems like at least at the margin they are a better company to partner with in the space.

Management & Governance

As Founder, CEO and Chairman of the Board to invest in the business you need to have at least a modestly positive view on Jared. He controls ~81% of the shareholder votes through Class B and Class C shares but has instead an approximately ~30% economic stake in the business. Since IPO it appears he’s been a relatively consistent buyer of FOUR shares, and a few of his purchases back in 2022/2023 look remarkably timed in retrospect. There have been two disposals reported but my understanding was that these were tied to donations at St. Jude Hospital, which might have helped him win them as a client. Also in a relatively unusual move, he personally funds half of the employee share ownership program from his personal stake. With full control, remaining in the leadership position and outright funding employee compensation with his own equity – it seems like from every perspective he’s treating this his own business. This is also clearly reflected in the cost structure, given the relatively limited use of SBC and his awareness that this is a real cost to equity owners.  Exhibit AV shows a comparison of SBC relative to revenues on a quarterly and annual basis for Shift4 compared to a Peers for the past 5 years – this shows how differently they utilize this compensation and financing tool relative to the industry.

Jared’s business sense looks good as we look back on the past few years too. He timed his IPO relatively well, during a period of euphoria for fintech’s. And while the opportunity was open, he successfully completed two convertible debt issuances at a <1% coupon which was used to execute on M&A. Jared also took an opportunity to acquire several distribution partners back in Q3/2022 for $260m – this move selectively shifted their distribution approach to 50/50 internal and external after previously using a 100% partner model. This deal added modest fixed costs but materially reduced variable compensation to the partners. And, unlike competitors who use a blanket organic growth strategy, they only did this for regions that were more densely populated and where they had higher visibility on the growth of the business. Jared’s ability to change his mind seems special, and unlike what I’ve seen with many other CEOs. There was a quote I had saved but can’t find about how he still reviews old emails and decisions he made >10 years ago to try to learn from – that’s what I like to hear.

I’m a fan of Jared, and how he thinks about business – his twitter feed has a ton of interesting comments at times. He’s willing to address criticisms openly, and each quarter they also source questions from X (formerly twitter) which I think are amongst the best questions asked. Even when faced with criticism from anonymous X users, he openly clarifies misunderstandings and criticisms. While some might argue that might not be the best use of his time, I think we operate in an age where this is much more helpful than not. If Jared or anyone at Shift4 reads this I’d suggest they try to organize some of the Q&A they have with investors like Morningstar does on their website.  Exhibit AW, below is a sample response from Jared after a X user made a public post that was clearly misunderstanding its M&A strategy.

What do I think the market is underwriting?

I like to get a base understanding of what the market is thinking for the key drivers for the business – these are the assumptions I need to use in my DCF model to get an intrinsic value estimate near the current price of ~$90/share.

Starting with Revenue drivers, we must assume that growth decelerates meaningfully over the next 3 years an approach 2% in our terminal forecast. This implies a 12% CAGR for revenues vs the 30% CAGR they delivered from 2019 to 2023. This appears unusually punitive given they still have a meaning conversion opportunity to convert gateway customers, have global market presence now, and strategic customers who are supporting their growth in new regions. Shift4 has also successfully ramped up in new verticals where it appears the runway for growth is far from mature. This sort of implies a low capture of its 3.5T TAM outlined from its investor day in late 2022 – this feels too low given historical trends and a large customer base which still has meaningful conversion opportunities to their E2E solution. Exhibit AX outlines the implied revenue growth rates and total revenues.

Since IPO, Operating costs (excluding D&A) have scaled lower by ~20% while adjusted EBITDA margins have scaled to ~43% by 2023. Using 2024 Guidance as a base implies another >500 bps improvement in margins as benefits from operating leverage, and scaling of fixed costs help profitability. We then set G&A to decline in percentage terms by ~2% per annum but still growing in absolute dollars with costs still up roughly doubling from 2019 levels by 2029. For Advertising and Marketing expenses and professional fees expenses approach 2.8% and 1.5%, respectively in our terminal year. This implies little to no improvement on a % of net revenue basis for these two-line items. With these expectations this implies reach ~49% in 2024, then after a period of stabilization grow to 52% by 2034. Exhibit AY outlines the implied operating costs figures as % of net revenues and EBITDA margins.

Using these assumptions, I get an EBITDA CAGR of 14% over the forecast period. For reinvestment, we assume capital expenditures at 1.5% of net revenues, intangible investments at 6.5% of revenues and investments into leased equipment at 7% for most of the forecast period. This implies total capex investment into the business at ~15% of net revenues – about where the business has operated historically. This also assumes no M&A, which is challenging to forecast the timing and magnitude of.

Even with these assumptions, my model suggests Shift4 could repurchase >$3.8b in shares over the next decade without having no absolute debt which appears very conservative given the relative stable, and recurring nature of cash generation at Shift4. In the DCF I use an 8.5% Cost of Equity, 6.5% Cost of Debt and ~18% Terminal ROIC. This implies a P/E multiple of 17x, modestly lower than the current multiple of 21x P/E as of October 2024. A snapshot of my DCF output is below in Exhibit AZ.

Personally, I’d be very surprised if this scenario played out over the next decade. Even if this occurred, as a shareholder you should be able to own the business and still generate an ~8.5% return which is far from terrible. I’d be very happy to take the over on these assumptions.

What do I feel comfortable underwriting?

In the base case I came up with a set of assumptions that I feel comfortable underwriting.

Starting with 2024 guidance as an approximate base for my expectations. Net revenues are expected at $1.37b, then expected to grow at a 16% CAGR into 2034. Driving this is E2E payment volume growth growing at an 18% CAGR, the gross take rate falling from ~2.1% to ~2% over the forecast horizon due expectations of more growth from Hospitality, and larger enterprise customers. Gateway revenues are expected to decline at 2% each year as these customers continue to convert to the E2E solution. Subscriptions expected to grow double digits until 2030 then continue to decelerate to ~7% growth in the terminal year. For network fees we expect them to modestly decline to 140 bps but about in-line with 2023 expectations for the firm - I’m uncertain they can get much more leverage on this line item but it remains possible. Exhibit BA shows my overall net revenue growth expectations, segment gross revenue expectations and take rate expectations.

Using 2024 Guidance as a base implies another >500 bps improvement in margins as benefits from operating leverage, and scaling of fixed costs help profitability. We expect G&A to fall to the low 20s by 2034, a 500-bps improvement, roughly half of what was achieved from 2020 to 2023. Advertising and Marketing expenses and professional fees fall modestly as a % of revenues approaching 3% and 1.5%, respectively in our terminal year. With these expectations this implies EBITDA margins reach ~50% in 2034, after modest decline in 2029 driven by reduced operating leverage. Exhibit BB outlines the operating costs figures as % of net revenues, Adjusted EBITDA and adjusted EBITDA margins.

To deliver on this expected EBITDA growth, I kept Shift4’s reinvestment needs roughly flat at 14-16% over the forecast period – largely matching depreciation. Incremental capital will be deployed via M&A, but I don’t underwrite any incremental acquisitions in the model.

With high teens EBITDA growth, Shift4 deleverages rapidly over the forecast horizon. I have them paying off all of their outstanding debt by 2029 then building up net cash on the balance for the terminal year. This leaves a large buffer for returns of capital to shareholders. Even with the net debt repricing at 6.5%, absolute interest costs fall over the horizon. FCF to the Firm reaches >$1b by 2033.

In the DCF model I utilize a 8.5% cost of equity, 6.5% cost of debt, 18% terminal ROIC and a 3% terminal growth rate. Using these assumptions, the implied terminal multiples are ~19x P/E and ~8.7x EV/EBITDA. Fair value in my base case is ~$130/share, which is 44% higher than the current stock price and implies an 10Y IRR of ~13%.

You can adjust my assumptions in the model below if you have different views on the key drivers. Below in Exhibit BC is a snapshot of my DCF output.

2024.10 Shift4 Payments Model (FOUR) icemancapital.substack.com

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Conclusion

All said, FOUR is an exciting business and operating in a consistently growing area. Payments generally grow at a multiple of GDP and should be more insulated than many other businesses even if a recession occurs. There appears to be significant reinvestment opportunities both organically and inorganically. They have cycled past a period with higher debt, substantial M&A integration, and new geography/vertical expansions. The future looks bright. Shift4’s competitive position appears strong, but the payments space will continue to evolve and future pressures or competitive threats may come from unexpected areas. As far as I can tell this is an above average business that should be able to generate ROIC’s ahead of its cost of capital for many years to come. In my opinion, Shift4 is set to create a ton of shareholder value over the next decade under Jared’s leadership. Given the relatively attractive risk/reward, I am currently a Shift4 shareholder.

As always, if you have any questions or disagree with any of the analysis/views, please fire away in the comments below. You can also reach me on X/Twitter at @icemancapital or icemancapital@gmail.com. Thanks for your time and interest in the idea.  

Overview

Fleetcor Technologies ( ) is a global B2B payments business focusing on fuel cards, accounts payable automation, foreign exchange, lodging, and toll payments. These solutions collectively provide a faster, more secure, and timely way to execute the payments component of operating their businesses. Each solution they have shares a similar set of characteristics, including largely focusing on businesses as customers where spending is relatively predictable, having a high percentage of recurring revenues, and requiring specialized technology platforms and proprietary payment acceptance networks. At its core, FLT enables their customers to optimize their own spending.

In late 2019, the Federal Trade Commission (FTC) filed a complaint against Fleetcor, alleging they had made false fuel savings promises and deliberately hid fees from customers. Uncertainty from the lawsuit, negative impacts from COVID-19, and an emerging concern from investors about the fuel card business as EV penetration increases all led to poor stock price performance. FLT was down 36% from 2019 into YE2022, underperforming the S&P500 and WEX by ~500 bps annualized.

The FTC case was closed in June 2023 with only injunctive relief requiring better disclosures and a negligible impact on financial performance. COVID-19 pressures on the fuel card, lodging, and tolls business look to have been transient, with FY2022 data showing a recovery to ~115% of 2019 revenue levels. Finally, the concern about the long-term value of the fuel card business is overblown, and they continue to invest in additional B2B payment capabilities, diversifying the franchise. Current market expectations still reflect some of these overhangs, which feels too punitive.

My base case fair value estimate is $400/share, implying a 10Y IRR of ~15%. In my view, the current share price represents an attractive entry point for owning a niche payments business led by a strong owner-operator (Ron Clarke) that also owns 5.5% of the company.

I’m still figuring things out, so feedback/comments on my assumptions or any analysis I have here is appreciated. I can be reached at icemancapital@gmail.com. Please see below for my DCF model, where you can find all of my key assumptions in the base case.

2023.07.24 Fleetcor Technologies Model icemancapital.substack.com

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Introduction to Fleetcor Technologies

Fleetcor Technologies (FLT) is a global business payments company, and its solutions can be broadly grouped into two buckets. The first is employee spending on operational expenses, such as when an employee utilizes a fuel card to refill a company-owned or operated vehicle. The second is corporate payments, such as when FLT can enable a customer to automate its accounts payable payments process to pay suppliers or other vendors. For the second bucket, there is often a distance between the group/individual completing the spending and the authorizer or group eventually making a payment. The former spend occurs on a more decentralized basis, and the latter occurs on a centralized basis, resulting in distinct requirements for each product to provide value to its customer base. The common thread between the businesses is that spending tends to be regularly recurring and relatively predictable over time. Exhibit A shows the historical revenue breakdown over time. As reinvestment opportunities have become more limited in the fuel market, the company has prioritized growth in non-fuel markets, diversifying the business.

While FLT serves customers in more than 165 countries, 85% of revenues last year came from the United States, Brazil, and the UK. In 2022 the company began to report revenues and operating income under a slightly different definition which I show in Exhibit B. The company’s origins lay in the Fleet business, which has the highest operating income margins of any segment in its portfolio.

History

Fleetcor’s history goes back to predecessors starting in the 1980s when fleet card acceptance networks were initially being built to meet the needs of commercial customers. On the supply side, truck stop networks were rapidly being scaled to meet over-the-road fleets (OTR) requirements, including higher canopies, high-speed pumps, dining and shower facilities. Major oil companies also created larger networks and benefitted from increasing card acceptance trends. Cardlock networks which are unattended and generally located in industrial or commercial areas also grew during this period.

In 1985, the Fuelman network was created with an initial focus on individual merchants but then expanded to include regional and national brands. At the time, they entered into franchisee agreements for 20 years, allowing their partners to access their payment technology. In return, they could sign up local/regional operators or gas stations in their markets. These partners would then pay back 5% of the total spend, a very high rate back to the FLT partners. Then, 10% was paid back to Fleetcor from all this revenue. The merchants generally saw higher volumes and spending, and FLT, in turn, received steadily growing royalties.

However, the economics for partners didn’t turn out to be as attractive as they had planned, and the majority of partners were close to or losing money at the time. The strained franchisee economics limited incremental growth prospects. At the same time, investment in maintaining and improving its payments network and at least some balance sheet mismanagement led to FLT itself being very close to bankruptcy. This led to Summit Partners injecting $45m into the business and the introduction of Ron Clarke to turn around the operations. They capitalized on an option within the initial agreement with franchisee partners that allowed them to acquire them at ~3-4x multiples of EBITDA. They also pursued a strategy of adding more regional and national convenience stores into their fleet program. Then through centralizing many functions and adding scale through the acquisitions, they were able to improve profitability.

In 2006, Bain Capital invested $75m into FLT, allowing them to acquire KeyFuels, a UK-based fuel card business. Keyfuels provided them with a European base, which they utilized for additional acquisitions of Abbey Fuelcards, CSS, ICP Smart Concepts, the FuelCard Company, and Petrol Plus Region. At this point, though, they didn’t lose full focus of the US market and won a contract with Chevron in 2007. Advent invested an additional $46m to support European expansion, which led to the launch of the BP Mastercard and the Fleetcard web portal. As the economy softened in 2009, it bought Corporate Lodging Consultants, eventually becoming the basis for its current lodging segment.

In 2010, FLT went public on the NYSE. Consolidation activity in new geographic regions continued into the mid-2010s when eventually, they began to expand their corporate payments portfolio. Sem Parar, its Brazilian Tolls business was acquired in 2016 and in 2017 FLT acquired Cambridge Global Payments which added international FX B2B capabilities. In 2019, it completed the acquisition of Nvoicepay, an AP automation provider; Sole Financial, a payroll card provider and Travelliance, an airline lodging program. In 2022, FLT acquired Accrualify, an AP software firm – pretty much since the mid-2010s, incremental capital was spent on “Beyond Fuel” aspirations, leading us to today, where most of the revenues are from non-fuel card sources. 

