Source Capital, Inc.
Q3 2013 Earnings Call Transcript

Published: 23 Oct 2013

[Mark Hancock:]

Good afternoon everybody and thank you for joining us today. We’d like to welcome you to the Third Quarter 2013 webcast for the FPA Perennial Funds. My name is Mark Hancock, and I’m Director of Client Service and Business Development here at FPA. The audio, visual and transcript aspects of today’s webcast will be made available on our website fpafunds.com over the next week or so. It is my pleasure to introduce the portfolio management team of Eric Ende, Steven Geist and Greg Herr of our small midcap quality strategy, which includes the FPA Perennial Fund. Today they will discuss the Fund’s performance, the related activity in the portfolio and current positioning. I would now like to hand over to Steven Geist.

[Steven Geist:]

Thanks Mark. We’ll start off with performance. Certainly the third quarter of this year, the stock market really took off. The Russell 2500 turned in a phenomenal gain of 9% for the quarter. The S&P was up over 5%. Perennial Fund had a very good quarter at plus 6.5%. So not quite as stellar as the Russell 2500, but still quite a bit ahead of the broader S&P. For a very large gain in the quarter, our performance relative to this 2500 is fairly typical. For the most part over most of the time periods, Perennial Fund is well ahead of the S&P 500 and is certainly ahead of both indexes for the very long term 15 year period. Now moving to some selected stock performance, beginning with the third quarter in Perennial. A couple of things to note on this chart. If we look at the best performers, if you look at the ending weight of those companies, you can see that those are all some of the larger weightings within the portfolio. If you jump across to the right and you look at the worst performers, you can see that generally speaking those are some of the smallest weights in the portfolio, again as you would expect considering we were up 6.5% from the quarter. In terms of best performers, O'Reilly reported a very strong second quarter, with same-store comps up 6.5%. Also WABCO reported an all-time record in quarterly earnings, and so both of those heavily weighted stocks were up a considerable amount. On the downside, EVS had somewhat of a disappointing second quarter, but margins are still at 32%, and they’re still the market leader in their niche of broadcast equipment. Knight Transportation was off slightly due to some soft pricing environment in the truckload category, but again it was not down by very much, and so the impact on the portfolio was relatively minor. If we go to the year to date, our stock performance, again the same story. When you look at the weightings within the portfolio, the best performers are all very significant weightings within the portfolio. In terms of the worst performers, the weightings are bordering, and in some cases almost inconsequential. O’Reilly was the best performer year to date, up over 40%, and is still benefiting from the CSK acquisition that they made several years ago and as they continue to integrate that into the store base. Signet also had a very strong same-store sales during the quarter, up 5% year to date. Again, it was rewarded in the marketplace. At this point we’ll be doing some company updates, and I’d like to turn it over to Greg Herr.

[Gregory Herr:]

