Although I’ve largely ignored engaging and depending on economic analysis in the past, I must observe that the main reason I got to research Argentinian companies, besides the fact that, incidentally, I live in Argentina, is that the country is facing huge structural changes. The economic environment no longer seems to posit a mid-term threat and, if reforms get fully implemented, it might not even posit a long-term threat. Notwithstanding this, considering the country’s history, it remains a risk present in the investment.

Having said this, I became more familiar with how countries’ prosperity manifests itself. Two indicators I’ll remark on are low-level, controlled, inflation, and a continuously increasing GDP per capita, which entails the average individual getting increasingly wealthier. In consequence, this boosts consumption and investment, both local and, once the effects are internationally recognized, foreign as well. The obverse might also occur if the government inspires confidence. It’s thus that I was inclined to investigate Argentinian securities and came across Irsa, which could potentially benefit from all tailwinds embedded in an economic recovery and growth thereafter. It’s a perfectly fine business that has been subject to Argentina’s calamities.

I’ve been thinking about Irsa since May 2024, but decided to wait for further assurance about the country’s future prospects. When these things occur, there’s too large a number of risks that escape the common spectrum thereof. More importantly, my intention is not only to play re-ratings, but hopefully benefit from an intrinsic value increasing longly after the investment is made. The latter could’ve only been assured, to some extent, if the country’s restructuring solidified.

Finally, before going into the analysis, there’s an element that’s got me puzzled for the past couple of months. Irsa is technically controlled by another publicly traded company called Cresud, which has a 53% stake in Irsa. Eduardo Elsztain is the person who essentially owns Cresud and Irsa, whose family members are on both boards and running the companies. I cannot infer to what extent this dynamic affects Irsa’s operations and equity holders, probably due to my ignorance.

However, I’ve always been suspicious of Argentinian management teams, having anecdotally heard of how they operate in general. Although incredibly talented, there’s always a sense of shadiness. There are too many things going on. Maybe this changes hereafter, but it’s a risk I cannot fully grasp that I thought should be mentioned beforehand.

I believe the past 5-years actions, track record in debt payback, and insider ownership, partly insulate equity holders from being taken advantage of. Furthermore, the business’s income is very high margin, mostly from royalties, and generates a lot of cash. I believe the chances of the large underlying margin of safety being eroded are incredibly low. Nonetheless, I think these risks should be reflected by appropriately sizing the position.

Business Overview

Irsa is, at its core, a real estate company with operations mostly centered in Argentina’s capital, Buenos Aires. It focuses on land development and buildings for various purposes. Over the decades, the company has acquired and developed shopping malls, office buildings, and hotels. On some occasions, Irsa acquires stakes in such enterprises. Management has complemented this by acquiring land for future usage and obtaining concessions for certain entertainment and convention centers.

Since Elsztain acquired and started running Irsa in the 90s, the company slowly began constructing its portfolio. Shopping malls were under a vehicle called Alto Palermo Centros Comerciales (APSA), in which Irsa had a 95% stake. The office portfolio was separately managed.

In 2014, both segments were merged under a single vehicle called Irsa Propiedades Comerciales (Irsa CP), which operated as a subsidiary. The rationale behind the decision was to increase efficiency and improve the cost structure of the whole corporation.

Over the subsequent years, Irsa used to pay a portion of its dividends in Irsa CP shares. In 2017, the company sold an 8.1% stake in the secondary market for $140M. After this transaction, Irsa held an 86.5% stake in Irsa CP.

In pursuit of further simplification of the corporate structure, increase efficiency, better incentive alignment, and improved liquidity, management decided to merge Irsa and its subsidiary in 2021, Irsa CP, where Irsa would be the absorber. The combined entity would then own all assets and obligations, presented on a single balance sheet. After the event, shareholders approved in the general meeting of September 2021 for Irsa to issue $152M in equity.

Shopping portfolio

Irsa’s shopping portfolio consists of 16 shopping malls, one of which was purchased in November of this year. Nine of these are located in Buenos Aires, whereas the remaining 7 are distributed throughout the country, though concentrated in major cities. Two malls are in Córdoba, and one in Santa Fe, Rosario, Salta, Neuquén, and Mendoza. It is to be observed that Córdoba, Rosario, Salta, and Santa Fe are the 3rd, 4th, 7th, and 8th, most populated cities in Argentina, with populations between 570,000 and 1,600,000. CABA, where malls are to be found within Buenos Aires, has a population of over 3 million people.

In aggregate, Irsa has approximately 370,000 sqm in gross leasable area across the portfolio and 1,485 stores. Collectively, they get tens of millions of visitors per year.

The company follows a dual billing policy within shopping malls. Tenants pay a fixed base rent and a variable component, which is a percentage of the tenant’s gross sales, generally ranging between 2-12%. Although Irsa collects the highest amount among both, allegedly, I believe it is the case that the contract seems to establish that tenants’ payments must always exceed a certain minimum. Nonetheless, in times of economic pressure, which has systematically been the case in Argentina, Irsa has been understanding with people, sometimes working out different payment schedules.

Combined, this base and variable rate make up almost 75% of the total revenue that shopping malls generate for Irsa. The remainder comes from other services, most of which correspond to admission rights, parking, and commissions. Key money and the brokerage fee must be paid in advance and when lease renewals effectuate. As of 2019, the amounts were 5x the base rent for the brokerage fee and 8x the base rent for the admission rights. These have not been disclosed as of the more recent past, but I suspect remain fairly in those ranges, considering Irsa’s reported revenue from these sources.

The following chart illustrates the percentage of revenue that the fixed and variable components represented of total rental income. The lowest rental income that shopping malls generated was $37.9M in 2021, with $23.9M being base rent, and $14M corresponding to the royalty on gross billings. Rent derived from a percentage of gross billings seems to have been increasingly taking share of total rental income. This suggests either that stores are doing increasingly well, or that there’s been some change in Irsa’s royalty fee. I’m inclined to suspect that, if the economy recovers and begins to grow, this source will contribute meaningfully more to Irsa’s rental income.

Aggregated tenant sales finished a mostly flat decade. In 2014, the portfolio of malls had total tenant sales of $1.46 billion, whereas in the fiscal year 2024, tenants had sales of $1.67bn. I must observe that Irsa’s fiscal year starts and ends in June of the calendar year. As of the writing of this report, namely December 2024, Irsa is finishing the second quarter of its 2025 fiscal year.

Notably, occupancy levels in shopping malls remained high, mostly above 94%. In the period 2019-2020, the country went through a severe recession, followed by the pandemic, which was managed quite peculiarly by the Argentinian government. For the whole of the pandemic, Argentina was one of the most restrictive countries. Overall closures had a negative impact on sales, which was enhanced by lower tourism levels.

What’s interesting about Irsa’s portfolio of real estate assets is that they are high quality and require very low levels of expense for continued maintenance and operation. The gross margin that Irsa has on revenue generated by shopping malls has been around 90% for the past 8 years. The operating margin has been more volatile because of around $25M in mostly fixed OpEx. When malls have normal years, with tenant sales around $1.4bn, Irsa’s operating margin on shopping malls is around 70-75%.

Note: The operating margin is computed on an adjusted basis. I took out the fair value adjustments that run through the p&l every single year.

Even though the book value of a business is rarely a precise estimation of its economic value, I believe there’s a huge dissociation between both with this company, which causes a two-fold problem, namely: (i) very volatile income statements; (ii) it’s much harder to assess Irsa’s earnings power at a first glance.

On the first point, I think most investors, when they come across an awful income statement, the company turns into an easy pass, which is perfect for a potential misprice to occur. In 2023, for instance, Irsa’s reported operating margin on malls was 49%, instead of the adjusted 73% margin. This is more pronounced with their office portfolio and land development segment, which largely impacted the company’s overall operating margin.

Irsa reported 692bn pesos in carrying value for their shopping mall portfolio as of June 2024; an amount that is equivalent to $513M. Over the past 5 years, the company has written down these assets for a total of $41.8M. This leaves them at 5.1x their adjusted FY24 operating income, or at 5.7x their reported operating income. This would mean Irsa is carrying its 15 shopping malls, excluding the last acquisition, at $1,531 per leasable square meter. In essence, a group of assets that have systematically generated lots of cash, even through terrible recessions, is carried at such a value.

The company has not only focused on acquiring and building shopping malls, but also on expanding individual ones. Over the past time, Irsa spent great effort in acquiring locations, land, buildings, or houses, next to constructed malls so that they could expand their operations. This way, Irsa has increased the shopping portfolio’s GLA by 53,521 square meters.

Since 2018, total tenant sales per square meter have averaged $4,110. By extrapolation, we find that Irsa’s expansions have led to approximately $220M in extra tenant sales per year. If we assume Irsa’s take rate on that is 5%, then the company increased its revenue by $11M annually. When operating at a 70% margin, this in turn translates into $7.7M EBIT. These numbers must of course be taken with a grain of salt, for the economics differ between malls.

The most recently completed expansion was in 2020, to Alto Palermo, which increased its GLA by 3,900sqm. During FY24, Alto Palermo has 20,733sqm of GLA, and reported total tenant sales of $217M, implying $10,500 in sales per square meter. With this in mind, Irsa might’ve increased total tenant sales by $41M with this last expansion, which translates into $2M in revenue and $1.4M in EBIT. Although the actual investment seems to not have been disclosed, Irsa estimated it at $28.5M before construction.

After considering non-rental income, the expansion might yield 6.5% per annum, though there may be some boost to all store sales. I must nonetheless observe that Alto Palermo is the mall with the highest sales per sqm in Irsa’s portfolio. It also probably holds the best location, and I ignore to what extent this impacts the investment required. Although it is not a mind-blowing yearly return, I can’t picture how it could cease to yield for at least a couple of decades. Furthermore, it’s an investment in tangible, high quality, assets, which have tended to preserve wealth very well in Argentina. This idea is at the core of Elzstain’s approach to business.

In August of 2024, Irsa acquired a location adjacent to the Alto Avellaneda mall for $12.2M. The property has a total area of 86,600sqm and buildable area of 32,660sqm. As of its current numbers, Alto Avellaneda’s tenants generate $4.300 in sales per sqm. Considering the extra GLA, this might translate into over $140M in total tenant sales. With a 5% average royalty and 70% operating margin, Irsa’s incremental EBIT would be $4.9M. After taxes, this leads to $3.47M in NOPAT. However, if we remember that Irsa’s income has a non-rental part, equal to ¼ of the total, we get that non-rental income on this expansion might be around $1.15M. The ultimate return on capital will depend on construction costs, but economics seem encouraging, mainly due to the life expectancy I suspect these assets have.

The last case I’ll mention in this line is a very recent one. On December 3rd, Irsa announced the acquisition of Terrazas de Mayo, a shopping mall located in Buenos Aires, outside the main part of the city, which is where most of its other malls are. The shopping has 33,720sqm of GLA, 90 stores, and 10 cinema theaters. Irsa agreed to pay $27.75M, 60% of which has already been paid. It’ll be unclear what the economics of the deal are until Irsa discloses the mall’s numbers (if it does). Terrazas de Mayo presumably has 7 million visitors per year.

Lastly, Irsa carries all-risk insurance for its portfolio of shopping malls, which would cover damages caused by most natural phenomena and social outbreaks. At the store level, tenants must secure adequate insurance. If the loss they experience upon an adverse event exceeds the proceeds from the claim, Irsa might face a loss.

Office portfolio

Irsa has 5 office buildings, although some are not wholly owned, for the company might have sold floors or units within them. This is the case of Della Paollera, for instance. The following image illustrates Irsa’s office portfolio, which, collectively, adds up to 59,000sqm of GLA.

Leases tend to have an average term of between 3 and 10 years, are generally stated in US dollars, and rates are mostly at market values.

In contrast to the shopping malls, what’s interesting about the office portfolio is that Irsa has placed great emphasis on diminishing its footprint. The company sold numerous units and floors over the past couple of years. As of 2018, the office portfolio had an aggregate 115,000sqm of GLA, whereas it finished the third quarter of 2024 with 59,000sqm. It must be observed that, at the same time, Irsa built and added a building to the portfolio, called Della Paollera, which is located in a premium area of the city.

Della Paollera offers a great illustration of Irsa’s past years’ rationale. Irsa began its construction in 2016 and inaugurated it in December of 2020, although work progress in June of 2019 was 95%. Throughout construction, the total investment presumably amounted to $110M, granting the company 30 office floors, or 35,000sqm of GLA, and 316 parking spaces. Over the past 4 years, Irsa has sold 23 floors for a total consideration of $232.2M, equivalent to $7,631 per square meter. After these sales, Irsa still owns 3 floors.

In addition to this, in 2021, Irsa made 2 large sales. The Bouchard 710 building, acquired in 2005, was sold for a total price of $87.2M; for it had 15,000sqm of GLA, Irsa sold it for $5,800/sqm. On the other hand, the company also sold 13 floors of Torre Boston for $83.4M. Considering the 13 floors had a total of 14,640sqm of GLA, each square meter was priced at around $5,700.

In April 2022, Irsa announced the sale of the República building for a total price of $131.8M. The building had 19,885sqm of GLA and 178 parking spaces. 80% was paid in cash, and the residual was in the form of land, namely 46 hectares in Buenos Aires, the province. This land counts with 521,000sqm of buildable area.