Business-to-Business (B2B) Payments Market Overview

Before we get into a detailed description of payments, I think starting the conversation with how a typical consumer-to-business payment works makes sense. In Exhibit C, we can walk through the major steps needed to complete a transaction—initially, the cardholder swipes/taps at a merchant’s point of sale terminal. The merchant then sends a clearance request to its acquiring bank, which is passed onto the network and eventually to the card issuing bank. The issuing bank then approves or rejects this transaction through the network. The card network will finalize the calculations (including tip or finalized amount) and enable the issuing bank to pay the acquiring bank/merchant. What the consumer sees is effectively an instantaneous transaction, but in reality, it takes a few days if you include the settlement period.

Exhibit D provides an illustration of how a typical B2B transaction occurs. Employees will initially identify a product or service they want to purchase and seek manager approval to complete that transaction. After getting approval, a purchase order is sent to the supplier. Once the purchase order is processed or fulfilled, the accounts receivable department of the supplier will send an invoice to the customer. The customer’s accounts payable department will then review & reconcile the final invoice with documentation from the supplier’s accounts receivable department. If approved, the AP department processes the invoice, and a payment is made to the supplier’s bank. A B2B transaction can easily take 30 to 90 days to complete, substantially longer than a typical C2B transaction which is usually ~2 days. In general, there are many more touch points in the B2B space due to the required checks & balances involved with what are usually large transactions. 

Exhibit F provides a simple comparison of how transactions between these two categories differ. The processes most businesses utilize to pay other businesses involve more steps, more time, and, as we will touch later on, a higher share of cash/check which are much more manual payment mechanisms. B2B transactions often involve payments through multiple networks and currencies. In contrast, a C2B transaction may only occur in a few payment methods and likely one currency where the consumer is located. Contract terms for each B2B transaction may also vary depending on the significance of the customer or supplier but are very likely standardized for C2B transactions. The biggest differentiator is likely that multiple decision makers and checks/balances are in place for B2B transactions where a CFO, Controller, or Accounts Payable Clerk is eventually responsible for making approvals and payments. The average size of a transaction is much larger for B2B transactions, and B2B markets often involve a formal contract between two parties. Products are usually received first in B2B markets and then paid for, while it is often concurrent for most C2B transactions. 

The B2B market where FleetCor participates is ~3-4x the size of C2B markets. MasterCard estimated the B2B market was $25T for North America and $125T globally in 2017-2018. This TAM isn’t necessarily entirely relevant to FLT, but I’ve shown in Exhibit F that a significant share of B2B payments are still being made by check & cash. The B2B market is still very check and cash-heavy because ~50% of transactions are invoiced on credit and business owners have historically been comfortable with these payment methods. There have been few catalysts outside of COVID-19 to accelerate this shift materially. SMB owners are also typically unaware of the hidden costs associated with these payment methods and have historically reinvested little into researching the market for better alternatives. Intelligence Insider data in Exhibit F shows that 43% of B2B payments are still made through cash and check and is well above the 19% percentage of the C2B market. Large businesses likely represent >50% of the payment flows. However, a big opportunity for payments companies remains with small businesses where >70% of invoices are manually processed and paid by many hand-signed checks.

Fuel

The Fuel segment provides two major offerings: (1) payment solutions to businesses and government entities that own or operate vehicle fleets and (2) program management services to major oil companies, leasing companies, and fuel marketers.

FLT’s payment solutions don’t just facilitate flows – they also provide customers with consumption data, give them controls to limit spending, and simplify reporting and billing. More importantly, FLT can aggregate buying power, negotiate discounts with suppliers, and share some of these savings with their customers. Essentially, they’re pursuing a shared scale economies strategy, which matters for fuel but can also extend to non-fuel purchases like oil, filters, washer fluid, etc. In select regions, they also offer maintenance services or, in the case of Brazil, indirectly provide an insurance product.

FLT utilizes 15 proprietary payment networks comprised of +80,000 sites to fulfill this demand. In addition to these proprietary networks, they use the MasterCard and the Visa network in select areas. Given the scale of this network, they are uniquely positioned to meet the local, regional, and national needs of their customer base – you can think about this like the one-stop solution for customers regardless of size. FLT enabled >11b annual gallons of fuel pumped globally in 2022, which would have represented ~8% of all the gasoline the US consumed in 2022. 

The company’s second offering - program administration services - also benefit from scale. This solution allows an oil company or convenience store operator to outsource all its sales, marketing, credit, system management, and administration of their entire fleet card portfolio. Through the aggregation of customers, FLT can spend a lower proportion on building and maintaining systems than customers would if they had attempted to replicate these capabilities in-house. The same benefits are realized from Fleetcor’s investments in physical and digital distribution.

FLT’s relationships on the supply side (gas stations) are critical in creating the overall proposition on the demand side (fleet operators) – you need both sides at scale to create value for both partners. The benefit for the locations included will be more volumes at the expense of price per unit. So as long as FLT can actually bring volumes to a site operator, the overall economics of partnering with FLT can still be accretive. Convenience store operators generally have high margins in their stores vs. on the pumps, so even if a small proportion of the incremental fleet customers come to purchase food, drinks, or other merchandise, it can benefit store profitability. For fleet operators, a lower price per unit of fuel is an explicit benefit. At the same time, simplified administration and reduced fraud are harder-to-quantify benefits that are still important in the overall value proposition.

Shifting to competitive dynamics in the Fuel Card market, we have generally seen consistent consolidation trends globally – but this phenomenon has been most extreme in the US, where the market had >7 major competitors in 2012 but by 2017 was left with only ~3 major players, as shown in Exhibit G. U.S Bank owns the Voyageur Fuel Card offering which skews towards government fleets and is an area where FLT/WEX rarely compete. Additionally, there have been reports that U.S. bank has stopped investing in this product line, turning the market effectively into a duopoly. Today, this appears to be the least competitive market they sell into, and operating income margins of >45% seem to suggest the same.

FLT’s customer base skews heavily towards small or mid-sized customers where fuel card penetration remains low – while for WEX, its primary competitor, its portfolio skews towards large partners where incremental penetration gains should be much more difficult to achieve. For the over-the-road (long haul) trucking market, penetration of fuel cards is >90% and >60-80% for medium to large-sized fleets. There appears to be limited evidence that this duopoly will be disrupted as well – even with the recent entrance of upstarts like CoastPay, AtoB, and Motive, neither has seemed to gain critical mass or be able to compete on a discount or security basis meaningfully. The medium-term outlook for the business appears attractive, given limited competitive pressures and highly probable penetration gains with SMB customers going forward.

Despite the solid state of the segment today, investors are right to look out into the future as to what a portfolio of fuel cards could be worth. From now on, mixed fleets seem like they will be very prevalent and will create complexities that some operators are not yet prepared to deal with. With legacy ICE assets, they will need to use fuel cards as they do now, but with EV assets, the customers will need help to find, pay and report on the usage of public recharging transactions. Also, recharging a fleet asset at home becomes possible, but employees are only likely to commit to this if a smooth reimbursement process is accessible. FLT has had the foresight to recently assemble a portfolio of EV Charging networks, EV Software and At-Home Recharging capabilities to help manage any fleet portfolio customer. Exhibit H shows the key assets in this portfolio.

A few corporates, including Virgin Media O2 (UK Telecom), seem to have bought into this value proposition. Fleet transitions are remarkably early – Virgin O2, for example, has bought just 400 EV vans, and the overall size of the fleet is 4,300 vehicles today. As this gets converted, it should create incremental opportunities for this part of their portfolio. There would be offsets as the uptake of EV penetration would cannibalize fuel card volume demand over time. So while there are some positive anecdotes here, ultimately, there is some uncertainty as to what the economics will be for them, and despite being pushed by the sell-side repeatedly on recent calls for details, they have yet to outline any detailed explanation of the economics. Its great management has been proactive about building a solution for them, but far more difficult to get comfort that the future economics of this business will be nearly as attractive as the legacy fuel card market, especially as competition from charge point operators, utilities, and other competitors seems to be abundant.

Corporate Payments

Corporate Payments is the next largest segment, representing 23% of revenues and 18% of operating income. FLT’s portfolio of solutions here aids businesses in streamlining back-office operations and making payments to different vendors. A customer can save time, reduce processing costs, and manage payment flows more efficiently using these solutions. They offer Accounts Payable (AP) automation, virtual card issuance, cross-border payments, purchasing card, and Travel & Entertainment Cards.

Starting with its Accounts Payable automation offerings can allow a company to automate its entire AP process, including domestic and international payables – an illustration of this is shown in Exhibit I.

Their systems allow a simplified way to scan invoices through prebuilt workflows and integrations with accounting systems like QuickBooks, commonly used at SMBs. For larger businesses, Fleetcor’s mid-market offering provides more capabilities, including thorough approval workflows, bank account data, on-demand reporting, and integration into major ERP offerings. Like other software or integrated tools switching costs are meaningful in that they can disrupt current operations and may require retraining of the employee base.

Given the attractive nature of the market, competition levels are likely to be in flux at some point. Competitors like AvidExchange have historically skewed towards the mid-market real estate sector, and Bill.com has skewed towards small businesses. Both of these rivals have begun to branch out from their initial focus areas, Bill beginning to go upmarket and AvidExchange diversifying its exposure into other sectors. But, the reality of it is that most of the AP automation offerings in the marketplace are not that differentiated relative to each other. Potential customers select an automation solution based on ROI (broadly similar), followed by ease of implementation and possible mitigation of execution risks. Several experts on Tegus confirm this as a priority over having a superior API set and software stack, which might only become highly sought-after characteristics with larger enterprises with more complex needs. Even then, with an estimated $12 per savings per transaction through automation, as shown below in Exhibit J, there might be enough potential penetration gains that drive growth for all players well before competition levels become more intense. For now, the value proposition is attractive, and penetration gains should drive attractive levels of growth for all players – but we won’t ignore the potential risks of this changing at some point down the road.

FLT’s scale in issuing virtual corporate cards in North America is unrivalled. They were most likely one of MasterCard’s largest partners, enabling $36b in virtual card payments last year, and were ~30% of all virtual volumes. Virtual cards are an unusual product compared to other payment methods, as each card is typically single-use for a specific amount or timeframe. Virtual cards are only accepted when a vendor accepts this as a payment, and an individual negotiation involving setting the Merchant Discount Rate (MDR) is part of the process. FLT’s acceptance network is estimated to be ~2-3x the enrollment rate relative to industry levels and about 4x the size of AvidExchange’s network. Another benefit for corporate customers to utilize a virtual card for payments is that they can capture some of the interchange fees in return. FLT highlights it has paid +$800m annually to customers in rebates as spend goes through this offering. So for many companies, there are benefits on the cost side as efficiency benefits are realized, a revenue benefit from rebates, and a harder-to-quantify but still valuable benefit from having fewer security-related incidents. Exhibit K below highlights the major steps involved with virtual card usage for customers. 

Longer term, it certainly seems difficult to know who the clear winners are in the corporate B2B payments market over time at this point, given the substantial fragmentation and potential risks of Mastercard/Visa increasingly speaking to opportunities in B2B markets, as shown below in Exhibit L. The launch of real-time payments network like FedNow could also add risks or displacement potential to parts of the overall offering, which I might not be able to envision yet. ACH has taken the majority of cash/check conversion in the past five years while card spend is growing too; it has been at a slower rate. MasterCard has increasingly been discussing B2B opportunities as part of its Value-Added services portfolio and highlighting an automated payables solution on which they partner with AvidExchange. Barring the realization of these risks, I’d think the outlook is attractive for now. They have a full suite offering in B2B payments, a long list of SMB customers who could potentially utilize this product, and tailwinds from the ongoing shift from checks/cash to cards.

Lodging

FLT’s lodging business was one of the first accommodation networks in the US to provide pre-negotiated rates to customers for B2B customers. Over time, FLT built out additional offerings for different sectors to help airline workers, passengers, and insurance policyholders who may be temporarily displaced from their homes. Its ability to efficiently serve the airline and insurance industry has led them to scale to >$100m in revenues for each vertical in 2022. FLT’s portfolio of solutions has expanded through acquisitions, including Roomex, Levarti, ALE Solutions and Travelliance – each added scale, sector expertise or technology capabilities.

They primarily use their proprietary hotel network to fulfill customers’ needs. Like their Fuel segment, FLT provides comprehensive reporting, control, and audit services. Similarly, they pursue a shared scale economies strategy, which allows them to negotiate ~40% discounts and pass on a portion of this lower pricing to the customer base. FLT was estimated to book >37m room nights in 2022, which is quite meaningful in absolute terms. The nature of these bookings is also very low risk as a corporate customer bears the cost, and the solution is a need, not a want which could be delayed/rescheduled if preferences change (which is what can happen with discretionary leisure travel). The business can provide a highly certain improvement to occupancy levels for hotels in its network. It’s worth noting that when the solution is needed, they are not giving the customer a wide range of hotel offerings but rather a quick & easy, cost-effective lodging option. Last year in the US, FLT believes they saved clients ~$420m in costs through its industry-leading purchasing power. Exhibit M provides a sample overview of the critical components of this value proposition.

FLT’s competitive position in the market should remain solid, given its scale and integration into operational workflows. When combined with discounted pricing, the reporting, monitoring, and integrated controls create a strong value proposition for customers. Exhibit N shows how FLT has ample opportunity in the future as <10% of the customer base utilizes all three of its major solutions, but +40-90% of these customers have needs across the whole portfolio. As FLT capitalizes on this cross-selling opportunity, this should drive more volumes to their lodging network and allow them to continue growing at attractive rates over the long term. 

The last major pillar in the Corporate Payments Portfolio is FLT’s Cross Border Offerings, often bundled with Accounts Payable Automation and Virtual Card solutions. Customers skew towards small to medium-sized enterprises that utilize the offering to pay international suppliers and operate foreign entities. FLT also provides hedging and risk management services to the customer base to help mitigate impacts from variability in foreign exchange rates. The company offers this settlement and payment offering through a network of correspondent payments, domestic payment networks, and technology providers, allowing them to send payments to over 200 countries and over 145 currencies. Like the fuel card offering, they also offer a white-label platform for financial institutions looking to leverage FLT investments. Scale is also an advantage here, given they are the largest non-bank FX dealer in the world, and customer satisfaction seems high as well, given +100% revenue retention last year. FLT can aggregate data from partners/customers to identify suspicious or higher-risk transactions. The biggest concern for customers is that they are not violating any major regulatory rules, and FLT can invest in infrastructure to mitigate the potential for violations or fines. The acquisitions of Global Reach Group and Associated Foreign Exchange both improved its portfolio of solutions and geographic diversification vs. what was historically a very North American-skewed business. 