Thank you, Steve. Thanks again to everyone for joining us on the call today. We very much appreciate you taking the time to be with us. We’re going to start with an update on O’Reilly Automotive, which those of you who have followed the strategy for some time know that this has been one of our long held positions in the portfolios, and the company recently had an Analyst Day at its distribution center in Salt Lake City. We attended and we thought it would be a good chance to update you on what’s happening with the business, and O’Reilly was at the end of the quarter, continues to be the largest position in the portfolio to give you some understanding about our thoughts on the business going forward. For those that might not be familiar with O’Reilly, the slide demonstrates, as the name implies that they’re selling replacement parts for cars both in the stores as you can see to retail customers as well as to commercial customers, mechanics, garages, that sort of thing. Historically, the split between those two has been about 50% each category. Right now, it’s a little more heavily weighted toward the retail part of the business, but we would expect over time that it’s going to be about half and half each. Now, it’s important that they sell to both of those markets because this allows them to get into both large and small markets. They can leverage their sales across both retail customers and commercial customers. It also allows them to fully leverage the distribution system that they’ve created, which we’ll talk about in just a minute. In terms of why we’re enthusiastic about O’Reilly as a business, there’s a couple of factors. The first is just the industry overall. Everyone knows that cars in general are better built in design today than they were in the past, and so the fleet of cars in the U.S has been aging. If we went back 10 years, the average age was about nine and a half years. Today, it is 11 years. So, you have more repair needs on the road today. We think that’s a very positive long term trend for O’Reilly. The second thing we like about the business is that it’s very stable over time. When the economy is booming, people come into the stores and they pick up things. When the economy is weak or there’s significant pressure, you still need to do the repairs on your cars, you can forgo a lot of other spending, but if you can’t get yourself to a job or to essential meetings, obviously you can’t earn any money, and so even in very difficult times, people are spending for repairs. We also are very positive on the management team here. This is a group that has operated the business extremely well throughout multiple cycles, also allocated capital particularly well. We’ll talk about that in a minute. Then finally, we think that the build out they’ve done at their distribution system is a really significant competitive advantage for the business and one that competitors will not be able to erode easily over time. Turning to what was discussed at the Analyst meeting, they talked about from the retail side introducing a loyalty card which is going to allow them to better track the spending of their customers. We’re expecting this to give a slight lift to sales in the future, but honestly it’s something that all the retailers are doing these days, and so it’s just a matter of them not being competitive we think with everyone else. Secondly, they introduced a new parts catalog and this is fairly important. It allows them to both look up parts faster and do more advanced searches. They’re also going to update the catalog in every two weeks versus every month. When someone comes in and asks for a part, it will give the employee an option of giving them a good, better, best result which we think will allow them to deal with price concerns and also sell some related products, so this should give a lift to retail sales we think over time. There’s also been an investment in inventory by the company over the last year, which we think will be meaningful in terms of providing availability for both import parts as well as some additional hard parts. You can see on the slide that they’ve increased the number of inventory hub stores to just over 250. We’ll talk about why that’s important in a minute. But the combination of those hub stores and the distribution centers means that 85% of their stores are getting deliveries more than once a day and they are [indiscernible] eight times a day. Particularly for the commercial part of the business, delivering to the garages and the mechanics, parts availability is the number one factor that they care about, and so being able to do that multiple times per day is a really big deal, and it is something we think gives O’Reilly a nice advantage in the business. So here is an overview of what the distribution system looks like, starting with the suppliers, all the way through the O’Reilly channel to the end customers. You can see that the distribution centers stock about six times the number of SKUs that the stores do. The hub stores, about twice as many. Something that we thought was pretty interesting, almost any part in the system could go overnight and arrive at a store anywhere in the country depending on people’s needs, so we think that’s a very significant advantage as parts availability as I said really drives the business. We turn to sort of an analysis of O’Reilly versus Advance Auto and AutoZone (inaudible) public competitors. You can see that just in terms of the stores per distribution center, O’Reilly is serving on average 166 stores from each of their 24 DCs. For Advance Auto, it’s more than twice the number of stores per DC, and AutoZone is well over three times the number. Down at the bottom of that table, you can also see that O’Reilly is dedicating twice the square footage, more than twice the square footage to distribution than AutoZone does. Now, if parts availability is what drives the commercial business in particular, the companies that are competing here certainly understand that. Advance and AutoZone are well run companies. The question is why wouldn’t they have built out their distribution as well? In the case of AutoZone, if you ask the management, they’ll tell you we’re call on capital focus and we get or maximize our return on capital by having nine DCs and serving the stores with this configuration. Anything else would be dilutive to our returns and we haven’t been interested in making that tradeoff. That’s absolutely true. What we’ve seen historically with O’Reilly if you go back over the last decade of their investment, returns on capital for the business were in the maybe 12% range on average over that decade. That’s well above their cost of capital, but significantly less than the spreads in AutoZone would have earned over the same time. Now, having made all this distribution investment, as we sit here today, O’Reilly is generating 18% returns on capital employed the way we calculate it. If you back out intangibles from the balance sheet, it’s more like 23%. So we think O’Reilly has gone through the period of investment and we’re now at the point where they’re going to be reaping significant returns and it’s too late for AutoZone or Advance to catch up investing organically in distribution. So turning to what the potential is for growth in the business, the company has grown the store base about 5% a year, the last five years. They talked at the Analyst Day about the opportunities in the Mid-Atlantic States in the northeast and in Florida. We think they can grow them at 4% a year going forward, particularly in those geographies. They’re going to be adding a distribution center in Florida that’s going to open the start of this next year. It will serve 300 stores down there, one in the northeast as well. And we think that that will continue to allow them to make the daily deliveries that are very significant for the business. So putting all this together, I’ve said that we think they can grow Source 4% a year. The comp store sales can grow 2% or 3% on top of that. So sales can grow in the 7% range. There’s still some margin opportunities, both gross margin and then some leverage on operating expenses. They can probably grow 8%, 9%. And then the company takes its cash flow and buys back shares with the excess. So we can see earnings per share in the 12%, 13% range we think over the forecast period. You combine that with the management team that we feel is one of the best across the portfolio companies. The stability of the business that I mentioned and the fact that you’re generating 18%, 19% returns on capital at this point. We think that’s quite attractive. You see what’s implied by the consensus evaluation at this point and we would say that the business is reasonably valued, given those prospects. We continue to be very enthusiastic about O’Reilly. With that said, I’m going to turn the call over to Eric to discuss Knight Transportation.