Irsa’s office portfolio is mostly composed of premium buildings, which is on which I’ll base the following chart and numbers. Since 2020, and ever theretofore, the rental price per square meter has been relatively stable, averaging around $24-$27/sqm. Occupancy levels in these premium offices stayed at 80%+ even through the pandemic, exhibiting resilience.

To shed some light on the attractiveness of the above-mentioned sales, I’ll utilize the last sale of a Della Paollera floor, which was 1,197sqm. At a $24.4/sqm monthly rental rate, the floor might’ve been rented for around $350,000 per year. When considering its selling price of $7.1M, its cap rate would have been around 5%. It’s worth noting that this floor sale price was below the last few years' average.

The office segment has generated total revenue of $18.1M, $12.6M, and $12M in 2022, 2023, and 2024, respectively. This is largely attributed to the company’s reduction of the portfolio. Margins have been systematically high since expenses associated with floor rentals are quite negligible. Notwithstanding this, Irsa had to do severe write-downs of their office assets due to the economic environment, as it did with shopping malls. Over the past 3 years, the reported operating margin for the office segment was -101%, -27%, and -348%, from 2022-24 respectively.

The carrying value for the office portfolio was $225M as of June 2024, implying $4,385 per square meter. This was down from almost $420M in 2022, when the “fair value” per square meter was estimated at $6,515.

To conclude this segment, the following chart captures management’s historical thesis for investing in real estate assets; and, more specifically, in premium real estate assets whenever possible. The value per square meter of constructed high-tier properties has tended to rise in Buenos Aires.

Hotels

As of November 2024, Irsa owns a stake in 3 hotels, all of which were acquired before the turn of the millennium. The company owns 100% of Libertador, 76% of Intercontinental, both located in Buenos Aires; and 50% of Llao Llao, a very exclusive and symbolic hotel located in Bariloche, in the southern part of Argentina.

Throughout the past couple of decades, all three hotels have done very well, except in 2020-21 due to the pandemic. Their public consists of wealthy Argentinian families and tourists. This feature has been particularly helpful for the portfolio's continuous resilience. Nonetheless, the Argentinian currency's latest appreciation in the parallel market, and if it happens hereafter, would pose a tangible headwind to the business, for it makes things more expensive to tourists and, to the extent that salaries do not catch up, to the Argentinian population as well.

Occupancy has been around 60% on average in the different hotels, with Llao LLao’s being higher and with a much higher rental rate.

The Hotel segment generated revenue of $45M in FY24, up from $41M in 2023 and $25M in 2022. Irsa does not tend to make fair value adjustments in the same manner as it does with its offices and shopping malls, for which the reported headlines are representative of the segment’s economics. The gross margin was 53% during 2024, the highest it’s been since 2019, and the segment’s operating margin was 29%.

The hotel segment is the lowest margin segment Irsa has. Moreover, it has a fixed cost component that represents a much larger percentage of total sales than other segments. This has caused the segment to operate at very volatile margins. When sales contract, margins tend to fall; the obverse is likewise true. I would argue that the pandemic and Argentina’s recession make this seem scarier than it would in a normal economy. Absent both extraordinary elements and hotels might be seen as perfectly fine businesses.

Irsa carries hotel assets at $23.4M on the balance sheet, slightly down from $24.8M in 2022. Over the past decade, there has not been much activity in the form of buying or selling assets in this segment. It’s only worth noting that Irsa sold its 49% stake in a hotel located in Rosario for $4.2M in 2015.

Sales and Development Segment

Historically, Irsa has re-deployed most of the cash generated in the purchase of land, buildings, and for obtaining certain concessions. The purpose of these is quite varied; some are for expanding the shopping or office portfolio, and others to keep potentially valuable land in reserve for future usage.

The segment has generated $4M, $12M, and $6.8M in sales during 2022, 2023, and 2024, respectively. However, this segment affected Irsa’s p&l the most. Assets included are carried at $581M in the balance sheet, which is substantially below 2023’s $790M, and 2022’s $863M. Absent the fair value adjustments, mostly of the sales and development segment, Irsa would have generated decent levels of profit, at naturally good margins. This, however, does not affect the company’s capacity to generate cash flow.

Irsa’s recent years are characterized by the company’s concentrating operations on shopping malls and offices. I believe this is materially changing and will highly influence the company’s investments moving forward. Although Irsa will continue to expand their currently held assets and acquire new ones when opportunities arise, it seems that management will more pronouncedly focus on the residential market.

Ramblas del Plata, previously known as Costa Urbana, is a project that management has shown excitement about for several years. Ramblas del Plata is a 70-hectare land with 866,000sqm of buildable area, but of which 71% will be destined to public use. Irsa carries it at $359M on the balance sheet. The land is in a very peculiar location in Buenos Aires. It’s next to Puerto Madero, a premium area within the city that has experienced great success since it was constructed in the 90s.

The company expects this to be a 10–20 years project, to which Irsa committed a total investment of $40M. The rest will be financed by buyers and worked out through agreements. After it’s finished, the company expects it could be home to 6,000 families, with capacity for over 10,000 houses.

Irsa went through a couple of years seeking approvals and certification required to begin constructing Ramblas del Plata. In the conference call held in November 2024, management mentioned the company is almost at the final phase of compliance. At any moment they could get the last paperwork ready and start the project shortly thereafter.

In late November, another announcement was made, alongside the acquisition of Terrazas de Mayo. Management pointed out that Irsa made progress in the commercialization of the project. The company received offers for 126,000 square meters, which represents 18% of the total sellable area. Should all of these materialize, Irsa would receive $40M in cash and the right to keep 16,500 square meters in functional units of fully constructed area. Over the next couple of months, Irsa would presumably start with building the infrastructure if the deals close.

Irsa’s Focus on the Residential Market

I have addressed the fact that Irsa has lately placed more emphasis on shopping malls, offices, and, to some extent, hotels. In Argentina, for over a decade, there’s been incredibly limited access to credit. The mortgage market somewhat thrived in the 90s and never recovered. Given how large of a purchase apartments and houses are, only a handful of families engaged in these. Residential real estate, if to anyone, only appealed to investors. However, this started to change.

One of the core tenets of Milei’s presidency is deregulation. Since December 2023, when his mandate began, his team has made great effort in deleting regulations across most markets within Argentina, including real estate. Multiple laws have been passed to congress, others by decree, and Milei’s commentaries seem to suggest this trend should continue.

Rental supply in Buenos Aires already reflected the increased simplicity and the fact that the government won’t intercede, or not as much as before, in private transactions. After this occurred, prices started to pick up and seemed to be looking for an equilibrium. Construction costs, due to the devaluation of Argentina’s currency, have been high for the past 2 quarters, but should also start trending towards an equilibrium, where it’s feasible to engage in real estate projects. If salary growth continues to outpace inflation, families will become increasingly wealthier, permitting them to afford rentals, at first, and then aim for more expensive ones.

On the finance side, Argentina’s risk premium in the bond market dropped from over 2000bps to around 700bps. Not only does this allow the government to borrow at lower rates but complementing it with a rapidly decelerating inflation allowed for a decrease in interest rates, which spread throughout the whole economy. Argentina’s central bank interest rate exceeded 100% in late 2023, yet it’s now at 32%.

The other important factor is Milei’s policy of not overspending on their income. The government thus far registers a budget surplus for 2024 and the president’s comments suggest that frugality will continue to be core to their strategy. Prior to this occurring, it’s highly likely that private banks focused on lending to the government, but now they’ll look for new customers, who’ll end up being Argentinian citizens.

Partly due to these reasons and many other presumably positive indicators of the country’s administration led to the rebirth of Argentina’s mortgage market. Mortgages are unbelievably important for the aggregate of a population to be able to purchase homesites. If mortgage rates are accessible, this should tend to strongly increase demand for real estate. Irsa seems thus very well positioned to capture a potentially big, rising, market.

During Irsa’s conference call, held in November of 2024, the team highlighted their feeling of the market. Tides seem to be turning. They mentioned that recent government actions are having a positive effect on the residential market.

Irsa plans to carry out two more residential projects, namely Del Plata Building, which will be in a great area of Buenos Aires and count with 720 apartments; and La Plata Project, which will have 100,000 of buildable square meters, out of which 22,000 will be destined to a new shopping mall.

Banco Hipotecario

In 1999-2000, Irsa acquired a stake in Banco Hipotecario, which subsequently increased to 29.9% ownership, which they’ve held since. The bank was founded in 1886 and has been a leader in mortgage lending within Argentina. During the late 90s, its privatization process began, but the government that succeeded the one that started with it decided to retain a controlling stake in Banco Hipotecario. As of 2024, the Argentinian government remains the controlling shareholder. Nonetheless, 7 of Irsa’s executives and directors sit on Banco Hipotecario’s board.

Banco Hipotecario has a 62-branch network that extends to all provinces across the country. The company had ARS 372bn in equity as of June of 2024, equating to around $275M, and total assets of around $1.8bn.

For it has been a household name for 130 years, the bank is very well-positioned to capture an upside in Argentina’s mortgage market. In addition to this, there is a possibility of Banco Hipotecario and Irsa cooperating on projects, creating very valuable synergies. While Irsa plans to undertake big residential projects, Banco Hipotecario looks to finance home buyers. It is to be determined how the economy continues to fare, but future prospects appear to be good, giving a chance for demand of these loans to explode.

In the fiscal year that ended in June of 2024, Banco Hipotecario approved dividends distribution of around $20M, of which $10.5M were distributed to Irsa. The bank operated profitably over the past 2 years, had returns on equity above 15% and its balance sheet is healthy, with liquidity exceeding total deposits. If the mortgage market effectively recovers and grows, Banco Hipotecario could pay dividends to Irsa for a long time to come.

La Rural – Special Mention

In the city of Buenos Aires, there is an emblematic building called La Rural, which is one of the most well-regarded convention centers in the country. It was founded in 1878 and serves as the place where fairs, exhibitions, congresses, and various events, including those business-wise, are held. La Rural has multiple millions of visitors every year.

Irsa acquired its 50% stake in La Rural by purchasing in two separate years, namely 2011 and 2016. The building generally requires a governmental concession to be utilized, which Irsa had formerly gotten. Irsa renewed its concession in 2022, extending its usage period of La Rural until 2037. In order to get this extension, Irsa agreed to pay $12M in annual installments.

Irsa received slightly over $1M in dividends from La Rural during the fiscal year 2024. The company’s interest in La Rural’s total 2024 income was $5.6M, and they carry their equity interest at $7.8M in Irsa’s balance sheet. The following chart includes the ownership, equity value in La Rural and Banco Hipotecario, and Irsa’s interest in their 2024 income. It must be observed that both businesses grew by over 150% yearly.

Cash Flow and Distribution

Irsa has been cash flow positive for more than a decade, with no year being an exception. During 2022, 2023, and 2024, the company generated $75M, $100M, and $76.6M from operating activities, respectively Moreover, in recent years, Irsa’s sales of investment properties outweighed purchases, creating a large inflow of cash.

Instead of reinvesting most of this capital, Irsa reduced its debt. The company had historically operated with relatively high leverage. But seemingly ever since a change in directors, and the merger with Irsa CP, capital has been used to deleverage the business and return a part to shareholders.

Considering Irsa’s high recent activity in the debt market ($52M issued in February and $42M issued in June of 2024), it might be expected for management to leverage up the balance sheet. However, I wouldn’t expect the business to return to prior levels. As of early 2025, net debt is around two times rental EBITDA.

After considering debt payback, Irsa still had cash available. During 2023 and 2024, management strongly favored returning cash to shareholders. Irsa distributed $64M in fiscal year 2023, $117M in 2024, and, in December of 2024, $78M more. At the same time, the company repurchased $34M in shares over the past 2 years. Both elements represented around a 30% yield for investors.

I contacted Irsa’s investor relations department in December 2024 and was notified that, onward, Irsa expects to again focus on reinvesting cash generated. Personally, I would believe they’ll continue paying dividends, and repurchasing stock as long as it seems below fair value to management, but much less aggressively.

Final Remarks

Irsa’s business is centered around redeploying the cash generated by its portfolio of offices, shopping malls, and hotels. I’m inclined to believe that Argentina’s economic environment in the past decade has been detrimental to Irsa’s operations and that the company can generate profits well above the levels heretofore exhibited.

The nature of the assets that make up part of Irsa’s portfolio, namely their local and national relevance, brand value, and quality, make me further suspect their intrinsic value is well in excess of the market’s view thereof. I suspect offices, shopping malls, and hotels have a long runway ahead. I believe chances are high that they’ll continue to generate good levels of cash for the coming years and probably decades.

I conclude their cash generation capacity after analyzing the assets’ economics, high-margin profile, and low capital requirements. On the other hand, the estimated competitive advantage period derives from the nature of these assets, how it has played out thus far, and how it has played out in other countries.

Moreover, if Argentina’s economy begins to grow after a decade of stagnation, consumption should pick up, inevitably benefitting stores within shopping malls. Land, office prices, and rentals would become more expensive. This would benefit Irsa in the form of higher rental revenue and higher base rent charged to tenants. Lastly, to the extent that any sales whatsoever are realized, the price at which these transactions will be made should exceed what the market might’ve agreed to over the past couple of years.

Even under stressful scenarios, Irsa’s portfolio has shown resilience, operating mostly profitably. Considering Irsa’s market capitalization of around $1.35 billion, or an enterprise value of $1.5bn, an investor purchasing a stake in the underlying business would be paying around 1.3 times its book value. I believe that, for the reasons laid in the foregoing report, such a price contains a large enough margin of safety to turn the potential upside into an attractive one.