A case study posted on the FLT website discusses how G Adventures ™ benefited from its Cross Border offering. This company had >150,000 customers annually and vendors located around the world. FLT helped them identify that their payment processes had too much manual intervention, which led to inaccuracies and an inefficient system. Corpay (Corporate Payments Segment) provided an automated payments solution that aggregated all payments in a home currency and then settled it into customers’ accounts in 1 amount (instead of multiple that had occurred before). Corpay then continued to work with G Adventures to enhance its payment processes. This led to creation of an aggregated payment and information file that G Adventures could use for reconciliation purposes. We show both of these processes below in Exhibit O. Upon completion of these changes; there was significantly less human intervention & manual processing needed for day-to-day operations, a clear win for the customer.  

Rounding it all out, each of the significant product offerings faces differing levels of competition. But, when FLT can bundle & sell this to a customer, the potential for substantial future challenges is reduced. There is the potential for this segment to represent the majority of revenues over the long term and, through additional acquisitions, have the potential to widen the competitive position for longer-term profitable growth.

Tolls

In 2016, Fleetcor expanded into Brazil by acquiring Serviços e Tecnologia de Pagamentos S.A. (STP) for $1.05b USD. They acquired this from a shareholder group including CCR SA, Arteris SA, Raizen Combustiveis SA (Shell + Cosan JV), and others. STP had near-national coverage in Brazil using its Radio Frequency Identifier (RFID) payments offering. In 2016, they processed $2.5b in payments for 4.5m users, which grew to 6.3m users in 2022. STP had 100% coverage on all roads that accept RFID in Brazil, which from my understanding, is all of the major routes and as shown below in Exhibit P, and is centralized in areas with the highest population density. The acceptance of this payment offering has expanded to include a broader range of use cases today, including parking, fuel, car wash, and quick service restaurants. 

In 2018, FLT also partnered with Arcos Dorados (NYSE: ARCO), the world’s largest independent franchisor of McDonald’s locations, to include the Sem Parar acceptance. The user experience management talked about sounded fantastic. Customers must have the toll tag on the dashboard and say, “I’m paying with Sem Parar,” and the payment is completed. ARCO ran this pilot on about ~1/3rd of restaurant locations at the time, but since then, we haven’t heard much about scaling this to ~1,100 restaurants owned/operated today. Sem Parar talks about +750 drive-thru locations (QSR merchants) accepting payments today; it’s very far from having meaningful penetration across the >120,000 restaurants in Brazil.

The actual Sem Parar solution is similar to the Fuel segment in that users will pay a monthly fee to access the product. What is different is that all the spend that goes through the toll product is passed on to the merchant, and most revenues are generated from the monthly fees. FLT’s premium toll plans include the addition of 1 audiobook per month, roadside assistance, and incremental financial insurance coverage. I guess that, in aggregate, their exposures skew to middle/upper-class consumers in Brazil. The recurring income stream makes it one of the highest-quality businesses in its portfolio.

Edenred, a competitor in Brazil, is amongst the few competitors to watch. Edenred acquired Greenpass, an alternative toll payment network in Brazil, and as it is integrated with their #1 fuel card business in LATAM, it could create more competitive pressures than we’ve seen in the past. However, what is more, important is that penetration of toll products is still incredibly low at ~13%, so both players are likely able to participate in market growth from alternatives rather than compete for market share from each other.

Other Operations

FLT’s portfolio also includes two other products - a Gift Card and a Payroll Card, representing 14% of revenues in 2022.

The Gift Card operation offers complete program management and processing in 64 countries, issued under the customer’s brand name but accepted in-person or online. Adding a gift card to a merchant’s payment offerings can increase loyalty, sales, and float and generate income from breakage fees (which is income generated from balances left on gift cards that are lost or never utilized).

The company also offers a payroll card in North America, which replaces payroll checks and runs on the MasterCard and Allpoint ATM network. The wages earned fund these accounts, which can then be utilized to complete purchases, transferred into other accounts or withdrawn directly from.

This segment has had little growth over time– I’d expect it to be divested eventually, given it has little overlap with the broader B2B strategy and customer base.

2019 FTC Case

On December 20th, 2019, the FTC filed suit against Fleetcor for falsely telling "potential customers that they would save money, be protected from unauthorized charges, and have no set-up, transaction, or membership fees." The complete filing is available here if you want to read the source document. These fees are estimated to have totalled "at least hundreds of millions of dollars," covering thousands of customers. The FTC claims that the three central claims they make to customers, including saving money, fraud controls and no set-up transaction or membership fees, are all false. We'll review all the allegations and some related excerpts from the document shortly.

The first claim the FTC makes is that customers are not saving money, which is likely due to the fees they charge for their products. Then in reference to what I believe was a response to the Citron report highlighting a similar claim – Clarke (CEO) asked employees to calculate the total US retail discount customers are getting, but the analysis only indicated they were saving "a fraction of a cent per gallon." This is a far cry from the 20-cent claim outlined in a previous advertisement shown below in Exhibit Q. But, even today, Comdata's lowest tier offering makes similar claims in that they could help the average fleet save ~$3,000 per truck using their solutions. In my interactions with the company, they have highlighted they roughly give pricing to their fuel customers at the midpoint of the wholesale and retail price. My best guess is that customers realize some savings, but it is probably not the magnitude they advertise, and the significant reason here could be that some customers don't reach the volume thresholds required to realize the full savings potential.

The second claim is that the cards “protect customers from unauthorized transactions.” When a customer signs up, they can select what authorizations will be set up for each person or driver. This process seems relatively straightforward, but it appears some of the controls on select cards (not all) might have been too weak on their part, allowing the sale of some additionally available merchandise (snacks, beverages, etc.) due to some internal issues. It likely stems from their network being built through multiple acquisitions and may not operate flawlessly. It doesn’t seem like they would willfully set up their systems to allow this behaviour or that it is happening on a wide scale. Another thorny issue highlighted is that with the fuel cards, the customer agrees to be responsible for all activity on the account regardless of whether they are within or outside the initial parameters set up. Most consumer cards don’t function like this. Unless a mom/pop plumber operation in your local town is rigorously reviewing the terms and conditions, it seems reasonable that they could be surprised negatively. Rounding it out, I think there are probably some cases where the initial setup goes awry, and they might sometimes hold too aggressive of a line with customers. But, I find it very difficult to think a business of this scale (>11b gallons per annum) isn’t mitigating at least some of these leakages – especially as they have begun to focus on retention rates which have drifted to the ~93-95% range in recent years.

The last and final claim seems at odds with what is disclosed in the terms and conditions. A review of the latest T&C quite clearly shows many of these fees outlined as part of the overall agreement. This doesn’t necessarily mean that in the past, there weren’t some less-than-ideal behaviours at FLT – even some customers argued that the company should change its name to “FeeCor.” Experts on Tegus have discussed how the firm used to take a very aggressive approach with fees following an acquisition utilizing it as the main driver to improve profitability. Account attrition would occur as expected, but the net benefit was still positive as tight expense controls, and this shift fee mix from customers would drive margins >50%. My best guess is that many of the small and medium-sized businesses they end up signing on are just not scrutinizing the contracts before signing them – this is sort of the opposite of what would occur at larger firms where specialists would review any credit or related terms and conditions for any contract they are signing. This also seems to be why WEX has continued to win with the largest fleet operators over time by taking a less aggressive stance. One other claim is that customers need to pay per-transaction fees in select situations. A common scenario where this would occur is if a customer wants to fill up from a merchant who is not part of its preferred network. The cost profile differs as the volume is pumped from out of the network, and FLT needs to charge appropriately for that. Exhibit S is an excerpt from the case filing outlining this issue. 

Further muddying the water is that many customers in the past have complained to the company and the Better Business Bureau (“BBB”). Ratings on the BBB website are pretty nasty, with an average rating of 1 out of 5 from an average of 90 customers. There isn’t much to counter here – this is probably far from the most customer-friendly organization, with many of their processes for dealing with customers, payments, and potential issues skewed toward the more aggressive side. However, it seems there is also a high possibility that its underlying IT systems assembled through frequent M&A lack thorough integration and may be much more prone to challenges that create errors that customers continue to report. 

In response to these claims, the company highlighted that the FTC allegations were only related to the North American fuel business, which generates ~$650m in revenues. Exposure at risk would fall by 50% as about half of that is generated from interchange fees, which means 15-20 % of EBITDA could have been at risk (2023), which is a meaningful dent but a manageable situation if it were to disappear. The other mitigating factor is that over time Tegus experts have highlighted that WEX T&C have drifted towards FLT standards but don't appear to be under the same scrutiny. 

Putting all of this aside for a moment and viewing the situation from 10,000 feet - most financial companies will have some complaints and unhappy customers. The public data in the release shows that complaints only occur 1x per 28,000 invoices (0.0036%) and are favourable relative to other card issuers. This doesn't scream behaviour so egregious that the company won't be able to remedy these issues over time. 

This cloud was officially lifted on Fleetcor as they reached an agreement with the FTC on June 9th, 2023, which required "FLEETCOR to implement a set of disclosure practices, such as crediting customer payments on receipt date or providing notice to customers in advance of receiving a new fee. As previously disclosed, FLEETCOR has voluntarily implemented multiple disclosure enhancements to improve the customer experience." Most importantly, though, is that even with the implementation of these changes, the company does not believe there will be a material impact on the company's financial performance – which was far better than we had expected. 

Management & Governance

Ron Clarke has been CEO since August 2000, before IPO, and Chairman since March 2003. He was initially brought in with the board's support to turn the business around. He definitely did this growing revenues at 19% and Cash EPS at a 21% CAGR from 2010 to 2022. A return on gross spend of ~21% over his tenure also looks excellent. Even with this strong track record, it appears he has been paid a lot over his tenure. As You Sow, a non-profit leading shareholder advocacy group, has ranked him as the 11th highest most overpaid CEO in 2022. This has been a theme in the past as well, going back to 2017, when Ron was getting paid nearly the same amount as the CEOs of Walmart and Starbucks, companies about 4-10x the size of FLT. In four of the past six years, shareholders have failed to approve the company's say on pay. Exhibit U below compares reported votes against proposed management compensation in 2022 and highlights shareholders' general dissatisfaction with either the structure and/or magnitude he is getting paid. 

With only 35% of shareholders approving the company’s last say on pay (2022), the board undertook an engagement process with the largest ten shareholders and a review of proxy advisory firms to identify areas to improve. This resulted in an agreement with Ron to not receive any long-term equity compensation in 2023 – the same as in 2020 and 2022. However, in 2021 he received 850,000 performance-based stock options with stock price hurdles of $350 and $400, respectively, with an estimated fair value of $55m. Annual incentives were based on an equal weight on GAAP revenues, Adjusted EPS (excluding the impact of changes in fuel pricing, fuel pricing spreads, FX rates, and M&A), M&A (and other transactions), and Growth/Other Initiatives. Notably, an ROIC/ROE metric is missing, which could aid in driving incremental focus on underlying returns in the business. Long-term incentives are paid out through a combination of performance shares and options tied to adjusted EPS and net revenue vs. targets, but details are not disclosed. Performance shares utilized an annual performance period which is too short-term oriented, in my opinion, and the metric/target overlaps with one of the short-term incentive metrics. So, for all functional purposes, it is actually a short-term incentive despite being labelled as part of the long-term incentive bucket. Far from perfect from my perspective, but at least the CEO owns ~5.5% of the outstanding stock.

Exhibit V shows the company’s relative TSR compared to benchmarks pulled from the 2023 Proxy Statement, which shows the material underperformance they have delivered over the past five years. This is why D.E. Shaw emerged as an activist shareholder and drove the creation of a strategic review committee and the introduction of 2 new board members. Potential spin-offs or an asset sale could materially change the sentiment on the stock. 

Valuation

The primary driver for FLT topline growth will be through growth in the number of transactions of each segment and the revenue realized from each transaction. Above in Exhibit W, we highlight our expectations on a segment basis out to 2033, which collectively gets to a 5.8% CAGR on a group basis. Additional details on the per transaction and volume expectations can be found in the model. These expectations are far below management's guidance for ~10% revenue growth over time (including M&A).

Below in Exhibit X, we expect gross margins to be relatively flat over our forecast period, roughly in the ~80% range in-line with historical trends. EBITDA margins are expected to expand by about 300 bps through operating leverage on selling costs as cross-selling is prioritized, and G&A is optimized over time.

This collectively leads to GAAP Net Income CAGR of 8% during our forecast period, with EPS growth expected at a 14% CAGR driven by buybacks where we deploy excess cash flow in our base case. ROIC is expected to gradually improve towards 25%, largely driven by falling improving NOPAT margins and only moderate growth in invested capital base during the forecast period. Excess cash builds on the balance leaving ND/EBITDA at -0.3x in 2033, leaving ample capacity for M&A if opportunities emerge.

My base case suggests that fair value is $403/share, which is well ahead of the current share price of $241. Exhibit Z shows a screenshot of my DCF output tab.

Conclusion

FLT is a niche payments player with an effective capital allocator at the helm. I believe the company has cycled through the worst impacts of COVID-19, the FTC case and concerns about its longer-term positioning with its refreshed fuel/mobility offerings. I see good growth opportunities across the company’s portfolio, and through cross-selling solutions to its large customer base should be able to drive above-market-like growth for many years to come. I believe you could generate an ~15% IRR from the stock today. Alternatively, the stock trades at a 14.7x P/E, a discount to the 17.8x P/E it has traded at over the past five years, and the business should be able to compound earnings at least a low teens growth pace driving similar return expectations. As always, feedback is appreciated.

Share Iceman Capital

Investment Thesis

Floor & Décor Holdings () is a leading hard surface flooring retailer in the US. The company sells luxury vinyl tile, laminate, hardwood and natural tile flooring to residential and commercial end markets, with a 95%/5% split of revenue respectively. The top 5 players in US flooring have ~44% market share, with FND sitting in third place at ~9% share. FND’s main competitive advantage over the long-tail of smaller players is scale. Although the other four main competitors also benefit from scale, FND has been able to differentiate themselves from their larger competitors by the following:

• Larger stores allow the company to carry substantially more product SKUs and inventory on hand, which allows FND to fulfill immediate customer demand and provide more convenient customer services.

• Scale allows FND to source product directly from suppliers, which reduces the use and cost of agents/brokers, importing partners and distributors. Some of those cost savings are shared with customers and helps support more competitive pricing.