[Eric Ende:]

Thank you, Greg. On September 26, just before the close of the third quarter, Knight Transportation announced that it would pursue a takeover of USA Truck on a hostile basis if necessary. This would be the first unfriendly deal in the portfolio in many years. The terms of the proposed acquisition were $100 million for USA Truck’s common stock, plus $150 million for assumption of its debt, a total of $250 million. On an equity basis, $9 per share offer would amount to a 40% premium of USA Truck’s share price at the most recent date and premiums at 50% to 60% over prices within the last month. We first purchased Knight in September 2002 at a price of about $7 a share. At the end of the quarter we owned 1 million shares, a 3% addition. Together with the similar Heartland Express, our total ownership of truckload carriers is 6% of the portfolio. The truckload industry has limited economies of scale. That’s why there are thousands of trucking companies instead of a couple dozen. Bigger is not always better in truckload. Larger merges however often fail to produce expected gains. The key is to decentralize operations. Knight and Heartland have done this and as a result, have retained their superior operating margins. Knight believes that there is lots of room for improvements in USA Truck’s operating performance, but that current management is not the one most likely to engineer this transformation, a view that appears well supported by the relative profitability of each of the businesses. With an operating margin of negative 2%, USA Truck loses $2 on each $100 of sales revenue while Knight’s operating margin at 15% indicates a profit of $15 from the similar amount of revenue. Typical industry performance is at $5 margin or about one third the profitability of Knight. Knight’s track record in acquiring similar trucking businesses has been quite good, with four small to mid-sized companies purchased over the past decade and a half. Knight has sought out USA Truck’s board of directors to engage in a serious discussion of the options as well as contacting large shareholders. Knight itself owns 11% of USA Truck’s shares. It is important to note that this is not a trivial deal. The $250 million purchase price compares with the current Knight equity market cap of $1.3 billion. Knight’s fleet has about 4,000 tractors on industry leading margins, while USA Truck operates about 2,000 tractors at essentially no return. We believe the opportunity for substantial accretion is clear. I will now pass the mic back to Steven Geist for additional company notes.

[Steven Geist:]