I must nonetheless observe that, as pointed out in the opening remarks, many things are going on with the business. Complemented with Argentinian companies’ perceived shadiness, plus the country’s history, these factors remain posing the largest risk in this operation. Except for a political and economic setback, these can be extinguished with further due diligence, which is what I encourage the reader to do.

Thank you very much for reading and I encourage you to reach out to me at giulianomana@0to1stockmarket.com if you have any doubts about Irsa.

Disclaimer: This is not financial advice.

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When HireQuest acquires a firm with company-owned offices, they sell them and enter a franchise agreement. After conversions are considered, the price HireQuest ends up paying for the acquired company ends up being much lower than headlines report. These are some of their acquisitions.

The staffing industry, being a people business, makes M&A highly problematic. Branches’ worth is defined by a manager’s capacity to keep the customer list together. Almost always, it’s done so because of the people in charge. Hence, when a staffing company is acquired by one with company-owned offices, managers resign, and the acquired branch might lose over 50% of their revenue. Additionally, turnover is enhanced when this occurs, making acquisitions highly deceptive. HireQuest avoids this issue by keeping the managers in place. It’s mostly them to whom the branches are sold.

HireQuest finds itself in a very advantageous position for M&A. In addition to the aforementioned elements, the staffing industry is highly fragmented. There are many small offices, some family-owned, that dominate niches and local markets. For most staffing players are very large, they don’t compete for these acquisitions. This provides fertile ground for HireQuest to deploy capital at attractive rates of return for a decently long time.

Disclaimer: This is not financial advice.

If you are looking for more information on HireQuest’s current stance, check my equity research and Q3 earnings review.

Franchimp is a website that contains information on franchising businesses. More specifically, it has financial metrics about the individual units within different franchising networks. Things such as how much the initial investment is for opening a particular store/office and the legal document that franchisors’ send to prospective franchisees.

To open a HireQuest or Snelling franchise and offering the different types of services the company has available, a franchisee’s initial investment is estimated to be between $45,150-$145,750. It usually takes 4-12 weeks for a franchise to be opened after the agreement is signed. The investment includes a sum that must be paid upfront to HireQuest, which ranges from $3,500 to $26,000. This encompasses the initial fee that’s between $2,500 and $25,000 depending on the territory wherein the franchise is set to be opened.

The population determines whether the initial fee falls near the higher or lower bound. Territories with over 1 million people require a $25,000 fee, whereas a $2,500 fee is for territories with less than 100,000 people. Although the franchisee is who ultimately decides where to open, HireQuest’s approval is required and the team assist franchisees on the process. Finally, HireQuest generally advises taking on a lease and they are willing to help negotiate with the landlord if the franchisee requests it.

After the person pays for the initial fee, he or she is scheduled to attend training sessions, alongside employees who’ll join them in the endeavor. They attend 2 weeks of training at an operating branch within 30 days before opening their own business. Part of the instructions relate to the usage of software, for which the franchisee has to pay $1,000 upfront.

The following table groups the types of expenditure franchisees need to incur, the amount in dollars, when they are due and to whom.

After the initial fee is paid, HireQuest demands franchisees to pay other fees related to the ongoing operation as well as to punish for delays or negligence. In addition to the royalty fee, which is a percentage of gross billings or funded payroll, these are the other fees I found relevant to franchisees.

Finally, there are two things I’d like to highlight. Firstly, HireQuest mentions the possibility of them financing up to $25,000 of a franchisee’s investment, though, in rare instances, HireQuest could provide up to $100,000. Secondly, the company generally agrees with franchisees to a minimum performance standard in HireQuest Direct franchises. If franchisees do not meet their minimum yearly target, they have to pay the fee they would have paid should they’ve met the standard.

Franchises Network

When HireQuest was a private company, in 2017, the company had a total of 79 franchised locations. After the merger and integration of Command Center, rapid growth followed in the network’s store count. By mid-2024, HireQuest had 414 stores.

The following chart illustrates the number of stores opened, closed, and acquired by HireQuest for the period 2018-2024. Over the period, most of the company’s growth came from acquisitions. By this means, HireQuest added 331 franchised locations to its network, before accounting for subsequent closures thereof. Stores opened during these 6 years amounted to 89, whereas 85 franchises were closed. Of the total, 53 closures occurred in 2023 and the first semester of 2024, combined. I suspect most of discontinued branches were from acquisitions made, with MRI being the network that probably experienced the largest number of closures.

It is worth reminding the reader that HireQuest’s franchisees might operate 1 or more franchises. Therefore, the closure of a location does not necessarily imply the loss of all the revenue generated by that branch. Operators with 2 franchises might choose to discontinue one operation but keep servicing part of the customers with the continued location.

“Of these closures, 11 were in metropolitan areas where our franchisees still maintain at least one office that we expect can service customers of the closed or consolidated offices” Q2 21 10Q

Turnover and losing the customer list are the most severe threats when acquiring a franchising business. It is remarkable to observe how many of the acquired branches end up continuing operations. Based on Hermann’s general commentaries, it’d be expected to lose a high percentage of each location’s business when it’s acquired, maybe exceeding 50%. In addition to this, employee turnover, if not managed appropriately, can destroy a franchising business. It is therefore very interesting to observe how many of the acquired franchises remain open, validating Hermann’s statements.

The fact that HireQuest can acquire networks whose size is very large relative to their own speaks well about the smooth integration process. In 2019, HireQuest essentially acquired Command Center, which had a size of almost 70% that of HireQuest. Thereafter, Link and Snelling implied the acquisition of a network 50% of HireQuest’s size. In 2022, HireQuest acquired MRI, which had over 200 franchised locations, while HireQuest had around that number as well.

Notwithstanding this, acquisitions blurry the picture as to how satisfied franchisees are, for it clouds the renewal rate, which, incidentally, is not reported. I suspect that, prior to the merger, and naturally thereafter, the HireQuest Direct network has had the most satisfied franchisee base, which led to a high renewal rate. Consistent growth with no severe declines and numerous franchisees owning more than 1 branch make me think the latter might be true.

When the merger took place, many franchisees signed 5-year agreements, causing multiple renewals to be scheduled for 2024. Furthermore, when HireQuest acquired MRI, dozens of franchise agreements were discussed and rearranged. Many of MRI’s franchisees opted to have their scheduled renewal in 2024. This is something that happened with other acquisitions, though to a lesser extent. HireQuest entered 2024 with 83 renewals to be signed in the course of the year. By August, 24 offices had been closed. Depending on the dates at which these renewals are scheduled, the corresponding renewal rate.

System-Wide Sales

Prior to merging with Command Center, HireQuest had system-wide sales of $190 million. In the last fiscal year, ended in December of 2023, the company reported $605M in system-wide sales.

It’s important to note that, whereas store count increased by over 340% during the period 2018-2024, system-wide sales increased 218%. This entails that the average sales per HireQuest location, including all trademarks, have fallen quite severely. Before the merger with Command Center, each branch generated 1.95M dollars in topline, on average. During 2023, each location generated, on average, $1.4M.

Note: The chart is made by dividing system-wide sales by year-end store count.

Note: 2022’s year-end store count includes MRI’s, but not their revenue during that year, for it was acquired in the last quarter.

The following chart computes system-wide sales per HireQuest brand, and thereby business model, for the three largest contributors. Although the company shares system-sales per brand on a quarterly basis, fourth quarters are not separately disclosed. Therefore, the fourth quarter of all years are estimations.

Part of management’s strategy revolves around leveraging their large and growing network of franchises and increase offerings. Some can be offered by existing branches, whereas others may take specifically dedicated locations. HireQuest bought Dental Power’s staffing division to launch their health platform; it launched TradeCorp for highly specialized labor in the construction industry; and DriverQuest for long-haul rides. Their impact on system sales remains negligible, but nonetheless growing, especially DriverQuest and TradeCorp, which I suspect don’t require dedicated locations for them to be offered.

Followed from system-sales each brand contributes, we can observe that, during 2023, 41% of the total was generated by HireQuest Direct network. This is done while HireQuest Direct offices might represent around 30% of HireQuest’s total network. Snelling and HireQuest contributed 26% of total system-sales, and the executive and permanent placement franchises generated 31% of total.

Royalty Fees

Different brands not only carry distinguished offerings, but some aim at significantly different end markets and differ in business model. HireQuest Direct does direct dispatch and focuses on daily-pay jobs in the construction and light industrial segments. This implies a cost structure and day-to-day operation that differs from HireQuest and Snelling locations, which are focused on longer-term positions in the administrative and light industrial markets. MRI offers permanent placement services and, Nortbound, executive placement. Both aim at different markets, the method by which they earn revenue is different than that of daily labor offerings and carry different margins. Therefore, to the extent that it is possible, each business unit’s royalty fee will be separately assessed.

Low data availability impedes me from finding and computing charts illustrating accurate figures. Apart from HireQuest Direct, other brands include a large degree of estimation.

HireQuest Direct

HireQuest Direct is distinct from the rest of brands in that acquired locations are rarely added to their network. I suspect that direct dispatch, being a rather unique feature in the staffing industry, turns HireQuest Direct into the most difficult franchise to grow inorganically. My speculation partly lies on the fact of how slowly this franchise – formerly known as Trojan Labor – had grown until 2019, compared to other units in the recent past.

HireQuest Direct generated over 90% of the company’s royalty income in 2019, suggesting that almost the completeness of the franchising network was made of HireQuest Direct offices. This translates into over 120 offices at that time, which reportedly increased to 131 by mid-2024.

Royalties generated by HireQuest Direct have thus remained relatively flat, with the implied fee over system sales varying. Having averaged 6.2% and considering the fee structure of decreasing fees per incremental million in sales, it’s plausible to think that the average HireQuest Direct location generates over $2 million in topline. This would be in line with the estimated average location’s revenue prior to the merger in 2019.

In the franchise agreement document, HireQuest disclosed the average and median gross profit and net profit for HireQuest Direct offices. Topline was not disclosed, for which margin calculation cannot be performed. Notwithstanding this, it’s fair to speculate that these offices may operate with a net profit margin of at least 10%, on average.

HireQuest Health

HireQuest acquired Dental Power’s staffing division in late 2021, but the company reported over $200,000 in income from fees for that year. It remained company-owned for some time and was sold in March of 2023 to an MRI franchisee for $2 million, payable over 5 years.

Since the time of the acquisition until mid-2024, HireQuest earned over $1.1 million in accumulated royalties from their health division. The percentage fee charged to the operation, prior to the franchisee joining, is obscured by disclosed data. After Q2 of 2023, I’d estimate the fee to have been around 6% of system sales.

Note: Q4 of 2022 and 2023 are estimates

As time goes by, quarterly reports will shed further light on this business unit, but my suspicion is that capital was fantastically deployed in acquiring Dental Power’s staffing division. Richard bought it for $1.9M in December of 2021, sold it for $2M in March of 2023, and generated 1.15M in royalties throughout late 2021 until mid 2024.

Snelling and HireQuest

Snelling and HireQuest represent the more classical staffing offices HireQuest has. Although they were reported separately for most quarters, throughout 2022 and 2023, management included all acquisitions’ royalties alongside these two. In consequence, the following chart plots my estimated royalty fees throughout this period.

It’s notorious how Snelling’s acquisition virtually created this business unit for HireQuest. Since inception, Richard had mostly focused in the direct dispatch model for daily jobs. Nonetheless, most of the industry’s offerings align better with Snelling’s business, for which new M&A is most likely to be added to their network. Snelling’s brand is a very valuable asset, and management will be extracting its juice accordingly.

MRI

MRI’s income from royalties is reported to have been $7.8M during 2023, whereas total system wide sales were not disclosed separately. Notwithstanding this, I’d estimate MRI had system sales of $180-$200M, implying MRINetwork lost around $80-$100M in system sales. Part could be attributed to offices closing due to the acquisition, but another part is due to the cyclical downturn the industry experienced, which continued throughout 2024.

The following chart reports MRI’s 2023 royalty income. During 2024, management did not disclose MRI separately, but they included it alongside Northbound and SearchPath. This partly makes sense since they share business model and, to some extent, end markets. These businesses generated $1.65M in royalties during the first quarter of 2024 and $1.74M in the second, representing a 4.3% and 4.2% of system sales, respectively.

Some Industry Considerations

The staffing industry has been around for numerous decades. In fact, the service is so fundamental and simple that it probably goes back further back. A more systematic approach to fulfilling this business need probably emerged as a consequence of economic growth. The American Staffing Association estimates that sales for the staffing and recruiting industry have grown from $92 billion in 2004 to $186 billion in 2022, exhibiting a 4% CAGR.

A further interesting point relates to the sources of sales. Broadly speaking, the industry is separated into search and permanent placement, both for employees and executives, and temporary labor and contract, where the services provided are on a per-day or week basis. To some extent, over the past two decades, more emphasis has been placed on working on a per-project basis. Having said this, ASA estimates that temporary services have systematically generated most of the industry’s revenue.

The industry is highly cyclical, greatly tracking the US economy. When businesses expect demand to increase, mostly catalyzed by a recent increase thereof, they adjust supply accordingly, hiring people beforehand. When tides turn, it’s not always the case that companies will lay off employees, but they will at least pause hiring. Under such circumstances, staffing companies’ revenue declines, for their services are not required. Although Robert Half is focused on financial services’ and administrative positions, I believe their quarterly revenue chart very well illustrates the industry’s cyclicality.