• Purchasing power over a fragmented supplier base. The company has >240 suppliers in 24 countries around the world.

• Superior customer service, which includes dedicated service teams for professional customers, digital applications, a loyalty program, design services that provide customers with end-to-end help from envisioning a project to executing installation of a project, and a full offering of all equipment and additional supplies required to complete flooring remodeling projects.

• A national footprint that should also allow them to meet the needs of larger commercial customers who operate across the country.

• Other value-added services including free storage in store, a customer friendly return policy and financing.

FND has seen its market share increase to ~9% over the last two decades, and as they grow, they should continue to see incremental benefits from its scale. Consumer preferences over the past decade have demonstrated a preference for hard surface flooring relative to carpet due to hygienic, durability and aesthetic reasons. FND remains very well positioned to continue winning market share in the flooring market, particularly from the long tail of small competitors.

The company’s two largest competitors, Home Depot (HD) and Lowe’s (LOW) have taken an approach to prioritize high turnover and lower inventory levels at the store level to generate an attractive ROIC. Their utilization of middlemen keeps inventory at the supplier/partner level until they require it. FND in contrast, prioritizes higher levels of inventory and no use of middlemen which should generate a similarly attractive ROIC over time. I believe FND is well positioned to grow faster than the industry as it replicates its store concept in more markets in the US, and potentially in Canada over the long term.

FND’s large store size and focus on the hard surface flooring market drive a superior customer experience. The company’s direct sourcing model eliminates the utilization of middlemen, which are widely used across the industry, and as a result it can obtain superior pricing for its customers. FND’s stores are also built to inspire and encourage customer interest in new innovative products and design trends. The company’s ability to help customer design remodeling projects from a blank canvas is a substantial differentiator compared to peers. FND has also dedicated substantial resources toward meeting professional customer needs, which I believe is important given the frequency of purchasing and influence they have on end customers who only seldom purchase hard surface flooring.

Lastly, the management compensation framework is robust with long-term compensation based on a ROIC minimum of 17% and EBIT growth targets. Annual bonuses are paid out based on net sales growth and operating income. Equity ownership is low, but I believe the FND employee stock purchase plan (ESOP) is attractive and aligns the employee base with shareholder interests. I would characterize management as very strong operators and believe capital allocation has been strong throughout the leadership of Tom Taylor, current CEO.  I believe that over time after the store footprint has been built out excess cash will be returned to shareholders through a combination of dividends and buybacks, and I expect they could repurchase ~56% of the float over the next decade as new store investment tapers off.

In the base case, I estimate that fair value is $85/share, which is in-line the current price of $86/share, and implies a 10-year TSR of 10%. In my view, the current share price represents a fair price for owning a high-quality business that has substantial reinvestment opportunities.

I’m still figuring things out, so feedback/comments on my assumptions or any of the analysis I have here is appreciated. I can be reached at icemancapital@gmail.com. Please see below for my DCF model, which has key assumptions built in.

Full Disclosure: I’m currently an FND shareholder, and may change my weight in the future.

2023.03.14 Floor and Decor Model icemancapital.substack.com

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Introduction to Floor & Decor

Floor and Décor (FND) is a hard surface flooring retailer which sells tile, hardwood, luxury vinyl planks and related décor to residential and commercial end markets. The company sells these products through 191 stores, 6 design studios, and ~100 commercial representatives. FND also sells decorative products, fixtures, shower doors and related installation materials. Exhibit A provides a breakdown of the company’s revenue sources by product type in 2022 and historical revenues on a company basis.

Before I dive into the business, it might be helpful to look at how the business model is set up (Exhibit B). FND starts with acquiring flooring and other products from manufacturers or suppliers. They then transport these products to its four distribution centers, which in turn prepare and re-distribute them to stores located throughout the US. At the stores, products are put on display on shelves, built into display vignettes, and eventually sold to customers. About 70% of products purchased in stores are from homeowners and the remaining 30% is completed by professionals. However, given the difficult nature of installing flooring products compared to other household remodeling needs, only about 15% of customers actually install the flooring product themselves –85% of customers rely on professionals to complete installation in their homes, offices, or workplaces. FND does not offer installation services, as they have deliberately decided not to compete with its professional customers. They have taken an approach to partner with the Installation Made Easy Network, which allows certified installers to provide quotes to the customer base – this can create steady source of new customers for professional installers.

A sample of Floor & Decor’s portfolio of products is shown below in Exhibit C and Exhibit D along with different characteristics each of the product may offer. The company aims to provide a good, better, and best offering to meet a wide range of customer needs at different price and quality characteristics. Within each category there is typically a wide range of colors and styles customers can choose from. These flooring products represent ~80% sales for the company. The remaining ~20% is made up of installation materials, tools, and adjacent categories which include bathroom lighting, countertops, shower doors and faucets.

History

Floor & Décor was founded in 2000, by Vice Chairman Vincent West who opened the first FND store in Atlanta, Georgia. His vision at the time was to create a low price leader in the hard surface flooring market. In 2002, they opened their second store and in 2003 there was a management buyout in partnership with Saugatuck Capital and Najeti Ventures. Vincent left the CEO role at this point, and shifted to becoming an active board member. By 2007, the company had grown its store count to 23 stores in total.

Vincent West then stepped back into the CEO role in 2008 adding a higher emphasis on merchandising and advertising at the firm. Amidst a rapidly decelerating environment in 2010, ownership changed again with Ares Management and Freeman Spogli & Co. taking control of the business. In the 2010 to 2011 period, the company was known to sell whatever product was available & often at low end pricing points only. This shifted over time with the hiring of Tom Taylor in 2012, who began implementing a good, better, best product approach. Tom brought 23 years of experience from Home Depot (HD) where he was an Executive Vice President. He has had an impressive career at HD where he began working at the age of 16. After his time at HD, he spent 6 years with Sun Capital partners as a Managing Director serving on the board of directors of ~20 companies in the USA & Europe. I believe his time at Sun Capital refined his capital allocation skills and allowed him to learn about a wider range of business models and strategies.

Under the leadership of Tom Taylor, the company went through a significant reinvestment period. Tom began to build up the management team and processes to improve per store economics and position the company for strong store growth over the long term. Results were encouraging with average sales per store doubling from 2011 to 2016 and further differentiated the company’s value proposition in the hard surface flooring market. The majority of the current executive team was hired during between 2011 to 2014, including Trevor Lang (President), Bryan Langley (EVP & CFO), Brian Robbins (EVP, Business Development Strategy), David Christopherson (EVP, Secretary and General Counsel), and Steven Denny (EVP, Store Operations).

This management team supported growth in the store base to 39 stores by 2013. In 2014 the company re-launched its website FloorandDecor.com and emphasized its Omni-channel strategy with its customer base. At this point, the company had strong store growth momentum and recent trends which led them to file an S1 and prepare for an IPO. The environment for IPOs unexpectedly decelerated for multiple years after this, and peers like Lumber Liquidators were facing elevated levels of scrutiny due to concerns of higher than acceptable levels of formaldehyde, a known carcinogen in many of their products which drove concerns across the industry.

From 2014 to its eventual IPO in 2017, the company continued to build on its processes adding additional distribution centers, running multiple experiments on stores on characteristics like size/location, staffing levels, and implemented a newer CRM system to empower its retail employees. FND began to prioritize Professional (DIFM) customers adding additional employees to serve this group, and eventually adding a robust loyalty program to increase the stickiness/frequency of visits from this group of customers.  In 2017, they finally completed their IPO at $21 per share, and interest in the business was remarkably high pushing the stock up 44% at open, and 53% by close. The capital raised was utilized to pay down debt and provided additional capacity to continue investing into its supply chain and store growth.

As a public company FND continued to deliver strong store growth and same store sales growth which averaged 11.1% from 2018 to 2022. Total stores had grown to 191 up from 100 at the end of 2018. During pandemic, execution at the company remained very strong, and in-stock levels remained high relative to peers allowing the company to capture much of the incremental demand for remodeling during this period. Then in May 2021, the company completed the acquisition of Spartan Surfaces for $90m, which expanded its addressable market to include the commercial flooring market that had an estimated size of $13b at time of acquisition.

Flooring Market Overview

Cyclical but Structurally Growing Market

The US Flooring industry has grown at a 2.7% CAGR from 2001 to 2021, as shown below in Exhibit E. Within that period there have been clear periods of cyclical growth including 2001 to 2006, and the gradual recovery from the 2010 trough to a likely peak in 2022. Expectations are generally for a slow-down in industry wide sales but their does not appear to be much consensus at what specifically that draw down could be in 2023 or 2024. Repair and remodeling demand was inflated in 2021 and 2022 driven by low interest rates, an aging housing stock, above average housing turnover, and growing interest from consumers to upgrade their homes. If I look at the sheer number of flooring retailers in the US, this has gradually declined as market share has shifted to home improvement centers, warehouse clubs and specialty retailers such as FND. As shown below in Exhibit E, industry wide sales have been accruing to a smaller number of stores in the USA.

The company’s overall addressable market is broken down into about 5 different competitor categories including regional retailers, home improvement centers, distributors, specialty retailers and other retailers. F&D estimated that Independent Retailers and Home Improvement Centers held ~2/3rds of the market in 2022 as shown in Exhibit F. FND believes they have been gaining market share from all other areas of the market and I estimate had 9% market share in 2022.

In the industry, the biggest shift amongst competing products has been the rapid volume growth and share gain of Luxury Vinyl Tile (LVT) which has largely come at the expense of Vinyl Sheet, Carpet, and Hardwood. This has only occurred in the recent few years despite this product being introduced to the market in the early 2000s – it was only lately that the design quality, installation ease, and durability performance reached a breaking point allowing it to be installed into many more settings.

“Flexible luxury vinyl can be installed in any room of the home, even bathrooms and laundry rooms. So long as the subfloor is properly prepared, there are not many places where flexible LVT can’t go,” shared Jenne Ross, director of marketing, Karndean Design flooring.

Blakley Satterfield, residential product manager, Mannington, said that traditional LVT is ideal for large rooms, multi-room installations and open floor plans. Additionally, the ability to be installed without transition strips makes it ideal for homes where residents use walkers or wheelchairs. Other benefits include the ability to install cabinets on top of the floor for faster, easier install; ability to be installed with or without grout; and, availability in both plank and tile formats. And due to its durability, flexible LVT is suitable for environments with heavy rolling loads, such as healthcare settings.”

Exhibit G shows that industry sales grew at an 3.6% CAGR from 2008 to 2021. Hardwood grew at a 5.8%, Ceramic & Porcelain Tile grew at a 4.0%, followed by Stone which had a +2.7%. The two slowest growing categories were Carpet +0.7% and Laminate 0.4%. LVT on the other hand grew rapidly over the latest 6-years, where it began to be categorized separately and can see accounted for much of the industry wide growth. On a volume basis, trends were relatively similar in most categories, and industry pricing appears to have increased at a ~150 bps CAGR suggesting little to no pricing power in excess of inflation across the industry. The one outlier trend on a pricing per square foot basis was LVT which has seen a decline in per square foot costs during the last 6-year period. In the past 5 years, there have been qualitative improvements to LVT products, and a relative pricing improvement to alternatives, which I believe explains why it has outperformed most of other hard surface flooring alternatives.

If I look at broader trends including each of the products into broader labels, I can see that hard surface flooring products have won market share from soft surface flooring products. Hard surface market share grew to 57% of the market in 2021, up from 44% in 2012 as shown below in Exhibit H. I believe this has been driven by consumer preferences shifting towards products that are easier to clean, more durable, and have a wider range of design options.

The average life expectancy is longer for hard surface products, which combined with its better price point and easier to maintain characteristics explains why it has been gaining share in the market. This shift has been beneficial for industry growth over the past decade but as the rate of change of market share decelerates so should hard flooring growth. As a result, the average life expectancy of all installed flooring should go up creating potential headwinds for hard surface flooring in the next decade.  The average age of flooring in US homes today is likely below longer term levels.

Homes in the US have steadily appreciated as interest rates have declined. According to the Case-Shiller Index, the average single family home price has grown at an 4.4% CAGR going back to 1987. Home prices in the US peaked in 2006, then fell by 27% into 2011, as shown in Exhibit I. From the beginning of 2012, to Q4 2022 the average home price grew at an 7.4% CAGR approximately, 550 bps ahead of inflation. 30Y mortgage rates have increased 360 bps from a low of 2.7% early in 2021. As a result, housing prices appear more likely to decline (at least in select markets) rather than increase as they have the past decade.

Below J show that Repair & Remodeling Spending has grown slightly ahead of home prices at an 8.1% CAGR the past decade. There is evidence of at least some pull forward of demand during 2020 to 2022 as average spending was up 20% from 2019 levels. On a per housing unit basis, it was up 55% when I compare it to the prior decade average of $1,452/house. To fund these expenditures consumers increasingly drew on home equity lines but this trend has appeared to reverse rapidly since reaching a peak in January of 2022 – it appears unlikely that this is a future source of funding given the uncertain economic outlook and the rapid deterioration in consumer sentiment levels in the past 12-18 months.

Competitive Landscape

Floor & Décor operates in a competitive but fragmented market. The two largest competitors are the two home improvement giants Home Depot (HD) and Lowe’s (LOW), which generated flooring sales in 2021 of ~$8.4b and ~$4.9b, respectively. After these two, Floor and Décor is the largest individual flooring retailer by sales in the US, as shown in Exhibit K. The industry is relatively fragmented with the top 5 holding ~44% market share but independent’s such as family-owned entities or regional players still represented ~53% of industry sales. FND management has highlighted in the past that they believe they have been winning market share from multiple areas due to its attractive value proposition, and industry trends towards hard surface flooring products.

Floor & Décor believes it competes very well with Home Improvement Centers and Independents on a range of factors including low price, service offerings, and depth/breadth of products in stores as shown in Exhibit L below. Many have called FND a category killer, and if FND can maintain these advantages vs competitors I see a high likelihood of retaining this title for years to come.

A comparison of square footage dedicated to flooring is outlined below in Exhibit M based on recently reported store counts for peers – this highlights FND’s economies of scale relative to peers. Longer term I see the gap relative to peers expanding as it reaches or exceeds its 500-unit growth target. As shown below, in Exhibit M they will have ~2x the dedicated square footage dedicated to retail flooring vs the combined square footage of all public peers. I expect this to drive purchasing power advantages over suppliers who are fragmented across the world. Both HD & LOW generate superior sales per square foot on a relative basis as their business model prioritizes  keeping inventory at the supplier level and only holding products on the books that have higher turnover.

