DSGR - Merion Road Capital Q2 2023 Investor Letter

2023-07-20 04:30:00 ET

Summary

• Merion Road Capital Management LLC is a registered investment adviser. We focus on value-oriented investing through rigorous fundamental analysis of a company's operations.
• The Merion Road Small Cap Fund returned 5% during the second quarter.
• The long-only portfolio gained a bit over 13% during the second quarter bringing the year-to-date returns to 29%.

Note: All returns are net of management and performance fees. Past performance is not indicative of future results. Returns for the Merion Road Small Cap Fund for the period prior to fund launch (01/13/22) reflect a basket of SMAs.

Note: All returns are net of management and performance fees. Past performance is not indicative of future results. Returns for the Merion Road Small Cap Fund for the period prior to fund launch (01/13/22) reflect a basket of SMAs.

The long-only portfolio gained a bit over 13% during the second quarter bringing the year-to-date returns to 29%. Valuations for the market and our portfolio have bounced back from a tough 2022. Given the fact that opportunity costs have increased (i.e. cash is now yielding ~4%) and I have a reduced sense of conviction in future earnings, I have generally been a net seller. While I still maintain a large position in many of the companies I have discussed previously, I have pared back on our holdings and our cash currently sits around 20%. I am constantly looking for new investments and would have no problem deploying the entire cash balance today should a new idea arise.

One new addition to the book has been Endeavor Group Holdings ( EDR ). EDR is a conglomerate of various entertainment assets led by legendary executive Ari Emanuel. Its properties include owned sports (primarily the UFC), events, and talent representation. Earlier this year EDR announced that it would merge the UFC with the WWE to form a new publicly traded company called TKO Group Holdings ("TKO"). From a business perspective, this makes a ton of sense as EDR will assume management and control the vote with 51%. While Vince McMahon has created tremendous value at WWE, he has always been a polarizing figure and more recently has faced sexual misconduct allegations. With WWE television rights deals coming due next year, it makes sense to bring a proven industry leader like Emanuel to the helm. Furthermore, EDR should have strong negotiating power by combining the WWE with the UFC, an increasingly popular and mainstream sport.

Given that WWE ( WWE ) is currently a publicly traded company, we already have a public mark on TKO. At 16x EBITDA, TKO seems to be fairly priced, perhaps at a small discount. If you believe that the value of live sports will continue to grow, which I do, then this should be a nice investment over time. It still seems like early innings for UFC growth and there is the potential for EDR to improve monetization at WWE. For instance, Emanuel is on record saying that the rate card for SmackDown is 30% cheaper than the rest of the Friday night lineup.

Backing out the value of TKO, the remaining EDR business is currently trading at <5x EBITDA which seems entirely too cheap. Roughly 40% of EBITDA comes from their events business where they own, operate, or represent more than 800 events annually. This includes owned properties in sports (Miami Open, Madrid Open, Euroleague Basketball), fashion (New York Fashion Week), and art and collectibles (Frieze, Barrett-Jackson). They also serve as the manager for high-profile events like Wimbledon, the Super Bowl, the Olympics, the Premier League, and the Final Four. As consumers continue to place a premium on experiences this business should grow as well. Another 50% of their EBITDA comes from their ownership of William Morris Agency ("WME"), one of the largest talent representation businesses. In 2021 they represented clients in 8 of the 10 top box office-grossing films, arranged 330 scripted series, closed 150 new book deals including 87 best sellers, and represented 3 of the 4 headliners at Lollapalooza. While growth has been spotty over the past 5 years, this is a high return on capital, an industry-leading business that should deserve a decent multiple. As I write this, reports have emerged that WME's competitor, Creative Artists Agency, is in talks to sell itself for $7bn; while it is hard to say what this implies for WME, it highlights the value of this business.

A large reason for the depressed valuation of EDR is the fact that conglomerates typically trade at a discount to their sum of the parts. To EDR's credit, they recently closed on the divestiture of IMG Academy and are using part of the proceeds to repurchase stock. The private equity firm Silver Lake is a large shareholder and understands how to unlock value after taking Dell ( DELL ) through multiple stages, culminating with the spin-off of their majority ownership in publicly traded VMWare ( VMW ). It is not unfeasible that a similar situation ensues here when TKO becomes eligible for a tax-free spin.

The Merion Road Small Cap Fund returned 5% during the second quarter. We benefitted from building a mid-sized position in Circor ( CIR ) shortly before it announced that it would be acquired by KKR ( KKR ) at a 55% premium. I owned CIR last year and had a poorly timed sale given macro-uncertainty and their outsized European exposure. Fortunately, I kept it on my radar and noticed that their financials proved more resilient than my expectations, and their long-awaited sales process was gaining steam. I sold our stock after the initial deal announcement but repurchased some subsequently as a bidding war emerged between KKR and Arcline. Though it seems like we may have seen the last offer, the door is still open for a competing bid and the cost for such optionality is low. Our position in the IT staffing company and data & analytics company, Mastech ( MHH ), sold off in April on no news and was our largest detractor. Their most recent quarter was disappointing, but not entirely unexpected given macro headwinds and their outsized exposure to the banking industry.