A large part of HireQuest’s business, and the industry for that matter, revolves around providing temporary services to construction companies. Being the latter very sensitive to economic cycles, as capital available for investments expands or contracts, staffing businesses tend to follow the same pattern. More specifically, HireQuest Direct, which focuses on daily paid jobs, will immediately suffer as projects are paused.

Moreover, staffing businesses’ margins tend to follow a cyclical pattern as well. A business that operates a model of company-owned offices has a relatively large component of fixed costs. They cannot stop paying for many operating expenses, such as the lease of a building or floor. Furthermore, since employees are hired before a client effectively solicits their services, payroll has to be temporarily incurred before adjusting to the new situation and hiring less people.

Despite the latter being mostly the case for staffing companies, HireQuest’s royalty model partly insulates them from cyclical margin contraction. The company earns either a percentage of gross billings or of funded payroll, independent of the gross margin franchisees may earn during a certain period. Therefore, even if franchisees might experience a contraction in margins, the downside HireQuest can experience is capped.

As a consequence of the industry’s cyclicality and its implications, the number of competitors tends to increase as economies grow and they diminish when economies contract. Incidentally, this largely contributes to creating fertile soil for Hermann’s M&A strategy. When staffing businesses struggle, HireQuest’s world of potential acquirees increases.

This is something that, throughout the years, has manifested itself on a broad basis within the staffing industry. The following chart, illustrating the percentage of business that’s captured by the largest 5 and 15 companies, suggests the industry has been tending towards consolidation.

My suspicion is that this trend will continue. However, it must be observed that most local and small markets are dominated by old firms, who keep the customer list together. If a business that runs a company-owned office model acquires one of these, it’s very much likely that they will lose a big percentage of the branch sales due to turnover and customers leaving. HireQuest is less likely to experience such a decline, for the same people that were running the branch tend to stay after the office is added to HireQuest’s network. It’s important to note that this fundamental aspect of the staffing business can potentially cause temporary sales to decline severely.

“You might have a big project that's ending. You might have an H.R. manager that quits, and you lose your third largest account. And you may be lucky to get 80 percent of your prior year sales, but it's understanding those types of things.”

The industry consolidation has a further positive side effect for HireQuest. As leaders get larger, their incentive to pursue small acquisitions decays. The high fragmentation, with many family-run businesses who may have 1-5 branches, causes a relatively large part of the industry to be of no interest to large players. This part of the market creates perfect conditions for HireQuest to continue growing through M&A with no competition for their deals.

The Staffing Industry and Unemployment

Historically, the demand for staffing services tends to increase as unemployment rates decrease. The latter implies a reduction in the pool of people you can potentially hire, and I suspect it’s further aggravated by the fact that good employees tend to be hired first. In these situations, a hiring company would need to incur substantial operating expenses to do the diligence and interviewing process. Hence the value proposition of a staffing firm that provides permanent placement or temporary labor massively increases.

The obverse is the case as well. The unemployment rate increasing not only damages the staffing firms’ topline because their services are in less demand, but the cost of hiring decreases. There is a further problem that, when the economy contracts, the reduction in potential clients incites stronger competition between staffing firms. On occasions, this can lead to pricing pressures, hitting margins.

Management suspects that, although growth for staffing services have outpaced overall economic and employment growth, there is a fundamental element that will continue to drive industry growth. Hiring is getting increasingly expensive, and the benefits of contingent workers are starting to be noticed by executives. Eliminating the need for looking for someone and running the interviewing process as well as compensation insurance avoids incurring extra expenses while still getting the activity done. Furthermore, the associated flexibility is highly desired if a business wants to expand or contract according to their true needs. Flexibility ends up enhancing efficiency.

With an empty vessel no cup can be filled. It is imperative that one maps out the dots composing their body of knowledge and infers how far they can foresee, though, naturally, probabilistically speaking. Counting with few pieces of knowledge impedes answering many questions, which end up conditioning a decision’s fate. Identifying where dots are missing is crucial when constructing an investment thesis. They provide the roadmap for research and, thereafter, help to thoughtfully assess situations.

Regarding the manner in which I weigh positions, the path I thought the soundest was one of cautiousness. My investment process will follow the punch card approach. I’ll very carefully select potential companies to invest in. But, furthermore, I’ll initially weigh with a margin of safety.

Businesses where I build up a position will, as per my own analyses, count with a margin of safety in the classic sense. However, I noticed there is always some specific percentage of total capital that I’m willing to allocate to a certain equity position, namely what I’m initially inclined to call its “fair weight.” I suspect this fair weight depends upon how certain I am about my answer to the most important question: how much is this asset worth?

I believe this to be highly related to the number of questions an investor is able to answer with respect to the related investment. The broader the range and the deeper they are, I suspect the better can one address future uncertainty, potentially overcoming unseen threats and succeeding.

Instead of adding up to fair weights, I’ve tilted towards staying well below these thresholds. I believe experience and knowledge forge judgment. And it is ludicrous for a relatively inexperienced investor to think their judgment is accurate. Therefore, I try having both margins of safety at this early stage. One in economic terms, whereby I try to purchase equities below what I believe they are worth; and in personal terms, seeking to protect the capital from myself.

Burford Capital operates in the legal finance industry. Litigation finance, differing from the latter in that this is specifically referring to single litigation claims, emerged more than two decades ago in Australia. The markets, however, did not become widely interested in this asset class up until recently. Burford was hugely incidental in the industry becoming better known. But the created mechanism is still relatively young, subject to future vicissitudes, and thereby pronouncedly filled with uncertainty.

An element of this is naturally priced in assets such as Burford’s equity, for the latter will tend to reflect the broader market’s expectations of cash flows. Intellectually, an investor could play the game of analyzing if there are factors the market has missed, mispricing the asset as a result. One could ride certain waves until prices more accurately reflect the previously missed factor.

In Burford’s case, I aim at pairing with two brilliant managers, Bogart and Molot, for as long as possible. But the important question is how long of a runway they will have. The market has systematically mispriced the competitive advantage period of good businesses and it is my intention to analyze if this is occurring with Burford Capital.

I think this can only be done by going after the hard questions. It’s not about numbers, but about words. I suspect thinking is the only approximately correct method of analyzing true asset mispricing, more so when speaking about CAPs. This writing does not include any models. Rather, these are the pieces of knowledge I believe can be used to, at least partially, answer the following questions:

• Should legal finance exist?

• Is it a net positive for society?

To answer these questions, I have sourced myself with material written by Burford’s Co-founder, Jonathan Molot, documents about insurance, and Economics.

In A Market in Litigation Risk, published in 2009, Molot dives into the role of litigation finance in society and whether the system should be embraced or discarded. For it was written before Burford started operating, it lacks the hindsight bias to which everyone is subject. This was theorization from Molot’s part, which I believe will help us get a better idea of whether this industry is entitled to survive or not.

Risk

Man has long been averse to risk. Since the very beginning of civilization, shamans were sought for advice, while oracles saw the future in the guts of sheep. These special individuals were presumably capable of obtaining insights of a divine nature, helping people make decisions. Being the future plagued with unseen threats, guidance, and to some extent, consulting, were natural outcomes as a common trade.

Risk, broadly speaking, represents the possibility of something going wrong. Encompassed within this definition, I’d argue that catalysts’ essence can be either definable or undefinable. Perhaps out of the latter is that unknown and unknowable territory is created. Unknown and unknowable situations represent obscure twists, which cannot be prevented nor contemplated before the aftermath.

However, humankind has identified potential events whose occurrence poses a threat to individuals. Risk of injury, risk of loss, risk of destruction, are some of the categories underscoring harm to individuals own self or possessions.

Definable risks are those that we know for sure exist. They can very well interfere with ongoing events and tilt future states of nature into undesirable forms. Definable risks may include things such as death and natural disasters. On the other hand, of undefinable risks we cannot get the grasp. They represent things affecting end results that are beyond Man’s comprehension and calculations. The only similarity undefinable risks have with their counterpart is that we cannot predict nor prevent them.

As mankind progressed, methods employed for transacting evolved. At the very beginning, trades may have been performed by trading objects belonging to one another. But different crafts and resources are obtained after different levels of effort, creating a wide array of objects’ values. Therefore, a trading system consistent of spices, which had value on their own, emerged. Spices could be used as the mediating object for estimating the value of things and trading more effectively. Corn, salt, wheat, were some of the favored ones, because of the value derived from utility and low obsolescence.

After several centuries, Man observed this was highly inefficient. Transacting in spices meant carrying and storing them, proving very expensive. Moreover, their estimated value fluctuated and depressed if agriculture was more heavily practiced; the obverse being equally true. This is the point when I suppose people started opting to transact in what were viewed as very valuable resources, namely gold and silver.

Both had held valuable for millennia in the eyes of different cultures. Their value first originated in their beauty, which could be exhibited in furniture or accessories. People caught up with their scarce supply and, being human nature what it is, gold and silver’s value was greatly enhanced.

It was then observed that their peculiar capabilities could be leveraged for transactions. Divisibility was a spectacular feature, as it allowed for much more precise value estimations and thereby a more efficient system. Furthermore, these metals were difficult to mine. Supply couldn’t be brought to market very easily, depressing holders’ net worth as a result.

Ultimately, the employment of currencies, made of silver and gold, later bronze and fiat, gave rise to the accumulation of usable wealth. After performing a trade, earning money in exchange and saving accordingly, people were able to make big purchases, such as a house or a car, thinking about the last century.

The problem lies in that this was only done by exchanging years of labor for these large items. Therefore, if these assets were subject to unfortunate events that led to their destruction, it’d be highly unlikely that the owner, an individual, could financially recover. These people would need to once again exchange years of labor for money and repurchase the asset.

In response to risky and frequent events, insurance companies were given birth. At a broad level, insurance makes individual risks be beared by a group of people. Spreading similar individuals’ risk over a pool containing them is a very effective way to deal with their destructive power.

When statistics can be leveraged to understand the probabilities of an event occurring, a sophisticated entity can price an insurance policy for giving appropriate coverage. The issuer of this instrument can repeat the procedure with other people who seek protection from a similar adverse event to diversify the risk.

This strategy dramatically decreases the probabilities of a single event taking the issuer out. Appropriately pricing policies will generate a large enough base of capital to cover incoming claims. New policyholders renew this base of capital and help sustain the whole system for other newcomers. It’s important to note that, if policies are priced below their fair value, the base of capital will eventually dry up, making the issuer default on remaining policyholders.

Heterogeneous vs Homogeneous Risks

Risks can be further classified as heterogeneous or homogeneous. The former refers to risks with unique characteristics, making it impossible to create a standardized pricing process. Homogeneous risks share characteristics between one another and the probability of claims can be estimated quite precisely because of this attribute.

Insurance against fire is a very pragmatic example to understand both types of risk and the underlying feature that allows for roughly precise pricing. Preciseness, nonetheless, is shown after issuing multiple policies. Every single policy can be mispriced, causing the insurance company to incur a loss. But, on average, over a large pool, policies will show roughly precise pricing.

Prior to the event, a homeowner can buy an insurance policy to cover the damages fire can occasion. The probability of a fire starting depends on numerous factors, most known and somewhat shared by policyholders. Moreover, the cost of damage follows a straightforward array of outcomes, up to the house’s full cost. In some sense, given the large database on this phenomenon, statistics can be used for developing a standardized process, whose inputs derive from these ‘shared’ situations by policyholders. This risk is therefore cataloged as homogeneous.

However, after a fire starts at a homeplace, there’s the risk of this fire spreading. How fast and to what extent it happens is entirely dependent on unique factors, namely the structure of the house, the inflammable properties near the place where the fire started, the possibility of fire extermination, the house’s distance to a fire department. Conditions in the case of fire spreading are unique, intrinsically different between potential policyholders, making this risk heterogeneous.

Insurance actuaries are taught how to price policies when policyholders’ situations resemble each other; when the risk itself is homogeneous. If the probability of a claim and the average dollar cost of the damages are known variables, pricing the policy can be done quite precisely. Spreading an homogenous risk over a pool is very efficient.

Having to carefully assess the consequences of a specific situation makes the pricing incredibly tricky. In the case of heterogeneous risks, you are dealing with something whose probabilities are unknown and potential states of nature present too wide an array of possibilities. Pooling these set of unique risks is possible, but inaccurate. There is more room for craftsmanship in the realm of heterogeneous risks and why I’d argue cannot be dominated by mathematics.

Risk-transfer Mechanisms

Although heterogeneous risks cannot be precisely priced, insurance businesses have found a way to profitably operate. Homogeneous risks, like death risk, gave rise to the most competitive insurance markets, namely life insurance in this case. The insurance industry permitted individuals and other entities to get rid of unwanted risks by paying a premium for coverage.

Turning to the corporate world, when a business operates in many countries, there’s an inherent currency risk that arises. If the currency in which costs are incurred does not match the currency in which income is earned, there’s a possibility of both fluctuating and causing some trouble. In this case as well, companies count with a resource for getting rid of this risk. They can utilize future contracts, whereby they agree to exchange a certain amount of currency with another party, at a predetermined price and future date. Pre-fixing the amount helps escape from an otherwise fragile position, exposed to misfortune and mischances.

