Dilok Klaisataporn
Dear Investors and Friends,
It has been a brutal year for the global stock and bond markets. It is the worst start to the year for the S&P 500 since 1970. For the first half of the year the Brasada Focused Equity Strategy returned -25.7% net of fees. We hate to lose money. In a world where the 10-year Treasury yield increases from 1.4% at year end to 3% at quarter end multiples on investment assets have to decline. A slowing economy and increased investor pessimism just adds fuel to the fire.
We are long-term investors and our performance over 3 years, 5 years, and since inception is still strong. The companies we own are recession resistant, cash flow positive, have a track record of creating value through smart capital allocation, and have strong balance sheets. We don’t own SPACs, longshots, undifferentiated companies, companies that are highly levered, generate negative cash flow, or need access to capital. The selloff has created a multitude of investment opportunities.
We have recently established positions in two new ideas discussed below which further illustrate the characteristics of that we are looking for in a long-term investment.
New Position: Azenta Life Sciences (AZTA)
Life Science Tools is a sector that we have always favored as it is recession resistant, and it has long term growth driven by innovation at biopharma companies. Many of the companies in the sector sell unique, mission critical products, have a high percentage of recurring revenues, and limited competition. Historically we have had success with Illumina and Danaher.
Azenta is a new name for us. The company provides biological sample storage management solutions and genomics services to biopharma firms as well as large clinic academic systems and academic researchers. Biological samples are important sources of information to develop new therapies as well as more complex Cell and Gene Therapies as well as individualized treatments. The acceleration of research and development towards Cell and Gene Therapies and mRNA vaccines requires large scale cold storage, which is Azenta’s specialty.
Today there are 9 FDA approved Cell and Gene Therapies and over 1,000 clinical trials. Azenta also offers genomic sequencing through its Genewiz subsidiary. This is a service that they can cross sell to existing sample storage management customers.
Their core markets are expected to grow 15%-20% per annum for the next five years. Given Azenta’s leading market position in automated sample storage, we expect them to take share from competitors and their customers, who are increasingly outsourcing non-core operations.
A key feature of the business is the biorepository sample storage division, which underpins their unique recurring revenue model. Approximately 60% of the 70m samples under their care are expected to be stored for up to 25 years. When looking at visibility of earnings approximately 75% of AZTA’s revenue is recurring with a customer base intent on storing for up to 25 years. This should lead to the conclusion this is no ordinary company, and should be afforded a higher valuation.
Under CEO, Dr. Steve Schwartz, Azenta has a management team that has proven they can execute and allocate capital for well over a decade. Earlier this year the company sold its semiconductor division for $2.6 Billion after taxes (their market cap is only $5 Billion). They now have a war chest for M&A and capex. We expect the company to build out their sample storage business globally, make tuck in acquisitions, and possibly a larger service acquisition like Genewiz that they can cross sell to existing customers.
At present, the company is trading at ~10x EV/FY’24 EBITDA with guidance of 20% revenue growth for the next few years. Given the conservativeness of management and the highly recurring nature of the business we expect the company to perform to their expectations irrespective of the current US business cycle.
Recent weakness in genomics services in 2Q due to China’s (~10% of AZTA revenue) onerous COVID lockdowns represent a unique opportunity for long term holders as the company has only stumbled a few times in the past ten years by no fault of their own.
New Position: Cadre Holdings (CDRE)
Cadre is another recent addition. We became familiar with the company in December, but were unable to build much of a position as the stock ran up. The company recently issued equity in a secondary offering that was poorly received, and the price declined to where it was when we first discovered it. We were able to take advantage of the sell off and purchase shares. Patience can pay off.
This is a scenario where we are betting on the jockey to build a compounder. In 1996 Warren Kanders bought a tiny company body armor company in Florida that was generating $11M in revenue. This was the seed of Armor Holdings, which eventually went public and was sold to BAE Systems in 2007 for $4.5B. In 2012 BAE sold back to Kanders the body armor and holster business. Kanders has been building the business, which is now called Cadre Holdings, and he took the company public in August of 2021. Kanders is the Chairman and CEO. He still owns almost 50% of the stock.
The company operates mostly in 3 different segments which are Body Amor, Duty Gear, and Explosive Ordinance Disposal. CDRE’s products are considered to be mission critical and over 80% of products are tied to refresh cycles of 7 to 10 years. The Body Armor business sells body armor to law enforcement agencies. The key brands are Safariland and Protech Tactical. They have a 40% share of the US market. Their primary competitor is Point Blank. CDRE tends to avoid selling body armor to the military because the margins there are lower. Law enforcement margins tend to be higher because the body armor must be fitted and sized.
The Duty Gear business sells safety holsters and other items to law enforcement and other US federal agencies. The company believes they have a 90% market share of US law enforcement safety holsters. The EOD segment sells explosive ordnance equipment, which are basically bomb detection suits similar to the ones in the movie The Hurt Locker. These suits and equipment are sold to law enforcement and military organizations. They have an 85% share of the global developed market.