Additional news on companies within the portfolio, I’ll briefly describe four of them. The first one is Maxim Integrated Products, the company that manufacturers linear and mixed signal integrated circuits. We haven’t discussed this one in quite some time. Annual revenues for Maxim, about $2.5 billion. They recently acquired Volterra Semiconductor for $415 million net of cash. Volterra’s business is in the designing ICs that manage power for power consumption for servers in storage units. This is a very important acquisition for Maxim. Maxim currently derives most – a lot of its business from mobile devices where again power consumption is important. Roughly 30% of their revenues comes from one client and that would be Samsung. So by diversifying their business, still staying within power management but diversifying into the server and storage market, they’re decreasing their exposure to Samsung which of course right now Samsung is doing very well, but the phone business is consumer oriented and you never quite know what will happen in that area, whereas we believe the server and storage market is much more stable and will help Maxim in the long run. Next up would be BioMerieux, which is a life sciences company. They design and manufacture in vitro diagnostics. It has annual revenues of about $2 billion. They recently acquired a company called BioFire for $450 million. BioFire specializes in molecular diagnostics. This is a very close fit, a strategic fit for BioMerieux which will not only benefit BioFire, but will also benefit BioMerieux as well. BioFire at this point has very manual production processes in their factories. BioMerieux will help them automate those processes, thus increasing BioFire’s margins and bringing them closer to the parent company. The deal is near term dilutive for BioMerieux and again that’s basically because of the investment in production processes that will have to take place. However, in the long run this is very good for BioMerieux. This will increase their North American footprint. It will also enable cross selling between the two companies, especially helping BioFire in the EU and the BRIC countries. Next up is FMC Technologies. We’ve talked about this many times in the past. They supply subsea production facilities, processing and high pressure control systems. Annual revenues of over $6 billion. They’re recently signed a substantial contract with Petrobras of Brazil for subsea manifolds for the offshore oil fields. For those of you not familiar with what a manifold is, it’s really a system with many inputs and many outputs. This will – at the moment this will go directly into FMC’s significant backlog. The $650 million worth of equipment will begin delivering in 2015. So this is a good long term investment opportunity for FMC. Just recently FMC signed another contract in Ghana for $350 million. So a lot of these contracts continue to roll in for FMC. Last, but not least, Noble. Again a company we’ve talked about in the past. They provide offshore contract drilling services. Their annual revenues are around $5 billion. Their board of directors recently approved the plan to separate Noble into two different companies. One new entity being focusing on the shallow depth assets, mostly jack up rigs and the legacy business for Noble, the deep water and ultra-deep water drill ships and floating rigs will stay with the Noble Corporation name. this has been in the works for over a year. The spinoff is still actually a considerable time period away. Probably it won’t be completed until late 2014. So we most likely will not be discussing this for another year. However, it is quite a significant event. There may also be a potential IPO with the spinoff and when all those details come about like I say in about a year we’ll talk about it again. But this is quite a significant change for Noble and it attempts to unlock the value of their deep water and ultra-deep water assets. At this point we have some questions. We will proceed to answer them.

[Mark Hancock:]

Thanks Steve. A few questions that came in before today’s call and a few during the call. So, let’s work with them and [with] (ph) clusters in sort of relevant topics. but a couple on the portfolio aspect, so as your portfolio companies report good quarter results, are you getting any indication of underlying strength in the U.S or global economies?

[Eric Ende:]

It’s relatively early in the third quarter reporting cycle, but the indications we get are that sales growth is harder to come by than improved margins. This is something which also encourages continued interest in M&A activity. Besides the macro picture goes to the world, the U.S is still viewed by many as a safe haven both from a currency standpoint and as a place to invest. There continues to be a good Europe, North Europe and Central Europe and a bad Europe which is all the other parts. Among emerging countries, Brazil and India appear somewhat more worrisome than in the past at a slower rate.

[Mark Hancock:]

Thanks Eric. Do you believe the profit margins or returns on equity of your companies to be sustainable or do you believe they’re prone to reverse in a downturn?

[Steven Geist:]

That’s a good question, Mark. So we’ve – there’s been a lot of debate I guess in the market about whether margins are at peak levels or not. I guess overall we would say we think the margins for most of the companies in the portfolio are quite sustainable. If we just think about some of the business models and the fact that these are high quality companies, O’Reilly which we talked about a few minutes ago has very limited margin fluctuation, even when the economy is weak as people are needing to repair their cars. We have a portfolio position in a business called CLARCOR which is supplying filters for commercial equipment engines. You might get a little less usage, but the profitability is still very good there for the aftermarket business. Copart auctions cars that are wrecked for insurance companies for salvage auctions. People don’t stop having accidents in a downturn, and there’s some pricing power for the business. So, overall these are all businesses that we would expect the margins to be quite sustainable. Eric talked about Knight Transportation. You would think about Knight and Heartland, the trucking companies maybe having some margin risk. Actually, both of those companies historically have really managed their expenses well in the downturn. So, it is a portfolio overall that we think has very sustainable margin profile.