Turning to another case, if a farmer will harvest a few months from now, there are two particularly damaging situations that may occur. Firstly, if he invested a lot of capital in seeding, fertilization and maintenance, and needs the income the crop will provide, a storm destroying the farm could leave the farmer in ruin. To avoid this, he can buy insurance. Secondly, if a farmer doesn’t want to be exposed to fluctuations of commodity prices from now until the moment of harvest, he can also leverage the futures market.

Running a bank can get more complex than a normal corporation. But they can utilize swaps, whereby they make custom-made contracts with other entities so that both parties can satisfy their many concerns; one of which may be matching currency and maturity between assets and liabilities. When a bank issues a large loan to an entity with doubtful credit reputation, it mostly does so with a very unique arrangement.

A company that wants to fund a new initiative, for instance launching a new product line, can either look for partners or opt for a joint venture. Otherwise, the manager can raise capital through the public or private markets, exchanging equity for capital, or issue debt at the rate of interest that counterparties think is fair for them to be exposed to the risk of default.

These and more financial instruments have been constructed with the objective of allowing individuals and corporations to transfer a risk they don’t want to or are incapable of bearing to a willing party. Fundamentally, these transactions represent a party who’s exposed to an undesired risk that is willing to pay a premium for another party that’s willing to bear it.

Litigation Risk and Some Benefits of its Transfer

Business managers would much rather be measured by the true performance of their companies. No executive wants to be evaluated by external events. The problem with litigation is that it is a risk outside of companies’ control, for the resolution depends on external factors.

Broadly speaking, I believe companies’ success, or lack thereof, should reflect decisions behind product, pricing, sales, and business-related activities. However, litigation costs have risen dramatically over the past couple of decades, getting to the point that it interferes with business results. Little has been done to develop a mechanism by which companies could get rid of litigation risk.

Appropriately pricing this risk is very complex, for it resembles fire-spreading insurance with increased uncertainties. The two questions are: (i) how much will a litigation cost in legal fees; (ii) how much will (or not) be the payment to the plaintiff for damages. If a third party is willing to take this risk, the following question is who will control the litigation. This last one is of extreme importance, as there is potential for litigation finance to alter the legal system altogether.

Despite there not being any mechanism for transferring this unwanted risk, the cost for corporations is massive:

• They have to incur expensive legal fees even when the litigation may be resolved in their favor.

• If the manager wants to raise capital, a potentially large litigation is a deal breaker for capital providers. It may be seen as an uncomfortable and unnecessary risk for the investor/lender.

• At a society level, having ill-suited entities bearing a risk that could be efficiently spread over a pool of alike risks is simply overall damaging.

In the public and private markets, there’s a further element that impacts companies’ ability to raise capital by affecting the enterprise value of the business.

Businesses are valued upon the cash flows they will generate, with earnings being a commonly utilized yardstick. Incurring legal fees affects the company in two major ways. Firstly, because of the opportunity cost of that capital, which could be deployed within the business’ core competency. But, more importantly, if a business is priced at 20 times earnings and $100M need to be destined to legal fees, it’s ‘costing’ shareholders $2bn in enterprise value.

Another relevant factor that plays a role with public companies involves the balance sheet. When a company has an ongoing litigation and the judgment’s prospects are favorable, the market rarely rewards the company in any form. The cash flow, even if expected, isn’t recorded as an intangible asset. Legal finance allows companies to unlock value from these hidden assets, not shown on the balance sheet. In exchange for a share of the proceeds, companies like Burford offer the monetization of pending claims.

On the plaintiff’s side, it’s often the case that an individual or corporation is damaged by another party, but they don’t have enough resources to start a lawsuit. Litigation finance evens the field. To what extent this causes an increase in litigation claims remains an obscure question. And how, if so, will the legal system react, is unknown to myself.

Jonathan Molot raises the point that the large, aggregated cost imposed by the legal system has an origin in governmental entities. The public and statal interest should be in minimizing these undesired and expensive costs, whose origin is their’s. If a market in litigation risk is feasible and the effects of the industry being created aren’t net negative, the government should help establish legal finance as a systemic solution.

As my last remark, corporations mostly prefer doing deals on a contingency basis, where the law firm gets paid with a share of the claim’s proceeds, hence only when the case resolves favorably. Nonetheless, law firms have a cost structure filled with fixed costs, for which they need to charge an hourly rate. This mismatch is bridged by litigation finance.

Conclusion

Throughout history, society has recognized different sets of risk and developed mechanisms by which risks could be transferred. A party that is exposed to a risk they don’t want to bear can pay a premium to another party, who is willing to bear it. I suspect it was, and is, only natural for this to occur with litigation risk.

Litigation finance, the mechanism by which this risk is transferred, presents numerous benefits to almost all parties. I severely struggle to imagine this incipient industry as a net negative for society. The question that remains obscure is how big of an impact will it have on the legal system, which acts as the backbone of modern society. It must not be overlooked how important this question really is, for it may be the biggest threat to the industry.

The legal system, as long as it keeps depending on human beings, who are subject to miscognition and humanly incurable traces of irrationality, shall always have uncertainty. Similar to what happened with the markets where insurance companies serve, for there to be a long-during market in litigation finance, capital providers need to be good at pricing the claims. The numerous intricacies underlying every single litigation make the cash flow, if any, very difficult to estimate. Consequently, pricing a claim is very complex.

Although there may be room for a sustainably profitable market to keep developing in litigation risk, capital providers can only survive if they count with a very specific skillset. However, for there have been experts capable of profitably pricing policies for natural disasters, I have every reason to believe that this talent can be developed and expertise achieved.

Finally, litigation risk being heterogeneous and lawsuits’ outcome seemingly binary pose two cornerstones to suspect that excess returns cannot simply be competed away. Additionally, something I have covered in the past relates to the customized deals that large corporations and large law firms tend to prefer. This conforms another argument that helps me comfortably make the foregoing speculation.

HireQuest franchising model makes acquisitions be much more profitable transactions than they seem to. Instead of rolling up the industry, they are actually rolling it down. The procedure they follow is very peculiar and a fundamental pillar of the thesis on HireQuest.

In this article, I go over:

• How HireQuest operates at much higher margins than peers

• Intricacies about their M&A system

• Analysis of the merger with Command Center

• Breakdown of all acquisitions made since going public

• How they convert company-owned locations into franchisee-owned

Superior Model

HireQuest finances initial working capital needs to franchisees and leverages their network of offices to access better workers’ compensation insurance, at a cheaper cost per employee. HireQuest does not intend to make a profit from these operations. The company shares the completeness of the efficiency gains from scale with franchisees.

Similarly, management devised a risk management incentive program (RMIP), whereby HireQuest rewards franchisees who maintain their loss ratio below a specified threshold. HireQuest covers up to the first $500,000 in claims, for which a low loss ratio is highly beneficial for them.

Instead of keeping the profit that would come from a lower loss ratio, HireQuest rewards the franchisee by charging them a lower price for insurance coverage. Therefore, not only does the franchisee benefit from a lower cost per policy, but they are also rewarded with an even lower expense. Other programs can provide them with credits on royalties, which HireQuest can comfortably offer due to their scale, helping franchisees improve the economics of their office.

When compared to bigger and more established players, HireQuest differentiate themselves by their pure franchising model. Each office has its respective owner, who’s personally interested in the success of the endeavor. This allows HireQuest to eschew incurring a very common expense present in their counterpart’s business model.

A network of company-owned offices requires hiring branch managers and middle managers to oversee them. When scaled, this gets to be a significant cost, which in turn affects store-level economics. Additionally, it implies increased amounts of working capital investments.

Another advantage HireQuest brings to franchisees is the capacity to leverage scale in order to get national accounts. Corporations that operate in multiple states or require national-wide staffing services tend to forge relationships with large-scale staffing businesses, who can supply them with on-demand labor as it fits their needs.

HireQuest’s franchising network puts them in advantage with respect to small players. Historically, these larger clients have tended to show pricing power when transacting with local staffing companies. By being part of HireQuest network, franchisees end up getting more access to big clients and better deals.

Better office-level economics translate into HireQuest enjoying higher margins on total system-wide sales. I must hereby observe that Robert Half, a public staffing company with company-owned offices, actually has a 5.4% LTM operating margin, but has operated much above this level for the past years. In contrast, ManPower’s operating margin has been between 2-4% in the past 5 years.

“And that's why when you look at, for example, Command Center as an example, is about half the size of HireQuest. It had about six regional managers. We had one. And so, to give you a sense of that, that means that if effectively Command Center was paying something close to six tenths of a percent just for regional managers, we were paying something like one tenth of a percent. That's a big difference when it comes to ultimately to your bottom line, and that's why we're able to offer the same efficiencies to our franchisees (…) And yet without the need to have this big regional, you know, sort of all these regional managers. And the point is, is everybody makes more money is really what it comes down to”

The Merger

HireQuest’s management team has done numerous acquisitions since the company’s inception in the 90s. Ever since going public, they have doubled down on inorganic growth. However, their M&A transactions are quite uncommon. Furthermore, individual offices experience massive economic changes due to HireQuest’s model. To shed some light on this vastly relevant aspect of the business, I’ll dive into the merger with Command Center.

When HireQuest acquires a staffing business with company-owned locations, these need to be converted into franchises. In consequence, the first thing Richard looks for when engaging in M&A is whether he’ll be able to successfully sell the offices. Ideally, they’d be sold to offices’ current managers or people familiarized with the operations of that particular branch. Otherwise, management ask other franchisees if they’d be willing to buy the location and add it to their portfolio. Deals of both kinds may carry unique arrangements. Occasionally, this cannot be done and HireQuest marks the location as a discontinued operation and held for sale.

HireQuest merged with Command Center in July of 2019, keeping the first of both names. Command Center issued 9.8 million shares that were transferred to HireQuest security holders. This meant HireQuest ownership of the combined entity was 68%.

After the merger, it was contemplated that HireQuest would commence a self-tender offer to purchase up to 1.5 million shares at $6 per share. The tender was fully subscribed and the company ended with around 13 million shares of common stock. After the tender, HireQuest security holders owned approximately 76% of the entity, with Richard owning over 43%.

At the time of the merger, HireQuest had over 90 locations, while Command Center reported 67. Even though Command had two thirds of HireQuest’s footprint, HireQuest had more than double their system-wide sales. On a per unit basis, individual offices generated more revenue within HireQuest network. Considering the fact that both served somewhat similar markets, it’s fair to speculate that the incentive structure HireQuest has may have tilted operators into this result.

On average, each of HireQuest offices had revenue of $1.9M, whereas Command Center branches, $1.45M. Richard pointed out during an interview that the main reason behind this large discrepancy is turnover. Turnover severely affects staffing companies; for, as a natural consequence of why employees look for these jobs in the first place, they are very difficult to retain. The difference lies in how much effort a branch manager puts into retaining employees and in finding replacements rapidly, as well as capitalizing on potentially new relationships with clients.  

I have hitherto laid down some of the reasons why the franchising model is superior to its counterpart. Per unit sales financially captures this point, but the efficiency at which the whole system works does so as well. Before the merger, during the fiscal year of 2018, Command Center had net income of $974,000, whereas HireQuest reportedly generated $7.1M in profit. HireQuest thereby produced $0.0375 in net income per dollar of office sales, whereas Command Center had $0.01 per dollar of branch sales.

I must observe that, in 2017, HireQuest had net income of $2.88M on $170M in system-wide sales. The huge factor that contributed to 2018’s massive increase in profit was a reduction in one SG&A item by several million dollars, namely management fees. In 2017, $3.4M were paid in management fees, compared to $249 thousand in 2018.

HireQuest’s business model superiority was in fact so notorious that Command Center’s board of directors advocated for the merger occurring partly because of this. Some years before the merger, a group of people had been corporately set to evaluate how could Command Center turn the situation around. Almost two decades of operations had passed and no executive could figure the system out, generating very poor results for shareholders as a result.

As part of the merger agreement, Richard asked Command’s CEO to help him during the transition phase. This is one of the operational risks that exists when making these types of deals. Turning dozens of branches from company-owned to franchisee-owned is not simple and can very well impact HireQuest’s operations. With this in mind, Hermanns tries to secure the conversion beforehand.

Branches Conversion

The merger effectuated in July of 2019. Already by October of that year, the executive team had converted all company-owned locations into franchisee-owned. For the sale of these branches, HireQuest received an aggregated payment of $16.2 million. Most was paid with 4-5yr promissory notes, while some had unique arrangements. More importantly, these branches thereafter operated under HireQuest’s umbrella, benefiting from workers’ comp, software, and working capital solutions. In exchange, the pay a royalty fee. The agreed-upon fee was also generally standard, though there were a few unique clauses.

Branches were converted on three separate general agreements, which occurred on differing dates. The first and almost immediate one was in July, when approximately 31 offices were sold for a total of $4.7 million, paid with 4yr promissory notes at a 6% rate.

In this transaction, I must observe, an entity called World Buyers purchased franchise assets for around $2.2 million. World Buyers represent what management calls “World Franchisees.” This is a small group of people that own an interest in some of HireQuest’s franchises; including Hermanns’ immediate family members and Edward Jackson, who has been involved with HireQuest for over two decades and owns over 15% of the company. As of 2023, Worlds Franchisees were 34 and they operated 70 franchises.

“Based on their respective ownership interests in the Worlds Buyers, this corresponds to a value of approximately $1.132 million for Mr. Hermanns’ children and approximately $0.461 million for Mr. Jackson”

The second transaction occurred in September, when approximately 27 locations were sold. HireQuest received an aggregated payment of $9.7 million, paid with 5yr promissory notes at a 6% annual rate.

