CHUBB - Laughing Water Capital - APi Group: Not Alone In My Optimism

Summary

• More recently APi Group became a large position as I added shares following a near 50% decline in price earlier this year.
• Management has laid out a clear path toward earnings power improvement in the years to come.
• Recent insider buying suggests that I am not alone in my optimism.

The following segment was excerpted from this fund letter .

APi Group ( APG )

APi Group ( APG ) – APG is the world’s leading provider of Life Safety services, which can be thought of as our fire safety business. APG was first introduced in the Q2 2020 letter, and we have owned it as a small position since that time.

More recently APG became a large position as I added shares following a near 50% decline in price earlier this year. The business has two segments, both of which are recession resistant. Safety Services (70% of revenue) which focuses on fire prevention services, and Specialty Services (30% of revenue) which primarily works with utility and telecom customers. In brief, fire prevention is still mandated by law regardless of the economy, and utilities and telecom continue to operate regardless of the economy.

Management has laid out a clear path toward earnings power improvement in the years to come.

• First, the industry is fragmented with many mom-and-pop players, and APG has been able to grow organically 6-7% a year for decades through a branch led model focused on providing better service, which in some ways is tied to scale. Management has indicated they are confident they can continue this cadence, which is likely conservative as industry rag Engineering News Record has predicted that fire safety should grow 9%, and recent growth has far exceeded the 6-7% estimate.
• Second, since the financial crisis the business has been focusing more and more on recurring services and inspection work, which is more predictable, and higher margin. Importantly, incremental margins tied to route density are significantly higher than run rate margins.
• Lastly, about a year ago APG acquired European fire and security assets ( OTCQB:CHUBB ) from Carrier Group ( CARR ). These businesses were an afterthought for CARR, which is primarily focused on HVAC. At a recent Investor Day, management detailed the opportunity to improve operations at these formerly neglected assets.

Putting it all together, management has outlined a plan that if successful should see normalized EBITDA and FCF grow by ~60% in the not-too-distant future. These estimates however are based solely on organic growth, and give no credit for intelligent capital allocation. This should be conservative as APG has a long and impressive track record of growth through acquisitions, and Co-Chairs Martin Franklin and James Lillie have a long track record of fantastic capital allocation and creative capital structure management.

In addition to a reasonable path toward earnings power improvement, perception is very likely to improve in the years to come.

• First, the Company flexed their balance sheet to acquire Chubb, but leverage should come down one turn per year as the Company executes. This deleveraging will accrete to the equity.
• Second, the taint associated with being a post SPAC equity will fade with time.
• Third, at present the SPAC sponsors have an unusual compensation scheme whereby they are paid on performance of common shares through a preferred equity structure that results in dilution. This arrangement clearly aligns the sponsors with equity holders, but is confusing to some investors and off-putting to others. In either case, it will be eliminated in 2026, making the story cleaner.
• Fourth, the sell side has been critical of the recent Chubb acquisition, but in my view this criticism is focused on the rearview mirror. The windshield should become more clear with time. As the Company executes, I do not think it is unreasonable to think that APG can trade at 16x EBITDA or 20x FCF, in line with other Engineering & Construction firms that in my view service less desirable end markets.

As revenue grows organically 6-7% a year, and margins widen through increased efficiency and density, I believe EBITDA will grow by ~60% over the next 3-4 years, which suggests APG currently trades at ~6x the FCF the Company will generate, assuming conversion of preferred shares. Additional upside is possible, perhaps even likely, as there is a long track record of successful bolt on M&A, and a very capable sponsor group will seek to maximize upside through creative capital allocation. As perception improves and revenue mix moves increasingly toward statutorily required work, I believe this business could ultimately trade at 20x FCF, which would imply ~200% upside.

Taken together, I believe the combination of reasonable growth, widening margins, and improving perception can lead to a stock in the low $50s in a few years, assuming that management does not do anything smart. However, given the combination of skin in the game and a world-class track record of capital allocation by the Co-chairs, this would be a very poor assumption. I think it is very likely that instead of sitting idly, they will be attempting to realize value in every way possible, with some combination of larger scale M&A, tax-efficiently spinning or selling the Specialty Services business, and returning capital via buybacks all representing reasonable paths forward. If things do not unfold as I hope, I think we will still do well over time. I would note that recent insider buying suggests that I am not alone in my optimism.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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