Below in Exhibit N, we show a breakdown of recent same store sales trends for FND and peers. This shows that for most of the large industry players, they saw above average positive impacts from higher ticket pricing starting in 2020. If we compare FND to LL flooring, we can see FNDs outperformance has largely been driven by higher volume growth.

PPI data shown below in Exhibit O shows the different product categories levels of inflation going back to 2000. This shows that that inflation in the industry was largely driven by hardwood and vinyl products – and as of early 2023 inflation growth rates have decelerated from peak levels seen in 2021 and 2022.

E-Commerce Threats

A discussion of a retailer in the US is not complete without addressing potential risks from Amazon - but to start I don’t believe there are any immediate threats from them encroaching into their core market. I believe this is driven by a few notable factors including the immediacy of the product for the biggest customer – PRO’s may be interested in products on AMZN, but if they are not available when, and where they are needed this can create working capital challenges, and can delay execution of planned projects. At FND stores, they can be assured they will leave the store will a full lot of product or installation materials if that is what they need. Second, I believe most consumers want to see and feel most products they are about to have installed into their homes for 10+ years, and if pictures or online visuals do not match consumer expectations this can lead to significant customer dissatisfaction. I would note that AMZN, and many e-commerce retailer’s business models are more oriented around smaller, high value products or those that are relatively standardized (i.e. books, home & kitchen goods etc.). Flooring is heavy, low value and is not standardized amongst different retailers – generally consumers are not aware what the best in class brand for hardwood or laminate products is today given the infrequency of purchasing. Below in Exhibit P, we highlight how heavier products are substantially more expensive to ship - FNDs business model is largely to distribute to the stores, and not to individual households. As a result, it can spread out these higher distribution costs, and offload potential last mile delivery costs to the customer who would typically pick up the product from stores.

I believe consumers are more likely to purchase cleaning products, or floor protectors from AMZN which are not core products FND focuses on. Additionally, with the marketplace offering, AMZN takes limited/no responsibility for the quality of the products it sells – flooring you purchase on the marketplace may not actually pass the quality, and safety requirements FND’s merchandising team would have for products that are sold in stores. As of last quarter, about 18% of sales at FND was through their website – but I believe this figure is actually inflated relative to reality as it is mostly being done by professionals who have installed a particular product before, or customers who plan on picking up products from a store along with verifying visually that this is the type product they were looking for. Overall, I just don’t see it as a great fit for AMZN and believe this is a not a material risk for FND in the near to medium term – however, things can change and we think it is a risk worth monitoring going forward.

Long Term Store Potential

Back in 2014, when the company filed its first S1 filing, management expected over the next 15 years it could reach 350 units. At this time the average store size was 70,000 square feet. Then by 2017, management increased this target to 400 units and estimated its average store size at 72,000 square feet. In 2022, management highlighted it aspired to reach 500 units’ vs 191 at YE2022 implying only 38% build out relative to estimated white space for the business.

Previous managers and executives in the industry have highlighted that they believe FND could actually reach more than 500 and potentially 1,000 on the very high end, which is still modest relative to HD & LOW store counts of ~2,000 and ~1,700, respectively in the US. I believe this going to be driven by incremental density of the store count, with a greater proportion of stores being opened in existing markets – this has already begun to shift, as ~50% of stores opened now are occurring in existing markets compared to 30-35% in 2017. Another area where management could expand could be Canada, where I expect they could easily end up with 30 to 50 stores based on population density analysis shown below in Exhibit R. Canada has roughly the population of California which has 27 stores today & we don’t believe FND has completed its unit growth in California yet. Alternatively, we can extrapolate from managements 500 store target which implies about 3.5 stores per million households – this suggests a potential store base of 56 units in Canada higher than the range that our population density analysis shows.  I expect that over the next 5-10 years’ management will continue to revise their long term target higher. I think there is also the possibility that they continue to experiment with some different store sizes, and I see a high possibility of the introduction of a reduced size format which may result in a larger proportion of new store opportunities in smaller markets.

Commercial Market

FND has historically prioritized reinvestment into the retail market, but this changed in May of 2021 when it decided to accelerate/improve its positioning in the commercial market with the acquisition of Spartan Surfaces (SS). Historically, FNDs commercial sales business had been growing steadily, up 6x in 2021 vs 2018 levels – the firm had sales skewed towards general contractors, owners, builders and developers. The addition of Spartan Surfaces added the capabilities to meet the needs of Architectural and Design (A&D) firms who have more complex needs such as pre-build design support, strong specification expertise, and turnkey installation coordination capabilities. Through this deal, FND was able to grow its addressable market from $6b to $13b and through additional investment since now has an addressable market of $16-17b, as shown in Exhibit S.

We think the deal created value through multiple levers. Through the consolidation, Spartan Surfaces and FND employees were able to access much deeper and broader product catalogues for their customer bases. This deal also allowed Spartan to obtain products at a lower cost due to the historical investments the company has made to build out its direct sourcing model. As the two businesses are integrated we would expect some incremental utilization benefits from existing warehouse capacity and over time would expect new Spartan sales offices opened will benefit from legacy investments FND has made. Tile has not been offered historically by Spartan, so there is also the potential to add this to their portfolio given FND’s expertise in this area. The main offset from expansion into the commercial market, is lower gross margins roughly in the high 30s compared to FND retail gross margins in the low 40s – despite this, we think the commercial business can still generate robust ROICs due to lower working capital and lower SG&A requirements.  FND has a long runway to grow as sales grow to $3-4m per sales representative (RAMs), collectively this could result in sales of $1.5-1.8b at maturity.

“Floor & Decor’s extensive sourcing and distribution capabilities of innovative, trend-forward products will serve as a key selling point for our business development team and for projects that depend on reliability and near-term supply. As we look to the future, we are excited that Floor & Decor has the experience and resources to help us accelerate our growth plans into many untapped and highly fragmented markets across the United States, while maintaining our unique culture.” Kevin Jablon, Founder and CEO of Spartan Surfaces

Unit Economics

We believe FND generates robust unit economics. Throughout the firm’s history, they have taken an experimental approach to tweaking how they are replicating the model across the country – I believe this approach is borrowed from Tom Taylor’s experience at Home Depot. In the early 2010’s the company invested around $3.5m into a new store, and would expect to generate $9m in sales the first year and $0.9m in EBITDA, as shown in Exhibit T. By 2016 the company was able to steadily reduce the net working capital for stores by extending out payables to suppliers and Pre-Opening expenses grew modestly. In 2022, FND made arguably the biggest change they have increasing capex by 3x to ~$7-9m, and prioritizing ownership of the stores. So far, the incremental investment is generating superior returns and sales of the new format are $4-6m higher in the first year and EBITDA is ~$1.6m higher. By the third year they estimate they are generating 2x the EBITDA of the prior model. This prioritization of ownership of the store should allow them to avoid substantial rent payments over the upcoming 10 years. The company has also highlighted the benefits from self-development which include a faster build time, ~15% cost savings and lower maintenance costs. As FND continues on this journey, we expect rent costs to fall as a proportion of sales – in FY20 it was 6%, we expect it to be in the LSD range longer term.

Below in Exhibit U we provide an illustrative overview of the per store economics assuming a $9m capex investment and straight line depreciation over a 20-year life. We assume gross profit margins flat at 42%, and SG&A margins at 30% initially but scale to 23% as sales mature over the forecast period. D&A assumption is based off a 20/year life for the building at $360k/annum. Collectively this results in EBITDA margins reaching 20% long-term. This results in an IRR of 25%, which we believe is very attractive and highlights the attractive organic reinvestment potential for the company.

Competitive Position

Advantage #1: A wider selection of hard surface flooring products and better in-stock levels

FND can offer customers a wider range of flooring and related products to customers because of its larger big box store format, as shown in Exhibit V. If we compare the square footage they dedicate to flooring products, it has 4-20x more space than peers and this increases the odds that a customer will be able to walk away from the store with a product that meets their needs & budget. For professionals, the higher level of in-stock levels ensures that when they are visiting a store they can leave with a full lot of product to complete an individual project. I estimate that >70% of the SKUs they offer would be in stock and the remaining 30% would be a special order from a DC. In the simplest terms, there are more products customers can choose from in FND stores and of the products they have in store, they are much more likely to have sufficient stock on hand.

Sales of flooring product for FND on a per location basis was ~$18m which was a magnitude of order different to peers who generate flooring sales per location of 2.5-3.6m. HD & LOW appear to Additionally, FND offers a range of ancillary products such as installation materials and tools which allow them to be a one-stop shop for customers.

“In a Floor & Decor, if you were to go into by tile, you would find in the average store over 250 options of tile. In home improvement center, you would find 55 to 60. So it's just --and the definition of in-stock in big box stores certainly different, right? We have multiple jobs in stock, we can earn PRO’s confidence, their trust they know the product is going to be there.” - Tom Taylor

“Floor & Decor offers more than four times against the specialty lumber retailer and home improvement centers. If you look at the numbers at the bottom, which compare in terms of in-stock assortment, you can take them home today. Floor & Decor has over 1,700 SKUs versus maximum 70 in the specialty lumber retailer against a maximum 50 in the specialty tile retailer and 400 to 450 in the home improvement centers if they have good jobs, lot quantity in stock. And independents usually don't carry in-stock assortment and they do a special delivery which could be two weeks plus to get it.” - Ersan Sayman

Advantage #2: Direct sourcing capabilities

FND is uniquely positioned compared to peers as they procure product directly from suppliers, eliminating the usage of a number of middlemen who all would have taken some form of commissions or markup on the products they would eventually sell to customers. This is an integral part of why FND is able to offer attractive pricing for products relative to the industry. Our research has indicated that generally prices are near or better than other retailers in many categories, and in select products like Tile, it is priced well below competitors. The Tile Shop often sells similar products for ~$18/square foot vs ~$6/square foot for products available at FND – while some of this can be attributed the quality differences I believe the majority is explained by a discrepancy in pricing strategies. In the flooring industry, the ability to find the same product at different stores is difficult given the wide range of products available in the industry. The company’s pricing philosophy is to have everyday low pricing, match competitor pricing, and notably will rarely utilize a promotional strategy to flex volumes which we believe creates a more consistent value proposition for customers compared to other approaches used by competitors.

Floor and Décor is able to pursue a direct sourcing model because it has expert merchants in house, and because it has reinvested over the past decade to build out its supply chain capabilities including 4 DCs and long term ocean carrier agreements. As FND has a more direct relationship with suppliers, this can allow them to more efficiently collaborate with them on new design trends, and increase the overall efficiency of both company’s operations. The elimination of middle men also reduces the time that product is held at various points before they eventually have it available for sale at stores.

FND is very often one of the biggest customers for a large number of small sized suppliers resulting in them having relative bargaining power. As newly opened stores mature over a 5-6-year period, this can drive above average volume growth for suppliers for a healthy period of time – then combined with actual new unit growth, it can create a situation where FND is almost always expected to be the largest customer for an individual supplier over time. We believe this leads suppliers to allocate supply when availability is tight to FND and illustrates why the firm was reported to have substantially better than industry levels of stock during the past few years despite supply chain challenges creating more difficulties for smaller retailers.

Exhibit W below compares the typical supply chain for independent retailers compared to FND’s.

Advantage #3: Differentiated Professional service offering (PRO)

FND has gone through a long iterative process to optimize its offering for professional contractors. Earlier in the company’s history, it was simply under invested into and had something like a makeshift bench made of cinder blocks & a few pieces of lumber, and a coffee machine. Since then, the proposition has dramatically improved to include a dedicated customer service desk, loyalty program, credit program, free storage & return optionality, phone applications, education events and delivery options. FND’s share of revenues generated from professional customers is the highest of the peer group as shown below in Exhibit X.

The PRO customers (DIFM) are typically Flooring Installers, General Contractors or Homebuilders with a median age of 50 years. Most of these customers have a relatively small operation with the majority generating less than $1m in sales per year and a median of only 3 employees. FND estimates that professional’s influence nearly 40% of its sales – that is, suggesting their brand or a specific location to customers when they are going ahead with its research & buying process.

Similar to many retail concepts, a few power users or high frequency purchasers can disproportionately impact per unit profitability. FND estimates that 59% of PROs are enrolled in the loyalty program so far, and this proportion has been growing since the launch of the program. Customers in the loyalty program spend near 3x the amount compared to PROs who are not part of the loyalty program. Additionally, trends remain supportive in early 2020 FND management highlighted that the top 10% of professionals did purchasing of 37 projects per year with FND and average spending was up 24% in 2021 vs 2020 levels.

In our discussion with industry experts, I discovered that it takes multiple years for FND to attractive professional customers from the point when they initially open stores due to the difficultly in marketing directly to these types of customers. Conversion rates appear high once customers are in-stores, however, with PRO’s purchasing >90% once in store and homeowners >80% once in store. This, in our opinion, is indicative of brand awareness continuing to improve throughout the US. Once these relationships are developed we believe customer satisfaction is generally quite high based on our discussions with industry executives and a comparison of NPS data from comparably.com, which is shown below in Exhibit X.

Advantage #4: Merchandising Expertise

FND’s operates a decentralized store model, and inventory is optimized by local managers to ensure products on display and in stock meet consumer preferences in that region. The company’s large store size and diversification across multiple products allows the company to adapt with design trends. If we compare this to specialty lumber or specialty tile retailing peers, they are unable to do this – The Tile Shop can switch the designs, colors and quality of the tiles it sells but it can’t maneuver into Hardwood if this becomes the latest trend. Exhibit Y below highlights how the company’s product mix has changed since 2012.

EVP, Ersan Sayman has been with FND as a merchandising manager for > 18 years, and leads this function at the firm. FND has built an approach to keep product leaders within the same category for as long as possible – IE) John, who has run tile sourcing for the firm will continue to run it and build his expertise in this area. Other product leaders will focus in other product categories. Specializing in one particular product category allows product leaders to develop continually year by year and develop strong relationships with the supplier base. FND also benefits from this as it continues to grow its private label portfolio – which has entry, good, better and best product offerings points as shown below in Exhibit Z.

The company has broken down this product mix setting process into 6 major components. First they have merchants actively researching trends, attending flooring shows, meeting with vendors, and reviewing competitor offerings. Then after collecting all of this information, they work with their manufacturer and design partners to create products, branding and packing. These new products are then presented to the regional merchants who are actively living and working in the specific markets. Managers are not left to make these decisions themselves – an inventory team, and store merchants review these suggestions and provide feedback to the merchandising group. Ultimately, demand is aggregated across the store base, products ordered and manufactured. Then, when the product finally arrives at the stores, it’s put on display, and potentially presented to consumers in vignettes. FNDs ability to merchandise, and localize assortment effectively is a difficult to replicate process. Exhibit AA shows the different sales mix from two locations, which are notably different and match local preferences.