During the quarter, I built a position in Distribution Solutions Group ( DSGR ) ahead of their rights offering. In addition to exercising our basic subscription rights, I put in for over-subscription and was pleasantly surprised to receive additional shares. DSGR is a specialty distribution platform formed when Lawson Products combined with two privately held entities, Gexpro Services and TestEquity in early 2022. Lawson is a North American industrial MRO distributor serving 80k customers across a range of industries including manufacturing, automotive, government/military, and construction. Lawson maintains cabinets at the customer location that they frequently restock with a myriad of low-ASP products. This allows their customer to reduce downtime and streamline product management. Gexpro is a global specialty distributor of highly specified products serving manufacturers in various markets including renewables, power generation, aerospace/defense, and consumer/industrial. Lastly, TestEquity is a global distributor of electronic production supplies and test and measurement solutions for aerospace/defense, industrial electronics, semiconductor production, and wireless communication. In aggregate, these can be described as low churn, highly recurring business models.

While DSGR is organized as a platform company with the three entities retaining prior leadership, they have a strong focus on leveraging the benefits of the three entities. This includes things like corporate synergies in IT and insurance, leadership incentives for cross-selling, and enhanced go-to-market strategies. Since they closed the merger, DSGR has grown revenue organically at a mid-teens rate and consolidated EBITDA margins have expanded nicely. Importantly, DSGR has a fully built-out M&A team with a disciplined investment framework around risk and returns and a developed pipeline. Management is fully aligned with shareholders as they own 10% of the company, while the former owner of Gexpro and TestEquity, Luther King Capital Management ("LKCM") owns another 65%. LKCM has significant experience investing in distribution companies and brings financial expertise to the table.

In March of this year, DSGR announced that they would acquire Hisco and merge it with TestEquity. Hisco is a mission-critical distributor that serves electronic assembly, aerospace/defense, medical, and other industrial customers with things like adhesives/sealants/tapes, soldering, and cleaning supplies. While Hisco's product mix differs from TestEquity, there is alignment between the industries they serve and their supplier base. This should enhance their customer value proposition and provide for cross-selling opportunities. Operationally, the two companies have meaningful overlap and there is the opportunity for consolidation. Furthermore, Hisco's Mexican footprint will benefit TestEquity in supporting nearshoring trends. DSGR made this acquisition at a stated EBITDA multiple of just 9.4x with the potential to bring it down to mid-7x when accounting for synergies. It was funded with debt as well as cash raised from the aforementioned rights offering. LKCM exercised their subscription rights and put in for oversubscription as well.

DSGR is currently trading around 9x pro forma EBITDA. This seems like a reasonable valuation for a company with a strong management team and a board of directors executing a thoughtful acquisition plan in a fragmented industry.

Sincerely,

Aaron Sallen

General Disclaimer

This material does not constitute an offer or the solicitation of an offer to purchase an interest in Merion Road Small Cap Fund, LP (the " Fund "), which such offer will only be made via a confidential private placement memorandum (the " Memorandum "). An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal. There is no secondary market for interests in the Fund and none is expected to develop. No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment. All statements herein are qualified in their entirety by reference to the Memorandum, and to the extent that this document contradicts the Memorandum, the Memorandum shall govern in all respects.

This material is confidential and may not be distributed or reproduced in whole or in part without the express written consent of Merion Road Capital Management, LLC (the " Investment Manager "). The information and opinions contained in this document are for background purposes only and do not purport to be full or complete. Unless otherwise stated, the information in this document is not personalized investment advice or an investment recommendation on the part of the Investment Manager.

The performance data discussed herein do not represent the performance of the Fund, but rather, represent the unaudited performance of a basket of separately managed accounts managed by the Investment Manager pursuant to the same strategy expected to be implemented for the Fund. Results generated in the Fund once outside capital is admitted could be materially different than those results shown. The results shown reflect the deduction of: (i) an annual asset management fee of 1.5%, charged quarterly; (ii) a performance allocation of 15%, taken annually, subject to a "high water mark;" and (iii) transaction fees and other expenses actually incurred. The management fee and performance allocation were applied retroactively and do not reflect actual fees charged. None of the results shown reflect the deduction of certain organizational and operating expenses common to investment funds, which would serve to decrease profits or otherwise increase losses. Results were achieved using the investment strategies described in the Memorandum.

Results are compared to the performance of the Russell 2000 Index, the Russell Micro-cap Index, and the Barclay HF Index (collectively, the " Comparative Indexes ") for informational purposes only. The Fund's investment program does not mirror any of the Comparative Indexes and the volatility of the Fund's investment program may be materially different from the volatility of the Comparative Indexes. The securities included in the Comparative Indexes are not necessarily included in the Fund's investment program and criteria for inclusion in the Comparative Indexes are different than criteria for investment by the Fund. The performance of the Comparative Indexes reflects the reinvestment of dividends, as appropriate.

This material contains certain forward-looking statements and projections regarding market trends, investment strategy, and the future asset allocation of the Fund, including indicative guidelines regarding position limits, exposures, position sizing, diversification, and other indications regarding the Fund's strategy. These projections and guidelines are included for illustrative purposes only, are inherently predictive, speculative, and involve risk and uncertainty because they relate to events and depend on circumstances that will occur in the future. The guidelines included herein do not reflect strict rules or limitations on the Fund's investment program and the Fund may deviate from the guidelines described herein. There are a number of factors that could cause actual events and developments to differ materially from those expressed or implied by these forward-looking statements, projections, and guidelines, and no assurances can be given that the forward-looking statements in this document will be realized or followed, as described. These forward-looking statements will not necessarily be updated in the future.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

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