Shortly thereafter, the last deal was made, where an approximate of 4 offices were sold to franchisees. HireQuest received an aggregated payment of $1.8 million in the form of 4yr promissory notes at a 10% annual rate.

“Our team worked expeditiously to gain state regulatory approvals and convert the acquired Command Center branches to our franchise business model within 10 weeks following our merger,” Rick Hermanns in October of 2019

The franchising model shows greater aptitude for an acquisition-driven business because managers tend to stay running their branches. When a staffing company with company-owned offices acquires another staffing business with company-owned locations, it’s common for people in charge of the latter’s branches to leave. This is massively damaging, for it’s likely that those people were the ones who kept the customer list together. It becomes very deceiving to acquire under these conditions. What seems like a $10M staffing business may turn into a $3M business after these people leave.

When HireQuest acquired Command Center, most branches kept being run by the same people. This operating framework largely removes the biggest risk when acquiring staffing companies. A transaction involving two staffing businesses with company-owned offices may require an additional 12-24 months just to get back to their prior level of business. Richard mentions that, although it was (in 2021) very hard to tell with Command Center because of the pandemic, sales at the different branches held up very well.

What I would argue occurred with Command Center is that shareholders ended up having more profit per branch. Removing middle managers, increasing efficiency with software and providing cheaper capital to offices translated into more cash flow per unit.

Although this was a merger, for which the following does not precisely applies, the income received from the sale of branches causes the price paid for an acquisition to not be illustrative of the true economic cost for shareholders. This is something Hermanns has done repeatedly over the past 5 years. He seemingly pays a certain price for locations but, after converting them, the price paid ends up being meaningfully lower.

After the merger consummated and the tender finalized, the combined entity had an approximate market capitalization of $80 million. HireQuest security holders owned 76% of the total, while Command Center shareholders owned the remainder 24%. This becomes very illustrative of the true economics behind each of both business models. With 98 locations, each branch in HireQuest network was assigned a market value of $620,000. In counterpart, each location in Command Center’s network was assigned a market value of $286,500.

Link and Snelling

In 2021, after Command Center was fully integrated and the pandemic effects diminished, Richard began re-acquiring staffing companies. During the first quarter of 2021, two significant purchases were made, adding several dozen locations to the network.

The first company acquired was Snelling, and the trademark remained unchanged. Snelling had around $87 million in system-wide sales and 47 locations. HireQuest paid $17.9 million for Snelling-related assets. Snelling run a franchising business model, but it counted with 10 company-owned locations. To de-risk the transaction, Hermanns decided to sell these 10 branches to third parties. In exchange, HireQuest received:

• $1M in promissory notes at 6%

• $1M in cash

• 1.5% of NTM revenue at the Ontario locations

• 2.5% of NTM revenue at the Tracy and Lathrop locations

• 2% of revenue at the Princeton for next 36 months

The second acquisition that HireQuest did in March of 2021 was Link Staffing, a multi-decade family-owned business. Link was fully run on a franchising business model. HireQuest acquired the franchising agreements of 35 locations as well as certain other assets for $11.1 million.

To further de-risk the whole operation, Hermanns signed the California based franchise agreement. HireQuest agreed to sell 6 LINK and 1 of Snelling’s branches to a third party. In addition, the remaining 3 Snelling locations in California were sold to the same third party. The buyer became the franchisor of all locations, but agreed to pay HireQuest a royalty fee equivalent to 9% of their gross profit in perpetuity.

The pandemic severely impacted companies who require physical attendance to their work sites. In consequence, the staffing industry highly contracted during 2020, which had leftover effects thereafter. In 2020, Manpower, whose earnings had been around 500M for the previous 4 years, had earnings of 23M on 18bn in revenue, down from 20bn in 2019, and some quarters with sales declining 30%. On the other hand, Robert Half, a very well run staffing business, had revenues contracting over 20% and earnings falling by over 50% YoY during the second quarter.

While it also affected HireQuest operations, the company kept running at over 20-30% operating margins, generating significant amounts of cash. In addition to this, HireQuest is run on the peculiarity that, when franchisees don’t expect much business in the coming months, they refrain from hiring. This stops HireQuest’s cash outflows and the collection of receivables causes a rapid inflow of cash.

Hermanns runs HireQuest in a way that minimizes the operational risk. He tends to fund acquisitions and growth initiatives with generated cash and almost never incurs large levels of debt. Therefore, although the company is affected by calamities such as the pandemic, HireQuest is usually one of the least affected companies. This puts them in a position of strength that Richard takes advantage of to acquire other staffing businesses that become distressed. Importantly, given the fact that almost all staffing companies are struggling at times of distress, there rarely is much competition for the deals Richard goes after.

This is what happened with Snelling. Snelling was struggling financially and was in need of capital. HireQuest offered Snelling’s team to buy the company and advance $2.1 million so that they could pay accrued payroll liabilities. The price paid for Snelling was $17.8 million, meaningfully below the asset value of the business. Consequently, HireQuest recorded $5.6 million as bargain purchase.

“The bargain purchase is attributable to the financial position of the seller and because  there were few suitable potential buyers.”

Other Acquisitions and Branch Conversions

HireQuest acquired Dental Power’s staffing division in December of 2021 for $1.9 million. Richard’s intention was to run it as a company-owned location for some time, using it as a platform to launch HireQuest health, and sell the assets for it to become franchisee-owned.

During the fourth quarter of 2022, HireQuest began holding the assets for sale and effectively sold them in March of 2023. A franchisee within MRI network acquired Dental Power from HireQuest at a price of $2 million, payable over 5 years. HireQuest recognized a gain of $340 thousand on the transaction and Dental Power’s branch is now franchisee-owned.

In January of 2022, HireQuest acquired Temporary Alternatives, the staffing division of a family-owned company based on Texas and New Mexico, for $7 million. It’s worth noting that this included $2.6M in accounts receivable. Temporary Alternatives had three company-owned locations which HireQuest sold for $2.9 million immediately after the acquisition. The buyers entered into franchise agreements with the company.

The following month, HireQuest acquired The Dubin Group and Dubin Workforce Solutions (collectively “Dubin”) for $2.5 million. HireQuest split the business into two separate ones, each counting with their own location. Immediately after the acquisition, HireQuest sold the Workforce Solutions segment, specialized in temporary labor, to a new franchisee for $350,000. Management has not yet found a buyer for the other location. In the meantime, HireQuest entered into an agreement with Dubin’s seller for him to continue managing the location as company-owned.

“We are delighted that Kenny Dubin, the founder of these companies, has agreed to stay on to help further develop these offerings."      

HireQuest acquired Northbound Executive Search in February of 2022 for approximately $11.4 million. It’s worth noting that this included $3.4M in accounts receivable. Northbound presumably generated over $15 million in sales during 2021. Immediately after the event, HireQuest sold the acquired assets for $6.4 million and the buyers became franchisees.

Northbound was co-founded in 2010 by Greg Feder and Rachel Feder. Both commented at the time of the acquisition they’d continue leading the company and working with Richard. They are still managing partners and have a place on Northbound’s board of directors. Moreover, the whole executive team and other partners remain in their positions. Most of these people have worked at Northbound for several years, with some going back over a decade.

In December of 2022, HireQuest acquired MRI, which was a significant acquisition. MRI had 232 franchise offices, mostly in the US, and had generated $283 million in system sales, which translated into 11.3M in income from royalties and 1.9M in LTM EBITDA. HireQuest recorded 4.9M in goodwill in the transaction.

In December of 2023, HireQuest acquired The Employment Company (TEC), which had ten locations in the Northwest and Central Arkansas, for $9.8 million. TEC was founded in 1979 and reportedly generated $34 million in sales on the trailing twelve months ended in September of 2023. Immediately after the acquisition, the assets were sold for $7.6 million. This led to the conversion of all acquired branches into Snelling franchises.

Conclusively, the peculiarity of turning company-owned locations into franchisee-owned end up very positively impacting the economic cost of M&A. Although the headlines may indicate a certain number, HireQuest has mostly managed to get a great deal of cash out of converting the acquired branches.

It’s fundamental to highlight that Richard seems to only acquire a business when the terms are highly favorable for HireQuest. This is partly the reason why he runs HireQuest on a very healthy balance sheet. Minimizing costs is a further cornerstone of Hermann’s strategy, massively helping in economic down cycles.              

“ as it relates to M&A, I'd like to point out that we've been able to maintain a healthy balance sheet and low leverage throughout all these transactions. Since the beginning of 2021, we've increased system-wide sales by just shy of $400 million. We've invested over $75 million in acquisitions and finished 2023 with net debt of $13.4 million. I'll also highlight that fully diluted shares over that time have increased from about 13.7 million to only 13.8 million at the end of 2023. That is, we financed our growth almost exclusively with cash flow from operations.”

Finally, Richard has repeatedly managed to keep the same people who were running the branches before them becoming franchises. This is one of the most crucial aspects of HireQuest’s M&A. Turnover is the most common value destroyer in these types of deals, and Hermanns has consistently managed to execute well above average.

Table of Contents:

• Brief history

• Overview of the business’ operations

• Characteristics of its franchising model, different from competitors

• How their working capital funding works

• How their workers’ compensation insurance works

History

HireQuest’s story begins in 1991. Richard Hermanns and Dan McAnnar had worked in the staffing industry, getting to executive roles, and decided to open their own staffing Labor World USA franchises. Richard operated in South Florida and Dan in South Carolina. After three years running their business, they decided to form a more solid partnership and expand into new markets. In 1997, they bought all franchises that Labor World USA had outside of Florida and changed their corporate name to Productivity Partners.

The next year, two trade names were introduced to replace Labor World USA, namely: (i) Trojan Labor, which would serve in the light industrial staffing sector; (ii) Acrux, aimed at skilled and semi-skilled labor. Some of the offices they opened were company-owned but, later that year, the team started pushing forward the franchising model, whereby entrepreneurs could run a franchise under any of both brands and pay a royalty fee. In 2002, HireQuest LLC was born, adopting the name that would carry onward.

In 2004, Richard and Dan acquired 14 Ready Staffing franchises. Three years later, they acquired seven more branches, getting to 42 Trojan Labor locations and four Acrux. By 2013, Hermanns realized that the franchising business model is far superior to the traditional approach. He therefore committed to having the completeness of the network running under a franchise agreement.

Half a decade later, Richard made a very peculiar decision. Having over 70 locations, HireQuest saw an opportunity to undertake the next growth phase. In 2019, they announced their merger with Command Center, a then public company. Command Center had almost the same size as HireQuest, pointing out the path that HireQuest would take thereafter. With this merger, the corporation adopted the name HireQuest, relocated headquarters to where HireQuest was based, Charleston, and the whole team got replaced by HireQuest’s executives. Richard Hermanns became CEO. His long-time partner, Dan McAnnar retired the following year.

Business Overview

HireQuest offers temporary staffing in various industries as well as executive recruitment services. Over time, and mostly due to the acquisitions made, the company has built a small conglomerate of trademarks, all of which serve their own markets. After briefly distilling these brands’ operations, I shall dive into the characteristics of HireQuest’s franchising model.

Broadly speaking, the business works as follows. People are employees of HireQuest’s franchisees, although I will more extensively address this point below, because it is not that simple. Customers ask for temporary staffing solutions to the offices and pay mostly a fixed rate per hour worked. Contracts may differ in time and pay rate. HireQuest earns a percentage of the gross billing that offices generate in the form of royalty fees or over funded payroll.

HireQuest Direct

HireQuest Direct, successor of Trojan Labor, is the most iconic brand that HireQuest owns. It currently has 128 branches across the US and 41 franchise owners. HireQuest Direct offers staffing services ranging from hourly labor to temporary and long-term contracts. They run their own screening, are in charge of the final placement, insurance, payroll, and taxes. The fact of the office being in charge of all paperwork and the hiring process immensely facilitates the fulfillment of clients’ needs, saves them time and resources.

HireQuest Direct serves in industries such as janitorial & cleaning; construction, including site construction, carpentry and others; hospitality for special events, including bartenders, cooks, food runners; operative talent needed for special events like setting it up or security services; traffic control; and warehousing & logistics. The comprehensiveness of HireQuest’s staffing offers allows for turnkey solutions depending on customers’ needs.

TradeCorp is a division of HireQuest Direct, specialized in providing on-demand labor for skilled positions in construction and light industrial. TradeCorp helps electricians, HVAC technicians, plumbers, metal workers and welders. They are continuously hiring people capable of performing these trades and have them readily available for when customers require their services. Conclusively, TradeCorp offers short-term skilled labor for specific construction trades.

Snelling

Snelling was founded in 1951 by Lou and Gwen Snelling. The first office was opened then, and, by the late 60s, the company got to 50 locations. Snelling serves numerous industries and provides on-demand skilled and semi-skilled labor for administrative, engineering, finance, hospitality, manufacturing, light industrial, and commercial needs. In contrast to HireQuest Direct which focuses on daily-work jobs, Snelling focuses on longer-term staffing positions.

Snelling offers three different forms of staffing solutions: (i) direct hire, whereby Snelling does all the screening and filters a few candidates for the firm; (ii) temp-to-hire, where Snelling provides candidates who are then subject to a 90-days trial period, after which the hiring firm decides if they permanently hire them; (iii) temporary staffing.