Advantage #5: Superior customer service offering

FND stores have been well designed to meet customer needs when they come into a store. This is driven by the setup of the floor space which drives traffic through the store and inspires customers.  ~2,300 square feet per store is dedicated to vignettes which are refreshed roughly once per year. If HD or LOWs attempted to match allocation toward vignettes within their stores, this would consume 40% of the entire flooring department which would materially reduce the depth/breadth of their flooring offerings and reduce sales per square foot metrics.

The company’s Free Design Services which are offered by flooring dedicated experts is a substantial differentiator in our perspective. This group of specialized design employees has an ability to work through projects from initial vision all the way to completion. The benefit of this group is that they can make recommendations for customers that meet their budget, lifestyle, and quality needs, as shown in Exhibit AB. This translates into superior customer satisfaction ratings, better sales conversions and ~2-3x higher total ticket vs non-design customers.  Within each store this would include at least 4 full time employees on this function. We believe this is very positive for its relationship with PROs who rarely have design personnel on their staff. Across four different service metrics measured at FND regularly, the design services appointment is considered to be amongst the biggest positive contributors. Management has continued to talk up potential of reinvesting further into this offering – even for its employees it has created multiple roles within this department allowing them to specialize, and grow their career within the firm.

On the technology front FND has also reinvested to ensure its associates are enabled to communicate internally, digitally manage tasks like quotes, adjust inventory, and optimize routing of products. All-in this minimizes time employees are spending on the administrative & upkeep activities and can allow them to spend more time with customers who need assistance when they come to the stores as products are bulky & difficult to move. The company has also set up its order fulfillment processes to ensure substantial customer visibility – each interaction is aimed to be connected and convenient for them. Below in Exhibit AC, is a summary of how the overall service offering compares with a few competitors. While PRO offerings are common across the industry we think the difference compared to a Home Improvement center is material, as the individuals on those professional desks are expected to be an expert across multiple departments and a SKU count of >35,000 compared to mostly flooring products and SKU count of ~2,400 at FND. Within Floor & Décor stores it is an expert to expert discussion not expert to generalist which should lead to higher levels of satisfaction. Other retailers generally offer installation services which FND has deliberately decided not to do as they do not want to compete with customers and instead prioritize being the go to supply house for its customers.  Ultimately, all these factors combined leads us to believe they have a substantially differentiated offering vs peers.

Management & Governance

Tom Taylor, has been CEO since IPO and only the 2^nd CEO since inception of the firm. From a strategic perspective, we believe he has focused on the right pillars to improve the competitive position of the business for the next 10 years. The biggest change has been the build out of the company’s direct sourcing model, expansion of its supply chains capabilities, and reinvestment into PRO offerings. Collectively, these changes have improved the value proposition for its core customer base and differentiated it vs peers.

After 23 years at HD, he had built a strong record of progressing into new roles and creating value. Co-founder Bernie Marcus identified Taylor as a young prodigy, and was an ongoing mentor during his time with the firm. He was the youngest manager they ever had, by age 26 he was a district manager, a very rare feat. Tom continued on in various senior roles at HD and eventually ran merchandising responsibility for all of the Home Depot stores. Even when he left HD, he continued to provide consulting services to them for two years – highlighting how the immediate loss of him could have been disruptive to the firm.

One of the few things I don’t love about management & governance is the lack of meaningful insider ownership, which is likely due to its shorter history, but even the founder, George West owns little stock.

If we look at the compensation structure for management, short term compensation policy is well structured as it is tied to Net Sales and Operating Income Targets. Longer term incentives are reasonably  structured with RSUs and PSUs tied to adjusted EBIT and ROIC targets over a three year period. In 2020, the management has also received one time awards over the past few years tied to delivering EBIT, ROIC and relative to peer TSR into 2022. Like many employers the company also added an Employee Stock Purchase Plan, which allows employees to receive stock at a 15% discount to the market price over each 6 month offering period. All said, there are some areas for improvement, but the overall structure is reasonable enough & unlikely to impair our ability for the thesis to play out.

Valuation & Scenarios

Revenue Expectations

The primary driver for FND growth is unit count, same store sales growth and commercial sales growth. Into 2032, we expect FND to continue opening stores reaching a peak pace of 35/per annum and gradually decelerating to 27 stores per annum by the end of our forecast period due to market saturation. Then for the existing stores base we expect MSD SSS% growth to drive average store sales to $28m by the end of our forecast period up from $24m in 2022. Over time we expect new stores to be gradually more productive relative to mature stores as brand value builds across the USA. Our expectations for total revenues, net new store openings and mature/new stores sales are shown below in Exhibit AD

For commercial sales, a small portion of overall sales today, we expect this to grow rapidly as FND continues to add sales representatives in new markets, as shown in Exhibit AE. By 2033, sales are expected to reach $1.6b up from an estimated $0.3b in FY23 largely driven by growth in the number of representatives from 100 to 500 by the end of the forecast period and maturation of the sales force to reach a ~$3.3m per annum sales rate.

Below in Exhibit AF, we expect gross margins to continue improving over time as buying power grows and mix improves. This results in 43% gross margins at the end of our forecast period vs 40.5% in FY22. For operating costs, we forecast a smaller impact from pre-opening as the pace of new stores opens declines relative to the store count. Then for selling and operating costs and general and administrative costs we expect this to decline to the high-20s as stores mature, and centralized costs are spread out over a larger sales base. This results in EBITDA margins of 15.2% in FY33 vs 12.9% in FY22, driven by a improving gross margins and operating cost leverage.

This collectively leads to GAAP Net Income CAGR of 14% during our forecast period, with EPS growth expected at an 24% CAGR driven by buybacks where we deploy excess cash flow in our base case.

Sources and Uses of Cash

FND should generate substantial cash flow in the next decade, even as they reinvest, and growth the store base. There remains potential to consolidate in the commercial sales market where buying a competitor with strong relationships could meaningfully accelerate growth in this market but, we don’t model in incremental M&A at this point. We have the majority of excess cash being returned via buybacks beginning at roughly the midpoint of our forecast horizon. This is expected to result in an -8% CAGR for shares outstanding or a 56% decrease in the share count from 2022 levels.  We consolidate the prior decade and our expectations for the next decade’s sources and uses of cash below in Exhibit AG.

Base Case Vs Historical Results

Exhibit AH shows my how my base case expectations drive top-line growth of ~11% over the next decade, and net income growth of 14% growth, with EPS expected to grow faster at 24%. ROIC is expected to gradually improve towards 22%, largely driven by falling working capital as the firm extends out payables over the fragmented supplier base. D/EBITDA expected to reach 2x long-term with most of the excess cash expected to be returned to shareholders.

My base case suggests that fair value is $86/share, which is effectively in-line the current price of $87/share.  I expect an investor could still earn at ~10% IRR over the next decade based on my modelling. Exhibit AI shows a screenshot of my DCF output tab.

Conclusion

FND is a category killer and leader in a slowly growing & cyclical industry. The firm is well positioned to continue growing its market share over the next 10y, and competitors are not structurally set up in way to compete effectively with them. My analysis suggests the current price is in-line to fair value for the business and I still expect to generate an 10% IRR through ownership of FND, at the current share price. As always, feedback is appreciated.

Investment Thesis

United Rentals () is an equipment rental provider that offers aerial work platforms, earthmoving equipment, forklifts and a wide range of other light & heavy equipment to construction, industrial and other end markets. URI is the largest equipment rental company in the world. Their market share sits at 16% in North America, while the top 10 have a combined market share of ~40%. Most of their competitors are small subscale regional competitors, and URI has a long list of competitive strengths and advantages over this cohort, which include:

• Wider selection of general tools and specialty equipment available for rental

• Scale gives them purchasing power over suppliers that many of their small competitors don’t have, and also helps URI get better warranty, spare parts pricing and improved payment terms

• National footprint allows them to meet the needs of large customers wherever those customers are located

• Industry-leading scale also gives leverage on fixed costs which improves unit economics

• Unparalleled data, analytics, and technology capabilities allowing personnel to easily determine availability of equipment, arrange for deliveries, monitor activity levels in real-time and consistently analyze operating and financial data

• Geographic and customer diversity which leaves them with limited exposure to any customer or region

• M&A expertise and integration capabilities

URI has seen its market share increase to 16% over the last two decades, and as they grow, many of these competitive advantages compound in importance. As consumer preferences change and renting equipment grows in popularity, URI is in a strong position to cost effectively take a greater share of this growing pie, particularly from the long tail of small competitors. My expectations for long-term growth exceed those implied by the current share price.

Most large competitors have copied some URI best practices but are unlikely to effectively replicate many of their competitive advantages, specifically when it comes to the magnitude of its scale and data, analytics, and technology. There does not appear to be any disruptive new competitors with any clear competitive advantages over URI. We believe the industry is sufficiently fragmented that the larger rental companies can continue to outperform overall industry growth.

URI has also built out a leading technology offering “Total Control” which drives a superior customer experience and is an area where competitor offerings are lagging. URI’s Digital Tools collectively allow the company to better capitalize on demand, acquire new customers and generate interest in its portfolio. The company has continued to aggressively grow its Specialty rental solutions business to further differentiate its portfolio relative to the industry. Specialty markets also have less volatility demand and lower penetration rates resulting in a superior growth and margin profile. The solution-oriented nature of specialty markets is differentiated compared to the core rentals business. I don’t think URI receives enough credit for this today and this should continue to be meaningful growth driver in the future.

Lastly, the management compensation framework is robust with long-term compensation tied to ROIC & Revenue metrics. Even annual bonuses remain reasonably well structured including adjusted EBITDA and an Economic Profit measure that incorporates a cost of capital calculation driving management to focus on both profit maximization and optimal capital investment. Equity ownership is low but mitigated in our view due to the overall compensation policy. I would characterize management as strong operators and capital allocators and would continue to expect some accretive M&A into specialty rental equipment markets or ongoing execution of its buyback program over the next 18 months. Excess cash is likely to be returned to shareholders through buybacks, and I expect that they could purchase ~34% of float over the next decade while having lower leverage than targets and growing operating income ~11%/year.

In the base case, I estimate that fair value is $511/share, which is a 34% discount to current price of $355/share, and implies a 10-year TSR of 12%. My bear and bull case scenarios also suggest a relatively narrow range of outcomes that are skewed to the upside ($349/share and $537/share respectively). In my view, the current share price represents a fair price to own a high-quality business that dominates in a fragmented industry - however, better entry points may emerge in the future as the business cycles through the current period of economic weakness.  

I’m still figuring things out, so feedback/comments on my assumptions or any of the analysis I have here is appreciated. Always open to the idea that I can be wrong. I can be reached at icemancapital@gmail.com. Please see below for my DCF model which has key assumptions built in.

2023.01.01 United Rentals Model icemancapital.substack.com

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Introduction to United Rentals

United Rentals (URI) is an equipment rental provider that offers aerial work platforms, earthmoving equipment, forklifts and a wide range of other light & heavy equipment to construction, industrial and other end markets. Exhibit A shows the historical revenue its key reporting Segments and a breakdown of the company’s customer mix in 2021. URI serves its customers through two business segments, General Rentals and Specialty. URI also sells used rental equipment, select new equipment, contractor materials and also provides servicing on select pieces of equipment.

Before we dive into the equipment portfolio of each segment it might be helpful to look at how the business model is set up (Exhibit B). URI starts by acquiring equipment from original equipment manufacturers (OEMs) or the used equipment market. They then prepare that equipment - including the potential installation of telematics - and move it to where they believe the equipment will generate the best potential returns in the rental market. Key Accounts spend $250,000/year with URI and represent 72% of URI’s customer base. After the equipment has gone through multiple maintenance cycles and has been rented out for much of its useful life (~7-9 years), any equipment that is still in good condition is then sold to different parties (often including current customers). URI also utilizes Auction, Broker, and OEM repurchase offers to generate cash from used equipment assets.

United Rentals Fleet portfolio by category is outlined below in Exhibit C, with Specialty Rentals assets highlighted in red. In 2022, the most popular equipment rented out from the company included Scissor Lifts, Boom Lifts, Warehouse Forklifts, Reach Forklifts, Skid Steers/Track Loaders, Mini-Excavators, Backhoes, and Air Compressors. Exhibit D includes select images of its equipment portfolio.

History

United Rentals was founded in 1997 by Brad Jacobs, and likely many successful entrepreneurs had a relatively unconventional background. He was initially studying math, classical music, and jazz at Bennington College and Brown University but eventually dropped out. His interest in making money eventually led him to cold calling his way into the oil trading industry. A few years later he co-founded Amerex Oil associates where he served as CEO until the business was sold in 1983. He then founded another oil trading firm Hamilton Resources, eventually growing this entity to $1b in revenues.

His first foray into a different industry was when he founded United Waste Systems. As Chairman and CEO, he pursued a strategy of consolidating small garbage collectors in rural areas (where competition was more limited) and then eventually IPO’d the business in 1992. By 1997 he had built the business with more than 200 acquisitions and integrated operations across 40 landfills, 86 collection companies, and 79 transfer/recycling stations across 25 States. The stock delivered a 55% CAGR from IPO until it was eventually sold for $2.5b to the entity now known as Waste Management Inc. United Waste Systems during its public life outperformed the S&P500 by 5.6x.

Brad Jacobs had collectively created 5 publicly traded companies each having performance >1,000% returns from the time of his leadership. What may not be evident from the above is that he has generally relied on similar investment criteria during each of these different iterations. He simply looked for large fragmented industries growing faster than GDP, and areas where scale & technology can drive attractive returns – so far this simple framework has been quite successful.

United Rentals early in its history was very focused on small acquisitions as the company built up its scale. Their were plenty of cost synergies URI could wring out of these small businesses including SG&A savings and the benefits of lower equipment costs by leveraging the purchasing power of the larger entity. Up until 2008, the portfolio of acquired businesses were relatively independent and had limited technology best practices embedded across the organization. In 2007-2008, the company was hit with multiple issues including an SEC inquiry, faster-than-expected deceleration in end markets, and integration issues from prior acquisitions. This eventually led to a sale process, and in April 2007 URI reached an agreement to be sold to Cerberus Capital – but later that fall Cerebrus pulled out of the deal as the GFC sent construction markets and credit markets into a severe downturn.