Regarding their customers, they sell at least one product to each of the top 50 law enforcement departments in the US. US state and local law enforcement and other organizations such as department of corrections and fishing and wildlife enforcement account for 57% of sales. International defense and law enforcement account for 17% of sales. US Federal Agencies such as DHS, DoI and all 4 military branches represent 16% of sales. Commercial customers represent 10% of sales.
US police expenditures and major law enforcement budgets generally increase at 2% to 3% per year. They are not cyclical and have not declined in prior recessions. The American Rescue Plan provides $350B to hire more police. The ‘defund the police’ movement is backfiring as evidenced by the recent recall of Chesa Boudin in San Francisco. Military budgets in Europe are going up and are likely to go up in the US as well.
As a call option, they are working with the military on a blast sensor for soldiers to help treat traumatic brain injuries. The sensors would likely be worn by all Special Forces soldiers. It’s possible that the program could be expanded to soldiers outside of Special Forces too. CDRE has a blast sensor product that is sold through the EOD business. They are working on a different sensor for the military. They and one other company are competing for the award. Phase I has been completed. Phase 2 should be completed soon. It is likely that a winner will be announced in 2023.
The company generates a significant amount of free cash flow, and the goal is to use that free cash flow to make acquisitions that will expand their market share internationally or allow them to buy companies with adjacent products. They are looking to buy companies that have a leading market position, a high cost of substitution, defensible technology, don’t compete with large companies, operate in a niche, have a strong brand, are mission critical, have a recurring revenue model, and are asset light
The goal is to grow revenues by 3% to 5% organically per year (2% to 3% volume and 1% price) and to make 2 to 4 acquisitions per year, which would equate to double digit EBITDA growth. The President, Brad Williams, and the CFO, Blaine Browers run the company on a daily basis. They are both from Idex Corp (IEX), which is considered one of the best managed Industrial companies. There are also 5 other ex IEX employees on the management team. They have instituted the IEX culture into CDRE.
Sold: POOL Corporation (POOL)
We originally purchased POOL in March of 2020. The stock performed much better than we anticipated due to the unprecedented demand for new pools from families stuck at home. Recurring revenue is one of the key attributes that we look for, and 60% of POOLs revenues are from maintenance type items.
However, we think that a meaningful amount of new pool construction was pulled forward into the 2020 to 2022 time period and that expectations for growth in 2023 are too high. Next, POOL has never had a formidable competitor. Their returns have not gone unnoticed and Leonard Green & Partners is building a legitimate competitor through M&A. Finally, POOL made a sizeable and questionable acquisition of Porpoise Pool & Patio late last year. We originally gave them the benefit of the doubt on this one due to their track record on acquisitions, but through further due diligence we wonder how well this is going to work out.
The combination of these factors made us uncomfortable with the downside risk and we exited the position during the quarter. In hindsight we wish we sold POOL at the end of last year, but we like to “water our flowers and cut our weeds”. POOL is a great company with a great management team, and it’s never an easy decision to sell something like this. Time will tell if we were right or wrong. So far this has the hallmarks of a well-executed sell decision.
Conclusion
The Federal Reserve has decided that inflation is enemy number one. Unfortunately, they only have tools designed to slow demand. They cannot fix supply chain issues, which are still a problem. They cannot increase the supply of gasoline and diesel, which are both limited by oil production and refinery capacity. The Fed is intent on raising interest rates to slow the economy and they are willing to push the economy into a recession if that’s what it takes to stop inflation. Their plan is beginning to work, but it will have consequences.
For instance, 30-year mortgage rates have risen sharply from just over 3% at the beginning of the year to 5.3% today. This is having an immediate impact on the number of people that can afford a home. Ultimately, it will reduce home prices, housing starts, remodeling activity, and economic growth.
We expect the economy to continue to slow as the Fed raises rates further. Offsetting inflationary pressure, many of the supply issues that have plagued the economy since the start of the pandemic appear to be reversing with shipping rates and transport costs rolling over. Easing of supply chain issues coupled with a decrease in demand could bring down inflation more quickly than many realize resulting in what we’d describe as a more ‘normalized’ environment in ’23 and beyond.
Bear markets are painful, and they are not something that can be avoided. They are something that you must accept as a long-term investor. Nobody rings a bell at the bottom. In 2020, the market hit its low on March 23rd well before the economy began to recover. By the end of May, the market was already up by 36% from the March 23rd low. Timing the market is a fool’s game. This is why we spend very little time on the macro. We instead search for unique companies, with great management teams, that can continuously reinvest capital at high rates of return.
Some of our best investments have been made in bear markets. When market participants are overly focused on the next few months, our long-term outlook allows us to look past any current turmoil. Despite the rough start to the year the thesis on all of our current investments is as valid today as the day we initiated the position. We don’t know where they will be trading next week, next month or at the end of the year, but we do expect they will be materially higher in two to three years.
We appreciate the confidence you have placed in us and wish you the best.
Sincerely,
Jonathan Reichek, CFA | Daniel Prather, CFA
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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