HireQuest acquired Snelling in 2021, when it had 47 locations and system-wide sales of 87 million dollars. The price paid amounted to $17.9 million and Snelling offices continued to operate under their brand.

DriverQuest

DriverQuest provides companies with commercial and non-CDL (commercial driver’s license) drivers. It serves numerous industries and customers, focusing on the long-haul and last mile segments. DriverQuest was launched in 2021 as a part of management’s plan to add verticals that can be leveraged throughout the network. Franchisees who’d like to offer one of these can opt in. By August of that year, Richard mentioned that over 35 franchisees had already started offering driving services.

HireQuest Health

HireQuest Health provides skilled temporary and direct-hiring staffing solutions within the healthcare space. The company serves hospitals, dental offices, physician groups, clinics, and medical centers. HireQuest Health operates in verticals such as inpatient & outpatient care, home health, hospice, senior care, private practice, pharmaceutical and medical devices, schools, and manufacturing & supply chain.

In 2021, HireQuest acquired Dental Power (DPS) for 1.9 million dollars. Dental Power was a 46+ years old family-owned business that provides staffing solutions for dental practice, including temporary and long-term contracts. The company counted with multiple long-term client relationships and a nationwide network with more than 100 thousand dental professionals. Dental Power had presumably generated $3.5 million in sales over the prior 12 months.

Thereafter, DPS operated as a subsidiary of HireQuest and kept its brand. Jamie Understein had been DPS’ president for 22 years at the time of the acquisition and remains a consultant for HireQuest. In March of 2023, HireQuest sold DPS’ assets to one of MRI’s franchisees, who would continue to run the business as part of their franchise.

“I am also so delighted to be passing along the Dental Power flagship services, started by my mother in 1975, to another successful family founded company.” Jaime Understein

Management Recruiters International

Management Recruiters International (MRI) was founded in 1965 by Alan Schonberg. MRINetwork has over 200 offices around the world, mostly in the US, and connects firms with candidates, ranging from graduates to high-level executives. MRI has been an industry leader for several decades, working with all types of companies, from startups to Fortune 500s, and has done more than 800 thousand placements worldwide.

In 2019, Bert Miller acquired MRI through a vehicle he controlled, named MRI Network Holdings, after which the company was renamed. Bert founded Protis Global, an executive recruitment firm focused on the beverages, consumer products, healthcare, and pet industries in 1995. He led it until the acquisition of MRI, whereupon he focused on strengthening MRI’s network-centric model. Since Protis Global inception, the firm has been part of MRI’s network.

HireQuest acquired MRINetwork in December of 2022 for approximately 13.3 million dollars from Miller. At the moment of the acquisition, MRI had around 210 active franchises and presumably generated $283 million in system-wide sales. MRI kept operating as a subsidiary, keeping its brand.

This acquisition complemented HireQuest’s business, helping HireQuest expand into the executive recruitment market.  It must be observed, however, that MRI also counts with a contract labor division, which, at the time of the acquisition, had over 50 million dollars in system sales.

Sales Consultants and Northbound are the two other trademarks that offer executive recruitment services. Nonetheless, it is to be observed that, similar to MRI, many franchisees offer short-term staffing services and advisory as well.

Northbound Executive Search was founded in 2010 in New York, wherein most of its operations reside. It provides short-term advisory services and mostly serves blue-chip corporations in the financial industry. Northbound was acquired by HireQuest in February of 2022 for approximately 11.4 million dollars.

Franchising Model

HireQuest runs a franchising business model. Offices that operate under one of HireQuest’s trademarks are franchisee-owned and pay a royalty fee to HireQuest. It must be observed, however, that some are company-owned and held for sale. The latter is the natural consequence of their M&A model, in which I’ll dive in the next write-up.

Offices are managed and run by the owner, who typically hires in-office personnel, recruiters to bring employees in, and business development staff. These costs are incurred by the respective franchises. HireQuest provides guidance and assistance when needed. They have “substantially less control over a franchisee’s operations than we would if we owned and operated an office ourselves.”

Management believes that franchisees owning the offices helps align incentives and impactfully enhances performance. Operators’ income will depend on how well their unit performs, hence making them have a personal interest in ensuring success. HireQuest has several programs to reward franchisees who execute well.

Several advantages further arise from the franchising model, probably the most important of which is the nimbleness and agility that result from the decentralization of control. When customers approach an office, it is in the owner’s best interest to serve them rapidly and efficiently. Their response will determine if clients hire them, and their service will dictate whether they come back or not.

The staffing industry has tended towards webs of long-lasting relationships, which is partly what causes it to be highly fragmented, with local players not being displaceable. Opportunities to forge new long-term relationships occasionally emerge and it seems better to have franchisors with strong personal interest in ceasing these.

Additionally, local ownership entails having a franchisee, or manager, that is most likely thinking about remaining in their position for a long time and that’s in charge of a single office. Their horizon and personal commitment lead to closer and better managed relationships with clients and employees. As a side note, it is to be observed that some franchisees have multiple franchises.

Owner-operators are also inclined to better handle the high turnover that’s present in the staffing industry. Most employees seek these firms temporarily, some may be permanently hired by another firm, and contracts are short term. A franchisee who’s personally interested in the branch performing well will be incentivized to appropriately deal with this large obstacle.

Direct dispatch

The remaining feature that characterizes some of HireQuest’s operations is their direct-dispatch approach, especially in the construction and light industrial segments. Employees go to the offices and are then sent toward their daily activity’s location. Management believes this dramatically increases the consistency with which HireQuest is able to fulfill their obligations. This drives customers’ satisfaction, makes the service more valuable, for it is more reliable, and eliminates a huge problem inherent to the staffing industry.

Additionally, a direct-dispatch approach addresses the main reason why the staffing industry came about in the first place. The latter arose in response to customers’ shift in labor needs. Some businesses are highly cyclical and cannot know when cycles turn. Peaks come somewhat suddenly, and managing cycles oneself ends up being a costly endeavor. Hiring, recruiting, interviewing, and workers’ compensation insurance are resource intensive, affecting companies’ bottom line. They may therefore conclude it’s safer to hire temporary employees during upticks in demand

Having a workforce immediately ready for when these companies require it is capital intensive but lays the ground for a competitive advantage. Delivering a better service is one of the only ways in which staffing companies can compete. Moreover, due to the aforementioned profitability dilemma, customers are happy to utilize staffing companies’ services.

“We believe we are one of the largest providers of direct-dispatch temporary staffing solutions in the light industrial and blue-collar segments of the staffing industry measured by number of offices” 2023 annual report

Centralized Operations and Benefits

Although HireQuest has essentially built a decentralized chain of chains of operations, there are a couple of things that the company does for its franchises, on a centralized basis. Some of these are practices and modus-operandi, whereas others imply the centralization of certain processes. On occasions, scale brings benefits, and this is the reason why management has opted to pursue this route since inception.

One of the requirements for building or owning one of HireQuest’s franchises is the utilization of the company’s proprietary software, HQ WebConnect. The software helps handle operating processes underlying running a staffing service, including payroll and accounts receivable, which is, incidentally, fundamental for HireQuest’s added value. Furthermore, it allows HireQuest to keep track of certain KPIs and detect potential fraud. With the objective of having a valuable product, HireQuest hires a dedicated team of developers who update it periodically.

Working Capital Funding

The staffing industry does not possess significant barriers to entry, but it does not favor small players. To build an office and get the business going, a significant amount of capital is required; if not for the building itself, in the form of working capital.

Temporary employees need to be hired before the client asks for your services, therefore requiring franchisees to incur salary expenses, with all of its implications. More importantly, clients’ receivables have a certain lag. These tend to be 30-60-90 payment-days terms, for which financing salaries for this period requires upfront capital.

This is more pronounced during the Spring and Summer seasons, when staffing demand is at its highest. Seasonality indirectly mandates that a large percentage of the yearly working capital will be needed in relatively concentrated periods, namely these two seasons.

Through the franchise agreement, HireQuest acquires the ownership of franchisees accounts receivable and funds their initial working capital needs. The company owns these receivables up to 42-84 days, after which they are charged back to franchisees.

“As accounts receivable age over 42 days, our franchisees pay us interest on these accounts equal to 0.5% of the amount of the uncollected receivable each 14-day period. Accounts that age over between 42 and 84 days are charged back to the franchisee and no longer incur interest”

Management believes this proves an inexpensive capital source for franchisees and helps them finance their growth. It’s interesting to note that management has historically found that franchisees tend to collect outstanding accounts faster than company-owned offices would. The arrangement seems to align interests in this regard.

Additionally, HireQuest encourages franchisees to expand operations. If they want to open a new office, even if destined for markets or industries they currently do not serve, HireQuest can provide them with credits on the royalty fees they’d pay. Furthermore, HireQuest can occasionally assist with acquisition funding. Naturally, this is only a good thing if management knows who to partner with. Otherwise, it’s value-destroying. Large players in the staffing industry have no problem with this, since these types of investments are centralized.

All of these may help explain why the industry remains fragmented with locally dominant players, but who didn’t expand. It also allows me to infer why the most classical approach that dominant firms employ is that of company-owned offices. Concentrating capital investments and the building of a single brand seem to be natural outcomes. Similarly, some companies may fear getting capped by bad operators.

Given the aforementioned local dominance, present since the industry’s inception, and a byproduct of long-term relationships, I suspect HireQuest’s business is not at risk on the name’s front. I wouldn’t bet on the company having to unify their operations under a single trademark. Although a very immature hypothesis, in which I’ll dive over the coming months, it doesn’t seem necessary.

Working capital investments are required for expanding operations by hiring temporary employees before getting paid by customers. This phenomenon is what drives HireQuest’s liquidity. For system-wide sales to increase, or even a single office’s sales, larger sums of capital have to be invested. Therefore, as the economy expands and franchisees expect increased demand, HireQuest’s cash balance falls and the company’s accounts receivable rise as customers are signed. The obverse also occurs. When the economy contracts, franchisees hire fewer temporary employees, for which less investment is required. As they start collecting their receivables and don’t immediately re-deploy that capital, HireQuest’s cash balance grows.

“As discussed more fully below, our already strong liquidity position has improved since December 31, 2019 because of decreased funding requirements for temporary employees and the decrease in our accounts receivable balance as amounts are collected and converted to cash” Q2 2020

This specific mechanic has helped management pay for acquisitions in cash when valuations started getting more attractive. It is to be observed, nonetheless, that receivables can end up not being collected. If the economy deteriorates enough, some customers may not be able to come up with the funds for paying, which I believe is part of what happened during the GFC.

Workers Compensation Policy

The second barrier new entrants and small competitors face is the limited accessibility to affordable workers’ compensation insurance policies. Companies have the legal responsibility of buying insurance to protect their employees. Whether it is a legal obligation or not varies depending on the state. This covers the pay for work-related accidents, illnesses, time lost from work, and other issues.

Given the fact that insurance companies spread risk among policyholders, a company with more employees tends to pay lower premiums per employee. Larger companies also present better conditions for insurance companies, some safety-related, which provides them with negotiation power. This leads to cheaper and better policies.

By being responsible for the whole network of offices, HireQuest is more efficient on a per unit basis than small players. Additionally, regulatory compliance is getting increasingly expensive, with litigation costs trending higher. Local players may not produce enough operating income to sustain these.

Worker compensation expenses are recorded as G&A expenses. The company has an established reserve for the future costs they estimate will have to incur due to claims. This includes reported claims that have not yet settled and claims incurred but not reported.

The length of compensation benefits varies per state. However, there are some where employees are entitled to receive benefits up to three-seven years if the injury persists. Given some claims end up being long tail (claimed after several years), estimating their cost is an excruciating task. In consequence, HireQuest’s reserve for this cost fluctuates significantly, affecting the reported income in both directions, depending on whether the reserve is raised or lowered.

This has in fact occurred over the past few years, whereupon workers’ compensation has very high volatility, in this case causing HireQuest to report much higher expenses. At the same time, the MRI acquisition, which brought in several other costs, and the ongoing amortization of intangibles acquired, caused operating margins to contract severely.

HireQuest developed a risk management program (RMIP) to incentivize franchisees to maintain workers’ claims at relatively low levels. By controlling exposure to large claims, ensuring a safe workplace, and resolving claims quickly, franchisees can achieve this. HireQuest rewards those who succeed in maintaining their loss ratio below a defined threshold by giving them a credit on generated royalties. Furthermore, the company pays franchisees a percentage of what they pay for workers’ compensation insurance if the loss ratio is maintained at desirable levels.

The following table illustrates the fluctuation that workers’ compensation claims (current liability), those net of current portion (liability), and the liability related to the RMIP. These have all severely impacted HireQuest’s financial statements.

I’m not very knowledgeable on workers’ compensation insurance, but I read as many sources as I could. Further, a friend spoke with IR and was kind enough to send me what they said. I’ll try to reproduce HireQuest’s insurance dynamics as faithfully as I can.

The company buys high deductible policies. When claims effectuate, HireQuest covers up to the first $500,000 in cost. Up from that threshold, the carrier (Chubb and ACE) pays for the expenses. Taking this into consideration, HireQuest incurs two costs: the premium paid to the carrier and the claims expense up to the initial $500 thousand.

There is an element, however, that helps offset this. HireQuest acts as an insurer themselves to franchises, for which the latter pay a premium to HireQuest. Management emphasized they do not intend to make a profit on this in the long run; rather, they only want to pass the cost through.