With the sale falling through, Mike Kneeland took over leadership in 2008 with no shortage of issues to address. The primary challenges were related to weak rental market rates and the high levels of debt it needed to finance/re-finance over time. To address short-term issues, he sold off parts of the rental fleet into used markets, cut capex, and completed layoffs to better match their supply capabilities with a very weak demand environment. One of the bigger strategic initiatives he drove was focusing more on National Accounts which required better equipment sharing across the organization but also had more stable revenues due to size/breadth. To meet these customers' needs the company had to build a culture that encouraged the growth of corporate profits even if an individual branch saw profit pressures. Incentives for managers were previously focused on EBITDA which encouraged empire-like building but he improved metrics to include EVA analysis. With the EVA framework all assets at the branch level now had a minimum required rate of return that needed to be generated before bonuses were paid. Furthermore, branch manager and district manager compensation were all shifted toward regional entities which tied those employee’s financial rewards to broader performance/collaboration.

Under Kneeland, COO Matthew Flannery also drove substantial operational improvements. This included pricing improvements, administration efficiencies, and logistics. Newer systems to drive effective pricing pulled this responsibility away from managers and towards an internal team which built up a view based on statistics across the nation. For customers who had previously bid for equipment at multiple branches, this more standardized pricing resulted in far fewer instances where branch managers accidentally underpriced their equipment. Large investments were also made into technology which improved order-taking, logging, and filing processes for both employees and customers. Mobile capabilities were also put into the hands of employees which put them in a stronger position relative to competitors.

After the internal operations were running smoother, the company looked to consolidate in the industry, eventually acquiring half of the largest top 10 competitors in the USA. Since inception the company has since gone on to complete >300 transactions which collectively added expertise in new product segments, new business platforms, or allowed them to obtain equipment when supply chains were constrained. We believe capital has been deployed effectively estimating that acquisitions have generally been completed at low-teens IRRs prior to revenue and cost synergies and in the high teens IRR range after synergies. Former executives in the industry we have spoken to have suggested URI is well positioned to continue with this strategy by leveraging their experience and scale.

The next phase at the company was of rolling out Kaizen processes across the organization. This started with about 8 events at select locations but grew rapidly into all regions as the response and results were very positive. The initial areas of improvement were how logistics were executed and targeted the most common issues that occurred for clients. URI formalized these initial lessons into forms which were then rolled out to the entire branch network. URI held hundreds of Kaizen events in 2014 and 2015, which eventually led to >100 formal operational excellence positions being added through the different regions.

In the latest 7-year period, the company continued to build up its general tools rental business and grow its specialty business which added higher ROIC & lower volatility profit streams. In 2014, the company launched United Academy, an online training platform for safety training and operator certification. By 2019, United Academy had >400 in-person or online courses. We believe this helps satisfy both national accounts and small customer needs while also reinforcing the URI brand. Additionally, the company has continued to digitize its capabilities during this period to more efficiently serve the customer base and drive internal cost improvements.

Rental Market Overview

Competing in a growing market

The U.S. General Rental, Construction, and Industrial equipment markets have grown at a 4.9% CAGR from 1997 to 2021 as shown in Exhibit E. ARA / IHS Global is forecasting a ~6% CAGR from 2021 to 2026 for the North American equipment rental market. If we look at peak industry revenues from 2007 to 2019 the market grew at a 3.3% CAGR. Over time the Top 10 U.S. rental companies have increasingly represented a higher proportion of total industry revenues. In 2010 they represented just 20% of revenues but by 2021 they represented 40% of revenues. URI has played a disproportionate role in consolidation activities over the past 10 years, and in general, larger competitors have also gained market share during this period.

Customers can choose to own or rent equipment. Rentals made up just ~20% of consumption in 1998, but a preference to rent vs own has increased dramatically with rental penetration now at ~60% in U.S. This has been driven by a growing focus on core operations, minimization of capital intensity, improved availability of rental equipment, reduced downtime associated with rented equipment and lower expenses as maintenance, pick-up/delivery and storage are all effectively outsourced. Exhibit F illustrates the longer term penetration trends in the US and compares the industry position to the UK which has effectively matured at 80% rentals.

The statistics above show the progress made across the industry with the rental model but we believe this still understates the longer-term potential of the business as there remain newer areas in the rental portfolios such as floor scrubbers which still have just low single-digit penetration today Ashtead, the #2 player in the US has highlighted in the past how the facility maintenance, repair, and operations market has an estimated size of $7-10b but only has minimal rental penetration today suggesting years of growth for this group over time. In Exhibit G, we show estimated penetration rates which highlight future sources of industry wide growth. In the near-to-medium term, cost inflation for new equipment, operating/technical changes, and Health, Safety and Environmental (HSE) related concerns are all likely to support the rental value proposition. For smaller operators, effectively maintaining owned equipment is technically challenging and rarely within their circle of competence. That’s where URI steps in with a focus on life cycle maintenance and dedicated employees to ensure that when customers not only get the equipment they need, but that the equipment runs reliably at high capacity. There remains significant room to grow USA/North American rental penetration to the 75-85% range seen in other markets around the world. Rental penetration may also receive an ESG-related penetration uplift at some point as more companies seek to offload their environmental footprint for reporting purposes.

URI is the largest equipment rental company in the United States, selling 37% more than the number two player Ashtead and greater than the number three to fourteen players combined. Rental Equipment Register, publishes annually an overview of the largest 100 equipment rental companies in North America. As shown below, URI and Ashtead (Sunbelt) dominate this space and the top 5 companies have nearly 40% market share with the rest largely made up of smaller medium size local or regional rental companies. URI has obvious scale advantages compared to most of these competitors while its larger footprint also allows them to drive higher utilization on its equipment fleet through sharing amongst different branches. Exhibit H provides an overview of sales for the top 50 equipment rental companies in the U.S.

Specialty Rentals

Specialty Rentals is an attractive and rapidly growing part of the market. While this part of the market is not universally defined by the industry it largely includes areas with lower penetration and is often sought after by customers looking for a solution rather than having pre-determined requirements. Customers will often come to URI with a specific problem like excess water on a construction site. A URI customer agent will then send over water engineers & specialist teams to suggest a solution and provide a cost estimate. The customer is typically quoted a fixed price which would cover both personnel & tool usage – this results in superior margins compared to the general rentals business as shown in Exhibit I. In these situations, the customer is prioritizing the problem getting resolved efficiently and quickly rather than achieving the lowest cost. The more specialized nature of this business, including the need for highly trained personnel, has allowed the industry to generate more robust margins and returns than in the general tools rental business as shown in Exhibit I.

Structurally improved Industry

A primary concern of some investors is that the leading rental companies could deliver peak-to-trough operating income performance similar to what had occurred during the past cycle (-76% for URI & -71% for AHT). But there remain many reasons why this shouldn’t be the case. To start, end customers in the last cycle generally had a greater bias towards owning their equipment and maintaining it themselves –only when they needed incremental equipment would they lean on rentals to “top up”. Over time customers have grown to appreciate the benefits of rentals (hence higher rental penetration), and the logistics services for rental companies have also improved to better match customer needs. Now for customers who are currently renting all or most of their equipment, the chance that they decide to go ahead with a large capital outlay amidst an uncertain environment seems very unlikely – we would almost expect that rental penetration could increase in the next downturn, offsetting some of the decline in end customer activity levels.

Market share for the top two companies has also grown to represent >25% of the industry as shown above in Exhibit J so pricing discipline should have improved vs the 2008 to 2010 period when there was a short period of very aggressive/uneconomic pricing occurring to minimize cash burn. This was likely exacerbated by the higher levels of financial leverage that was also utilized throughout the industry – Both United Rentals & Ashtead had ND/EBITDA >3x during this period.  Last but not least, we believe there have been significant improvements overall to how companies manage their fleet – incentives are better structured to drive equipment to areas where it will be utilized. Pricing should have improved as entire fleets are now being tracked digitally and algorithms are now guiding decision-making. Improved operational efficiency, continuous improvement programs, and the adoption of technology like telematics have supported companies like URI seeing margins move up 1,300-1,900 bps vs 2008-2009. Longer term we have seen lower debt utilization by the industry and gradually improving ROICs as shown in Exhibit K. All said, the industry is much better structured than it was 10+ years ago, and in our view much more ingrained into the operations of many customers’ workflows.

Illustrative Unit Economics

Below in Exhibit L we provide an illustrative overview of the companies per unit economics assuming $100 capex investment and straight line depreciation over a 7-year life. This implies depreciation of $12.70/year and then at the beginning of the 8^th year we assume they dispose of the asset at 1.7x book cost. Then in the process of renting out the asset we assume ~47% EBITDA margins after accounting for key operating costs. We assume a nominal 1.3% of revenues dedicated towards spare parts costs and a 7% net working capital assumption. In the forecast period, we assume revenues generated from the asset decline alongside book cost – matching the historical relationship on a corporate basis. This results in an IRR of ~16% which we believe is attractive and highlights the organic reinvestment opportunities the company has.

Suppliers Unlikely Threat

One commonly perceived risk is the idea that suppliers could circumvent URI and start their own rental business. In our view, it’s not that simple. For starters, URI is one of the biggest purchasers of equipment for most OEMs and URIs largest supplier represents only 9% of capex which has steadily declined from 25% in 2009 as shown in Exhibit M. For that OEM to go into direct competition with one of their biggest customers for an uncertain return seems like a risky proposition. It’s also important to recognize that many customers will need more than one type of equipment on a job site, and not all OEMs can offer everything, which means that either the customer has to deal with another partner (adds friction for end customers) or the OEM has to acquire equipment from a direct competitor (seems unlikely). The OEMs also don’t have expertise in maintaining, moving, procuring, or training customers to properly utilize equipment.

In Exhibit M, we show two of Caterpillar's largest dealers Finning (FTT) and Toromont (TIH), which both have small rental operations and whose portfolios skew towards construction, and earthmoving equipment (CAT products). On a combined basis, these two companies have grown revenues at only a 2% CAGR in the prior decade, a rate which is well below what has been achieved by the industry at large. TIH has increasingly focused on equipment rentals and over the prior decade it has had some success growing its operations. Despite this recent momentum, we expect lower ROI over a full cycle due to disadvantaged purchasing scale, reduced cross selling potential and limited regional diversification. Both of these dealers are effectively land locked given the exclusive agreements they have with Caterpillar – this limits long term reinvestment potential, and the ability to move equipment to higher demand regions. United Rentals scale advantages are clear when we compare TIH location count of 70 to their 137 in Canada.

Competitive Position

Advantage #1: A wider selection of general tools and specialty equipment driven by asset sharing

URI can offer customers a wider selection of general and specialty tools than most competitors and offers an estimated 4,300 classes of rental equipment to its customer base. Having the right equipment available for customers has always been an important component of the customer value proposition. As URI has continued to grow investments into different specialty tools and onsite services this has allowed them to increasingly become a single source provider for many different job sites.

It is important to note that URI’s overall fleet is managed on a company-wide basis. This means that it is much easier for customers to find the right piece of equipment even if it is not currently nearby and results in superior rental asset turnover as shown below in Exhibit N. If customer needs are more complex and require a combination of heavy, light, and specialty tools they are much more likely to find all their tools with URI. Having one provider for these tools instead of multiple providers greatly simplifies the customer operations. Alternatively, if the customer were to select 3-5 different equipment providers to obtain equipment for a construction site this would need to be scheduled and managed, effectively drawing resources away from the core competencies of most contractor businesses.

Underpinning the portfolio of assets is logistics capabilities that make this sharing possible. URI has a fleet of ~12,900 vehicles which are used for delivery, maintenance, management, and sales functions. Providing customers with an option for delivery or pick up can allow them to optimize costs on their end and outsource needs to URI if required. Having access to the full fleet instead of just what is available at a specific store improves availability metrics for customers and for URI it improves turnover and capital efficiency.

“In the past, we served the customers with the resources and the fleet of a single location. But today, our metro customers have access to the entire network of local stores. And since we've introduced the metro concept, our fleet transfers, a measure of capital efficiency, have increased substantially, in fact, have increased by 30% since 2016. Free-flowing fleet between locations means an improved customer experience, better margins and returns and ultimately, less capital expenditure.” Michael Durand 2018 Investor Day

Advantage #2: Purchasing Power

URI also benefits from scale in that they have considerable purchasing power and is known to obtain better pricing relative to smaller regional or local competitors. Throughout the 2010s, the company acquired several large rental businesses including RSC, NES, and NEF, where it was revealed they had a ~2-8% supplier pricing advantage over these entities. By obtaining better pricing, the company can generate better returns on investment than peers who may charge similar rates for renting equipment. In terms of the sheer magnitude, URI bought ~50% more equipment last year compared to Ashtead and 5x more than Herc, the two largest peers. Management has discussed in the past that as the company’s purchasing volumes go up they are often able to achieve greater discounts – IE) The first 100 units could be $100, the next 100 units would be $95 and the next $100 could be $90.

URI focuses on the total cost of ownership of each asset when going through negotiations with its suppliers and emphasizes equipment availability, warranty coverage, training, parts, freight costs, and technical support quality when assessing each vendor. For warranty, they specifically evaluate the duration, potential reimbursement rates when issues arise under a warranty period, and what is covered under the agreement. Select vendors also provide additional training so that the company can ensure equipment is well maintained over its useful life and utilized effectively by customers. Parts need to be replaced during the life of a rental asset, and availability/pricing of these parts can be provided on preferential terms relative to smaller peers. Purchasing power ultimately drives down the company’s capital costs, and operating costs and supports higher equipment availability for customers (better service). Exhibit O provides an overview of all of the different areas they negotiate with suppliers.

Advantage #3 National footprint allows them to serve large customer needs

URI’s geographic footprint allows them to meet the needs of large customers better than regional competitors, and the importance of large customers is evident when we consider that >72% of URI revenue comes from customers who spend more than $250,000 per year and often rent equipment from multiple locations. To serve these customers, the company simplifies the procurement process establishing a single point of contact for them and thus creating a more consistent level of service regardless of where the equipment is being used. Large customers may often get better pricing than smaller customers, but URI believes this is more than offset by the consistency of rental frequency and longevity associated with larger projects.

For any customer, one of the primary goals of delivering a project is to ensure that it is completed on budget and schedule. Through the procurement of required equipment from a highly reliable supplier like URI, they can eliminate a source of risk that could create a waterfall of other issues. Even if a piece of equipment has a failure, a replacement machine can often be more quickly obtained given the size of URI’s fleet. Additionally, when telematics is installed, URI gets immediately notified when there is an issue.