[Mark Hancock:]

Thanks. One last question on margins or ratios, etcetera. Are you (inaudible) P/E ratios today than 10 years ago where the interest rates are low and likely to stay that way for some time to come?

[Steven Geist:]

I think that the simple answer is no. We all know that the normal rate for interest rates should be higher. Obviously, they’ve been low for a long time, and as the question suggests, they could stay low for quite a while in the future. But our bias is not to be paying any more for businesses than we have historically. The only thing I would say is the low rates in general have -- we’ve seen example of various asset classes inflating as a result. And the same, I guess, is true for equities. And so, that’s just an impact on the market overall that we all have to deal with.

[Mark Hancock:]

Great. With that, a few questions on liquidity or cash levels, and a couple of our shareholders have commented that cash is near an all-time high. And then two related questions sort of why that or any comments related to that.

[Steven Geist:]

Yes, certainly a very timely question. At the end of the third quarter, cash levels were about 9% of the assets, somewhat higher than recent history. Recent history would indicate that our cash levels have typically been mid-single digit as opposed to high-single digit. A good part of this can be explained by what occurred in the second quarter. You may recall from last quarter’s call we liquidated three companies from the portfolio, Manpower, Actuant, and VCA Antech. We are continuing to look for opportunities to reinvest that cash. However, we have always said that we would not chase stocks. We would not overpay for stocks, and so at this point, we feel that the market continues to be overvalued and we’re willing to sit with that excess cash until some more opportunities present themselves. In the distant past, cash has actually been higher than where it is now, so this is not unfamiliar territory for us, but eventually it will get invested and all those investments will meet the same financial metrics that every other company in the portfolio meets.

[Gregory Herr:]

Steve, I would just add on top of that that we have started purchasing two new positions in the portfolio. As Steve said, those were not enough to offset the cash that was generated from the three sales in the second quarter. So, as he suggested, we’re going to continue to be disciplined and take our time when we find the right evaluation opportunities.

[Mark Hancock:]

Great. Thank you all. that ends the questions thus far. There might have been one or two that we didn’t address. I will be back to those individuals directly offline to address one or two comments, but thank you. Thank you too for participating in today’s third quarter 2013 webcast. We invite you, your colleagues, and shareholders to listen to the playback and view the recordings on our website as we’ve said within the next week or so at fpafunds.com. We urge you to visit the website for additional information on the funds, such as complete portfolio holdings, historical returns, and after-tax returns. We will after today’s recording give you the opportunity to comment or give constructive advice or criticism. We take it seriously. So if there is anything that you feel you have some comments on, we appreciate any feedback that you might have. Please visit our website fpafunds.com for future webcast information, including replays. We will post the time and date of the prospective calls towards the end of each current quarter and expect the calls as is in the case today to be held three to four weeks following each quarter end. If you did not receive an email invitation for today’s webcast from CRM Funds -- [e-mail], please email us at [e-mail], and we will add you to that list. We hope that our quarterly commentaries, webcasts, and special commentaries will continue to keep you appropriately informed on the strategy. We do want to make sure that you understand that the views expressed on this call are as of today October 22, 2013, and are subject to change based on market or other conditions. These views may differ from other portfolio managers and analysts of the firm as a whole and are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any mention of individual securities or sectors should not be construed as a recommendation to purchase or sell such securities, and any information provided is not a sufficient basis upon which to make an investment decision. The information provided does not constitute or should not be construed as an offer or solicitation, with respect to any securities, products, or services discussed. Past performance is not a guarantee of future results. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance in the security examples discussed. Any statistics have been obtained from sources believed to be reliable, but the accuracy and completeness cannot be guaranteed. You may request a prospectus directly from the Fund’s distributor, UMB distributors LLC or from our website fpafunds.com. Please read the prospectus carefully before investing. FPA Perennial fund is offered through UMB distributors LLC. This concludes today’s call. Thank you and enjoy the rest of your day.