2023-05-03 12:41:00 ET
Summary
- Brasada Capital Management is a privately-owned investment management firm based in Houston, Texas. We strive to maximize long-term returns using conservative approaches with a focus on reducing risk, fees, and tax implications.
- For the quarter Brasada Focused Equity Strategy returned 8.3% net of fees while the S&P 500 returned 7.5%.
- We focus on being invested in unique companies, with first class management teams that are recession resistant, have a long runway of growth, and can reinvest capital at high rates of return.
Dear Investors and Friends,
For the quarter Brasada Focused Equity Strategy returned 8.3% net of fees while the S&P 500 returned 7.5%. The macro environment today is incredibly confusing. The Fed raised rates in March and Powell said they do not plan to cut rates this year, yet the market expects the Fed will cut multiple before year end. The yield curve is deeply inverted. There are market strategists that claim we are in a new Bull market, while many others believe that the Bear is not over and we will hit new lows. The market has been resilient and has overcome a number of obstacles since the end of 2021 including:
- Interest rates rising at their fastest pace in the last 40 years.
- Collapse of massive crypto exchange, FTX.
- Russia/ Ukraine War.
- Increased Tensions with China.
- SPAC evaporation.
- Historic decline in bonds and stocks.
- Banking crisis with the 2 nd & 3 rd largest bank collapses in U.S. history.
- Largest Fed balance sheet on record.
If we spent 90% of our time trying to determine the direction of the economy or market we would be unsuccessful. We instead spend 90% of our time following the companies we own and searching for new ones to purchase. We like the companies we own and have a list of others we would like to buy at the right price. We expect to remain in a volatile environment and will redeploy our cash/treasury bill holdings into new ideas as the opportunities arise. During the quarter we initiated a position in Rentokil Initial, increased our position in Canadian Pacific, and we sold Google.
New Position: Rentokil Initial ( RTO )
Rentokil Initial is a UK based company that has pest control operations all over the world. They acquired Terminix on October 12, 2022. Prior to the Terminix deal RTO was the #3 pest control company in the US and approximately 44% of their sales were in North America. Today they are the #1 pest control company in the US and in the world. Almost 70% of sales are in the US. Regarding the pest control mix about 60% of pest control sales are residential, while about 40% are commercial, which by nature has lower customer churn.
Rollins ( ROL ) is considered the best operator in the industry, and Rentokil is considered a good operator but not on the level of ROL. Terminix was considered poorly run for years due to multiple CEO and strategy changes in a short amount of time. The pest control industry is fragmented globally and in the US. RTO and ROL are the top two players in the US and after that there are hundreds of smaller regional players. RTO and ROL are acquisitive but aside from the Terminix deal most deals are tuck in type deals that have high IRRs and are very accretive.
The pest control business is recession resistant. If you have roaches or in my case wasps in your house and you cannot get rid of them yourself, you are going to call an exterminator. If a restaurant or grocery store has a rat or roaches in the restaurant, they are going to be out of business fairly quickly. On their recent Q4 call ROL said that the market has the opportunity to grow mid to high single digits.
Terminix has had a number of leadership changes in recent years. I recently spoke with an executive at ROL and he told me he didn’t even know anyone there anymore. Brett Ponton became the most recent CEO of Terminix in September of 2020. He joined the company from Monro Muffler and had no pest control experience. In a recent interview with Potomac M&A Tony DiLucente the former CFO of Terminix from 2017 to 2021 said “There were a lot of distractions during my tenure. Let’s face it, I had four CEOs that I worked for in four years. When I think of why we’re underperforming from an organic growth standpoint is we had too much turnover at the very top. To me, that’s the number one root cause. We’ve done some good things in the time I was there. I’m proud of what we’ve done but we could have done more if we had a little bit more consistency at the top.”
John Myers built the RTO US pest control business from scratch and has been at RTO since 2008. Andy Ransom has been CEO of RTO since 2013 and he has done a fantastic job of growing RTO globally. We believe RTO is going to bring stability to Terminix, which is something Terminix desperately needs. RTO should be able to improve customer attrition, reduce technician turnover, and be more efficient with marketing spend. RTO has said that there will be at least $200M of synergies in 3 years. 50% of the cost savings will come from closing branches that overlap.
ROL trades at 28X 2023E EBITDA and about 36X 2023E FCF. RTO trades at 14X 2023E EBITDA and 25X 2023E FCF. While we do not expect RTO to achieve the multiple of ROL, we do think that it is undervalued. We think that the multiple will expand as investors become more aware of the company, and as they make progress with Terminix.
Canadian Pacific ( CP )
We have owned CP for about 2 years and we increased the size of our position during the quarter.
On March 15 th, the Surface Transportation Board ((STB)) approved CP’s merger with Kansas City Southern (KCS). This was the first Class 1 Railroad merger since Canadian National acquired Illinois Central in 1999. This will also be the last major railroad merger as any future combinations would not be able to gain approval from the STB. CP/KCS will be the only single-line railway connecting Canada to Mexico. It creates new rail options for shippers, and the company expects it to shift 64,000 truckloads from road to rail.
Keith Creel is the CEO of CP and he actually worked at Illinois Central when it was acquired by Canadian National. Creel is the protégé of Hunter Harrison, who was the Bill Walsh of railroading. Just as Walsh created the famous West Coast offense. Harrison created Precision Scheduled Railroading ((PSR)) and implemented it at several Class I railroads. Creel was with Harrison at Illinois Central, Canadian National, and he succeeded him as CEO at CP. CP has thrived under Creel’s leadership, and we believe there is an enormous amount of value that he can create with KCS. A picture is worth a thousand words and below is the new CP/KCS map.
Sold: Google ( GOOGL )
Approximately 14% of our portfolios are in Treasury Bills. Given that we are in a volatile and unpredictable environment we would like to preserve that 14% so that we can be offensive if the right opportunities present themselves. In order to buy RTO and add to CP we needed to sell something, and we chose to sell GOOGL. We have owned GOOGL since 2014 and it has been a great investment for us. Our original thesis was essentially that GOOGL dominated the internet and was poised to grow in search and through YouTube for years. The landscape is very different for GOOGL today vs. in 2014. The company is more mature which makes it less recession resistant.
In the past GOOGL was a secular grower and could easily growth through a downturn. Today they have such a large share of advertising dollars and an economic slowdown will have a greater impact on their growth. When we purchased GOOGL they had about 54,000 employees. They hired 72,000 people in the last 2 years and today they have about 178,000 employees. What do all these people do?
Meanwhile, GOOGL’s monopoly is at risk. They are reliant on Apple to have Google search as the default on iPhones. Amazon is now a competitor in the ad business, Microsoft has the potential to be more competitive with their integration of ChatGPT, and ChatGPT itself and other AI applications have the potential to take eyeballs away from Google. If that is not enough, the
DOJ is coming for Google, and if they are successful, it will further weaken Google’s position. It is not the end of the world for GOOGL. We still expect them to dominate search, they should be able to fix their cost structure, and the multiple on the stock is not demanding. However, we think there are better stocks to own for the long term.
Conclusion
The world is an unpredictable place. At the beginning of the year nobody thought Silicon Valley Bank would fail and few thought that UConn would win the NCAA basketball tournament. We just try to control what we can control. We focus on being invested in unique companies, with first class management teams that are recession resistant, have a long runway of growth, and can reinvest capital at high rates of return. We continue to believe that this strategy is conducive to superior returns over time. We appreciate the confidence you have placed in us and wish you the best.
Sincerely,
Jonathan Reichek, CFA
Ed Zhang
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
For further details see:
Brasada Capital Focused Equity Strategy Q1 2023 Letter