United Rental’s UR Control platform also provides a clear snapshot of equipment available for rent, an ability to extend or end rentals, and a way to set up automated custom reports. For project managers or financial analysis purposes, this can allow customers to see which tools are being used most efficiently and where potential resources are being wasted. For large enterprises, these tools greatly simplify the overall financial analysis and management of spending levels.

An additional reason why the national footprint is relevant for certain types of contractors is that depending on the state in the US, there are often reciprocal agreements in nearby states allowing contractors to work in multiple regions. As contractors grow in scale, these agreements create natural areas for the company to grow into over time. URI provides a seamless ability to continue growing into new states and little to no retraining is required as the UR Control platform is standardized regardless of where the equipment is utilized. Exhibit P highlights the location count advantage the company has over its peers – this results in URI having better coverage across multiple geographies to serve rental equipment demand.

Advantage #4 Better unit economics due to better leverage on centralized costs

The rental industry is reasonably fragmented, with the top 10 companies representing 40% of revenues for the industry, and thousands of small competitors filling out the long tail. Each of these small competitors have duplicative administrative functions which are not efficient and all else equal - this should result in lower corporate margins.

In our view, the average small competitor is much less sophisticated than industry leaders. Areas like credit can be better managed and equipped with stronger internal/external tools and processes while smaller entities are more likely to run into adverse selection issues. Additionally, areas like Information Technology can be scaled across a larger organization to drive better information flow, and overall productivity. Exhibit Q shows a comparison of small public rental companies vs URI, and illustrates the superior leverage URI can generate on SG&A.

Advantage #5 Unparalleled data, analytics, and technology capabilities

URI is well known for having the leading technology platform in the industry, which provides customers with 24/7 access to URI’s products, tools, information, and services. The website “UR One” is a modern, clean, and consistent interface for the entire customer base which allows them to rent, buy, manage orders, equipment purchases, and complete training. Additionally, on the website, they have built out a rich library of content and expert guides to ensure customers are selecting the right tools for the job. URI offers its “United Academy” to ensure that customers are well trained on the equipment they will be using and is aimed at reducing incidents on worksites.

We believe the company’s investments in this area are one of the biggest differentiators compared to smaller peers. Through these investments, the company is better able to implement Kaizen processes that utilize data and adjust practices to eliminate waste. URI has also automated more administrative processes which frees up further resources and allows the company to dedicate its workforce to satisfying customer needs & driving long-term loyalty. Previously, the management team has highlighted how they built fit-for-purpose mobile applications for specific tasks like Pickup, Inspection & Repair, Route Optimization, and Staging – each of which we believe aids in an efficient operation.

For customers who use a combination of owned assets and rental equipment, URI offers Total Control ® which lets them locate & track utilization levels, maintenance, obtain invoices and complete bill payments. Potentially most importantly for larger contractors they can create custom reports and track KPIs which allow the company to better estimate whether projects are tracking on budget. URI’s internal data can also provide benchmarking reports (shown below in Exhibit R) to highlight how performance compares to the industry and dedicated employees then provide recommendations on how improvements can be made to customer processes. If spending exceeds or is approaching targeted levels customers can be notified through alerts or customized electronic reporting. Customers have consistently reported a wide range of benefits from utilizing the platform with cost savings being one of the most frequently cited areas as shown in Exhibit S. Collectively, technology investments drive efficiencies in URI’s operations but also for customers which we believe improves the overall customer experience.

“And standard process is really good. But it's even better when paired with the right technology. In a large distributed organization like United Rentals, it's imperative that we enable our local teams with the right technology in the right places. And we've deployed each tool based on field feedback. We've created, tested and scaled new tools in very specific places throughout the supply chain and order process. These enhancements reduce keystrokes, reduce footprints and support consistent and standard work. And they also enable us to scale across the organization our true competitive advantage. Alongside our standard processes, the right technology allows us to rapidly improve the efficiency of our existing location and also aids in integrating new acquisitions. The benefits are clear. Locally, our teams are able to operate more efficiently with standard processes enabled by technology. And across the enterprise, we're able to use data to identify opportunity for innovation. “– Michael Durand 2018 Investor Day

Advantage #6: Geographic and customer diversity leaves them with limited exposure to any customer or region

United Rentals has ~1,255 locations in the USA and another 196 locations spread across Canada, Asia Pacific, and Europe (~1,450 in total). Despite a much higher skew towards large national accounts, they still have low customer concentration with the largest customer representing just 1% of revenues over the last 5 years. Even when we consider the top 5 customers, that mix has shifted from 6% to 4% of revenue over the past 5 years. These metrics suggest low individual customer concentration but underlying correlations are likely higher than this data suggests. Customer activity levels will be driven by the economic environment, interest rates, and overall equipment availability.

The best example of how URI could better manage through a cycle would be to look at Canadian Industry Data, show in Exhibit T. The Canadian rentals industry had peak margins in 2014 then went through a 2-year downturn where industry margins fell by 830 bps. During this period, URI used its relocation and repurposing expertise to move equipment out of Canada and into stronger markets while demand was depressed. This highlights another dynamic where subscale regional peers would not have this option and may have been forced to sell assets into a weaker demand environment to generate cash flow.

Back in 2015, former CEO Kneeland explained, " While we expect to see a drag in some trade areas from the slowdown in upstream oil, our exposure is greatly limited by our size, agility and diversification. Furthermore, we believe that low oil prices will be a boon to many sectors we serve, spurring demand in manufacturing and other markets hungry for our fleet."

Advantage #7 M&A Competency

United Rentals is widely known in the sector as one of the few companies in the space with the experience and capability to complete large acquisitions. Sunbelt, the company’s largest competitor has also reiterated to investors many times in the past that they prefer to build out the asset base organically leaving even fewer bidders at the table for many deals URI is interested in. Herc, another growing competitor (but still much smaller) has limited integration experience, and are likely to only to consider M&A as an option to grow in special circumstances. It is important to remember that URI was effectively built through ~300 transactions. While not every deal was a success, this high-frequency iterative process has given them plenty of experience to improve their M&A prowess. The current CFO has been the first to admit that URI has made every mistake in the book, but through these mistakes and iterations, they have built the most robust M&A playbook in the industry. This means even in complicated or “hairy” situations the company can make a bid for incremental assets and generate attractive returns. Much of the industry utilizes software “RentalMan” which is an ERP offering from Wynne Systems, which makes integrations much more seamless. URI has also made incremental investments into software customizations on top of this system to aide and improve its overall processes.

If we look at the major transactions completed since 2012, the company has typically categorized deals into two groups (1) Core Rentals and (2) Specialty as shown in Exhibit U. Most of the large deals completed since 2011 have been funded with cash, and in my opinion, only one was a disappointing deal when I look back at the track record. That deal was National Pump, which was acquired near the peak spending environment in the oil and gas sector. The subsequent decline in oil and gas activity led to disappointing post-acquisition performance relative to initial expectations. Outside of that deal, I believe most have achieved returns in-line with management and investor expectations. This has been driven by two factors (1) the company’s ability to deliver cost synergies like a reduction in redundant costs at the acquired entity (SG&A etc.) and obtaining better discounts on purchased equipment, and (2) effectively cross-selling incremental services. We estimated that through cost + revenue synergies they have generally been able to improve EBITDA performance by 25-30% on deals in the past.

Management & Governance

Observation #1:  Strong Leadership & Deep Bench

CEO & President, Matthew Flannery is the 4th CEO the company has had since its IPO. He joined URI in 1998 when it acquired McClinch Equipment and has since held multiple executive roles. Annualized returns during his tenure look better than any of his predecessors. We believe he has continued to drive consistent execution and profitable reinvestment into specialty assets. Recent investment shifts have included incrementally buying a higher share of electric-fueled equipment and consolidation of Ahern Rentals - both of which should help better position the company long term.

There is a very deep bench of potential successors below Matthew who could all take on incremental responsibility over time. This includes Dale Asplund who is the current COO. The COO role was held by each of the previous 2 CEOs, suggesting he could be one of the future successors. Within the C-Suite the only notable change has been a change in the CFO position where Ted Grace, (Former VP of Investor Relations) has taken on the role in 2022 after the prior CFO had left for a similar role with US Steel. From the outside, that move appears to be a downgrade on the size and business quality front, so we would imagine other factors may have been at play in her decision-making. Ultimately, we continue to believe the company has strong leadership in place and we see limited succession concerns longer term.

What I don’t like is how little inside ownership there is. Collectively, there is about $100m in ownership by the board and executives. Which is quite low given the top 5 executives compensation was in excess of $27m last year. Insiders have also been net sellers over the past 12 months while aggregate exposure has been largely maintained as additional granted shares have provided some offset. Looking specifically at KPIs for the annual bonus program we believe it is reasonable focused on Adjusted EBITDA and the Economic Profit Indicator (EPI) captures the spread between the ROIC and assumed WACC – importantly, when they calculate this measure they use a conservative 10% which is well below the 8.7% WACC Bloomberg has reported over the past decade. Longer term incentive plan focuses on revenue growth and ROIC calculation which is relatively clean. Rounding it all out, we see more positives than negatives and would like to see management ownership at higher levels.

Observation #2 Better-Than-Average Culture & Employee Focus

As it stands, URI is heavily reliant on its team to deliver a positive customer experience, and as a result, employee satisfaction is critical over time. Management believes they have been able to achieve this through consistent promotions within the company and by providing an attractive environment for employees to grow. And the proof is in the pudding, with employee turnover rates below levels reported by competitors like Sunbelt Rentals over the past few years as shown below in Exhibit V.

URI, like many corporates, has also implemented an Employee Stock Ownership Plan (ESOP), which we believe helps drive an ownership mindset throughout different layers in the organization. The program appears quite attractive, and when combined with the 401K, employees could be earning up to 25% of their base salary/year through these additional incentives. Also, as we compare Glassdoor ratings vs peers like Sunbelt and HERC Rentals they appear to have modestly better recommendation & approval ratings. Last year the company was also selected as one of the Forbes Best Employers for 2022 and the Top Workplaces USA Award by Energage.  In short, I believe they’ve reinvested adequately into their employee base and in building their corporate culture.

Valuation

General Rentals, Specialty, and OEC Growth

The primary driver the of General Rentals and Specialty segment is the average Original Equipment Cost. As URI wants to generate more sales over time, they need to have the relevant equipment and locations near the customer base so it can economically serve this demand. We still see the potential for rental equipment penetration to increase over time and the location count is expected to grow alongside a growing fleet. Historically, the company’s fleet has grown meaningfully when an opportunity has come up to acquire a peer – but with Ahern Rentals now acquired there are limited larger peers they could acquire, incremental growth is likely to be organic. Exhibit W shows the average fleet size over our forecast period along with company’s location growth over the past 10 years and revenues per location which are expected to reach a record high in 2022.

My 2031 forecast shows aggregate revenues growing to 20.3b, and specialty growing faster than the general rentals business ending the forecast period at 33% of total sales. It is important to note that incremental growth is still expected all segments due to expected market growth and increasing penetration. We expect an 9.7% CAGR for Specialty and General Rentals Revenues to grow at 6.6% CAGR. If we assume 3% market growth over the next decade, this implies a TAM of 94.4b in 2032 – If URI continues to capture similar levels of industry wide growth as it did the past decade (38%) then it appears we should expect them to have near 22% market share. This market share estimate largely matches competitor expectations for the top 3 players and the top 50% of the market to be represented by 2-3 players.

As shown in Exhibit Y, Gross margins are expected to reach a record high through a combination of more disciplined industry pricing and increasing share of specialty. However, temporarily we expect them to have peaked in 2023 then be under cyclical pressure for 2 years. In the base case, we have gross profits roughly doubling by 2029 and growing at a 9.2% CAGR from 2021 to 2031. We expect a modest 50 bps improvement to SG&A costs over the forecast period through continuous improvement initiatives. We see incremental declines potentially harder to achieve without some wide scale process automation or other factors beyond our knowledge but acknowledge we could be surprised here.

This collectively leads to GAAP Net Income CAGR of 11.6% during our forecast period, with EPS growth expected at a 16% CAGR driven by buybacks where we deploy excess cash flow in our base case.

Sources and Uses of Cash

As I already highlighted, URI should generate substantially more cash flow than they can spend organically and while we see the limited potential to complete larger acquisitions, small tuck-ins should continue to represent an attractive reinvestment opportunity as these locations/equipment/expertise are rolled into URI network. We don’t model in incremental M&A, instead, we have the company returning capital to shareholders via buybacks and dividends which we expect to be initiated in about 5 years as shown in Exhibit Z. Through buybacks shares outstanding are expected to fall by ~34% over the next decade on our forecasts.

Base Case Vs Historical Results

Exhibit AA shows my how my base case expectations drive top-line growth of ~7% over the next decade, and net income growth of 11.6% , with EPS expected to grow faster at 16%. ROIC is expected to gradually improve towards 19%, above the prior peak as specialty share becomes a larger proportion of the business. D/EBITDA expected to remain 2.0x long-term with most of the excess cash expected to be returned to shareholders.

My base case suggests that fair value is $511/share, which is a ~34% discount to current price of $355/share. In other words, I expect that an investor today could earn a 12% annual return over the next decade. Exhibit AB shows a screenshot of my DCF output tab.

Alternative Scenarios

In the two scenarios, we adjust a few key drivers including OEC fleet growth, the share of specialty revenues, margins, and SG&A leverage.

Bull (14% 10Y IRR) – Sales are expected to grow at 7.5% CAGR vs 14% historically. Gross Margins are expected to reach 45%, up from the prior peak of 43% in 2014. Specialty Revenues are to reach 33% of revenues in 2031 vs 22% in 2021. Gross Profits are expected to grow at 8.4% CAGR and EBITDA is expected to grow at 9% CAGR.

Bear – (8% 10Y IRR) – Sales are expected to grow at 1.9% CAGR vs 14% historically. Gross Margins are expected to match 43% in-line with the prior peak. Specialty Revenues are to remain flat at ~23% of revenues in 2031 vs 22% in 2021. Gross Profits are expected to grow at 4% CAGR and EBITDA is expected to grow at 4.6% CAGR.

Conclusion

URI is the leader in a fragmented industry that is being consolidated and has a long list of competitive advantages that should help them continue to take market share over the next 10 years. The business is exposed to economic cycles, but an increasing proportion of it is becoming more stable/resilient. Capital spending can be rapidly cut during periods of economic turmoil which should leave leverage manageable throughout a cycle. My analysis suggests that the gap between the current price and fair value is reasonable and that this business stands out as one of the few which I believe could have a stronger moat in a decade than today as it continues to expand.