The net benefit or expense that the company will record on their p&l depends on all three elements.

“For example, if our blended manual premium rate for the year is 8% of payroll, the base rate premium paid to the carrier is 2% of payroll, and the total cost of claims (up to the deductible) is 4% of payroll (or 50% of manual premium), we would record a Work Comp Net Benefit equal to 2% of payroll.”

Typically, manual premiums collected had been enough to cover for the base rate paid to the carrier and claims that arose. But, over the past couple of years, manual premiums declined substantially, whereas the base rate and claims’ cost declined, but on smaller proportions. Therefore, manual premiums have not been enough to cover both expenses and HireQuest recorded a net expense from workers’ comp.

“This increase is primarily due to (i) medical claims that were higher than historical claims, (ii) continued increases in medical costs and (iii) 2022 was a one-time benefit from the Snelling acquisition”

Terms and Royalties

When franchisees sign the temporary staffing franchise agreements, HireQuest grants them exclusive territory. No other HireQuest franchisee can operate an office in a protected area. The extension of the accorded territory varies depending on numerous factors. Large cities that tend to be more densely populated give room for more franchises operating, diminishing each particular’s territory.

Typical franchise agreements are signed for five years. But the acquisitions HireQuest made over the past few years entailed management negotiating the sale of hundreds of branches. Some of them ended up having longer-term agreements. Therefore, there’s a current mix on agreements’ duration.

Franchise agreements for permanent placement, mostly inherited and assumed from MRI’s acquisition, tend to have a 10-year duration. But there are ongoing agreements for longer periods. Management plans to standardize the length of the agreements as renewals come into effect.

Acquiring staffing companies with different economic characteristics and end markets caused royalty fees to differ depending on the trademark. It is not to my knowledge that management would also want to standardize these, for it may be a mistake. The following table illustrates the royalty fee each franchise incurs.

There are some elements I’ll hereby point out. The actual royalty fee that ends up being paid by franchises exposed to ranges (6-8%, 5-8%, 1-9%) depends on the office’s sales volume. Branches that generate higher levels of revenue are charged incrementally lower fees. For instance, HireQuest Direct franchises pay an 8% fee on the first million in billings, which diminishes by 0.5% for every extra million dollars in billings, up to 6%. Importantly, the lower fee is charged to each incremental million in sales.

Royalties are billed on a weekly basis, except for MRI, which are monthly. HireQuest counts on, as mentioned, several incentive programs, many of which provide franchisees with a credit on their royalties. Reported royalties are net of these credits and incentives, and management mentioned they’ll grant credit for low margin business.

Winmark was founded in the 80s and, by the late 90s, it was struggling financially. During that time, management had a meeting with John Morgan, whereby they asked him to become CEO. Morgan accepted under the condition that he would be the only one in charge. Thereafter, he turned Winmark around and shaped its culture.

Winmark’s business used to revolve around selling merchandise to franchisors and opening as many stores as possible. Completely in the opposite direction, Morgan mostly focused on generating revenue with a 3-5% royalty fee and partnering with talented and trustworthy operators. This playbook is the backbone of Winmark’s strategy and has been successfully utilized to this day.

The other major decision Morgan took was starting an equipment leasing business. After 2003, the completeness of the generated cash flow was reinvested into this activity, which got to a meaningful magnitude. When John stepped down in 2016, Brett Heffes succeeded him.

Under Brett’s tenure, Winmark discontinued the leasing operation, thereby liberating all operating cash flow. To deploy it, management adopted a very simple and prudent policy. As much cash as possible gets reinvested in the core resale operation; excess cash is returned to shareholders.

Over the past couple of years, the team has engaged in stock repurchases on an opportunistic basis. If the price is considered unattractive, management analyzes repaying debt and distributing dividends. Regarding the latter, they have opted to stick with a flexible policy. A small dividend is yearly paid and, if there’s excess cash after exhausting other options, special dividends get distributed.

Conclusively, Winmark is a stable, slow grower, with seemingly durable cash flows, requires no capital to grow, and is wildly profitable. With no avenue for reinvesting, most cash will be prudently distributed to shareholders.

Personal Commentary

I just wanted to let you know that I created a website where I posted all of my past equity research reports, in their PDF format. Most are free. Hope you find it useful, here’s the link:

Link to Equity Reports

Disclaimer: This is not financial advice.

Noticing there was no supply for her need, Martha decided to start Play it Again Sports. The idea was to build retail stores with a “garage sale-looking environment” to captivate franchisees who would like to sell used products.

In parallel, Ron Olson and Jeffrey Dahlberg started a consulting firm in 1986. Martha was one of the first customers they had. After noticing the success and potential of her idea, Ron and Jeffrey bought the rights for Play it Again Sports in 1988. This became Winmark’s first division, then called Grow Biz International.

By the year 2000, the company had opened multiple lines of franchises but was severely struggling financially. John Morgan took over as CEO and turned the business around. He sold the company’s corporate headquarters, three franchises’ rights and re-built the organizational structure, replacing most people. Winmark went from an $8.5 million loss in 1998 to consistently profitable after 2001. Morgan led Winmark until he stepped down in 2016, when Brett Heffes replaced him. Brett continues to hold his position as CEO of Winmark.

Business overview

Winmark is a franchisor focused on sustainability and small business formation. They ‘champion and guide’ entrepreneurs interested in operating one of their five resale franchises:

• Play it Again Sports (began in 1988): Buys and sells gently used and new sporting goods, equipment and accessories.

• Once Upon a child (1993): Buys and sells gently used children’s clothing, toys, furniture, equipment and accessories. The primary target is parents with children under 12 years.

• Music Go Around (1994): Buys and sells music instruments, both gently used and new, speakers, amplifiers, and music-related electronics.

• Plato’s Closet (1999): Buys and sells gently used teenagers’ clothing and accessories. The primary target is mostly teenage girls.

• Style Encore (2013): Buys and sells gently used women’s clothes, shoes, and accessories. The primary target is women between 20-50 years.

Each of these work by buying ‘gently used’ items from customers and re-selling them. People that sell the items can receive cash or a higher amount in credit store. Some of these franchises also sell online. On average, it is estimated that Plato’s Closet pays customers around 30%-40 of the price they’ll be selling an item at. The other franchises operate similarly.

Management is very selective of the people with whom they do business. Several requirements need to be met for a person to be considered as a potential operator. The company seeks franchisees who:

• Have a sufficient net worth. For example, to operate a Play it Again Sports store, operators are required to have a net worth of 400,000 dollars and 90-105k in liquid assets.

  “Play It Again Sports expects franchise candidates to have an approximate investment of $300,000 to $410,000 to open a store”

• Prior business experience.

• Intend to be integrally involved in managing the store. This implies operators cannot open one as a hobby. Rather, they need to run the store full time. At the same time, they are required to sign a non-compete agreement.

Winmark has partnerships with different businesses for each brand. When franchisees buy new products, a portion of them need to be bought from these set of partners. Nonetheless, the majority of the products sold are bought from customers.

Once Upon a Child, for instance, buys approx 30% of new products from 4 partners. MGO, 50% from 5 partners. No significant vendors in Plato’s Closet nor Style Encore. On the sports brand, no number mentioned.

John Morgan Shaping the Culture

John Morgan crafted Winmark’s brand and culture. When he sold his business to TCF, he asked for equity in exchange, for John considered TCF to be undervalued. After the stock did fantastically over the subsequent years, Morgan and his partner became very rich. Shortly thereafter, both began an investment firm. Morgan was soon called for a meeting with Grow Biz’ management and large shareholders. They wanted him to take over as CEO. John agreed, but on one condition:

“It wasn’t going to be groupthink. It was going to be my way or the highway”

Morgan recalls having found an absolute mess in Winmark. By 1998, the company had more than 1,200 franchises, but growth started slowing down, which is when the bleeding started. In 1999, revenue declined 32% and, after having 7.2M dollars in net income in the previous year, the company reported a loss of $8.5M. John Morgan’s employment agreement started in 1999 and, in the year 2000, Winmark had a loss of $350,000.

Once John took over, he did a complete turnaround. Grow Biz International was renamed as “Winmark”. Morgan shut down three lines of franchises the company previously offered, namely: (i) Computer Renaissance, computers resale; (ii) Retool, consistent of tools resale; (iii) It’s About Games, which was disposed and Winmark recorded an asset impairment of over $11 million. Computer Renaissance was sold for $3 million and Retool, 3 years after being acquired, dissolved. Moreover, John Morgan decided to sell Winmark’s headquarters. Koch Trucking bought the property for $3.5 million.

Prior to Morgan joining, the team had acquired the franchising rights of Plato’s Closet. As soon as John took over the firm, he realized the potential this franchise had and decided to bet heavily on it. As of 1999, Plato’s Closet had a total of 5 stores, which scaled to a couple hundreds in the subsequent 15 years. Morgan kept three other franchises: Play it Again Sports, Music Go Round, and Once Upon a Child.

In addition to all of this, John completely changed the business’ strategy. Grow Biz used to give franchises to whomever had the money to open one, independent of their capabilities. Furthermore, the majority of the company’s topline was generated by selling products to franchisees. Morgan decided to award franchises, instead of giving them away. Winmark started intensely screening for candidates and placed more emphasis in helping them thrive. At the same time, Winmark would no longer generate most of its sales by selling products to franchisees, but rather by charging a royalty fee.

When John Morgan was appointed CEO, he was awarded 600,000 options to buy stock at $5 per share, which would vest over the subsequent five years and expire in 2006 if unexercised. Morgan made full use of the options. Thereafter, he was awarded no more options and complemented this with continuous purchases of Wina’s shares in the open market. Throughout the years, John got to own 34% of Winmark’s equity in 2013, equivalent to over 1.7 million shares.

Another peculiarity this man had is that his compensation was the lowest among executives. In an interview, Morgan highlighted how he was aligning incentives between everyone within the company.

-Interviewer: Is your share-buying a slow way to take the company private?

Morgan: I want the company to be public. To motivate the employees, it has to be a public company. Stock options are the best way for them to grow their net worth.

-Interviewer: The Winmark March 2013 proxy disclosed that you and your top three managers all earned the exact same salary ($267,250) and exact same bonus ($267,250) for fiscal 2012. Why the same?

Morgan: You don’t do things just because you can. You do things because you have a reason to. And my reason to do this is that this motivates them. It works.

Winmark does not have an IR team and management do not do conference calls. Quarterly press releases and annual reports are as short as it gets. Hereafter, I will dive into:

• The Franchise Agreement

• Winmark’s historical financials

• Trends worth paying attention to

• How the business has evolved

• The closure of the leasing business

• Capital allocation policy

• Winmark’s current position and Brett’s vision

The franchise agreement

To open the first store, managers have to pay a fixed fee of $25,000 in the US and 34,000 CAD in Canada. To open subsequent ones, the fee drops 40% to $15,000 and 19,200 CAD. Typically, stores open 10-14 months after signing the agreement.

The initial term is 10 years with the possibility of 10-year renewal periods and provides the franchisee with an exclusive geographic area. Management reports to have 2,800 available territories. Franchisees are then required to pay weekly continuing fees, namely royalties, equal to a percentage of their gross sales, generally between 4% and 5%.

Winmark has three further requirements for franchisees, namely: (i) each franchisee needs to pay Winmark an annual marketing fee of 1,500 dollars; (ii) they are required to utilize Winmark’s operating system for managing the store; (iii) 5% of their gross sales need to be spent in advertising and promoting the store. There’s the possibility of extending the latter to 6% and destine 2% to an advertising fund, which Winmark manages.

Moving past the agreement, the company helps franchisees succeed with:

• Training. Each new manager is required to attend two training programs regardless of prior experience. They are instructed on how to actually run the store, including “how to evaluate, purchase and price used goods directly from customers,” which implies learning how to use the software.

• Support for opening the store and ongoing assistance.

“Our franchise support personnel visit each store periodically (in person or virtually) and, in most cases, a business assessment is made to determine whether the franchisee is operating in accordance with your standards”. They also help with operations.

Franchising Numbers

The franchising business has been doing fairly well since Morgan took over. The number of stores have grown from 824 in 2006 to 1319 in 2023 with 89% being in the US. More importantly, the renewal rate for finalizing agreements has averaged 98.6% over the same period. Such a high renewal rate illustrates how solid each partnership is, which is fundamental for turning each store into a long-enduring productive asset for Winmark.

The two brands that have been mainly fueling Winmark’s growth are Plato’s Closet and Once Upon a Child. The former has grown store count at a 6.2% CAGR since 2006, now representing 38% of total stores, up from 33%. Once Upon a Child increased its footprint at a 3.9% CAGR, from 214 stores in 2006 to 416 as of last year. It is worth noting that Play it Again Sports store count declined from 388 stores in 2006 to 273 in 2021. Thereafter, growth restarted.

Total store count growth has been relatively stable. An average of 49 stores were opened every year since 2010, while each year has finalized with an average of 62 signed agreements for opening new ones. I suspect the increase that has occurred throughout time is mostly due to management’s focus on opening “quality stores.” Growth is sacrificed in pursuit of building a reliable chain of operators. It is interesting to note that headcount had barely grown until 2017. Thereafter, coincidental with Brett becoming CEO, employee count has fallen from 107 to 83 in 2023.

I suspect this element starts to show the nature of Winmark’s business, one which I find extremely appealing. Winmark does not require capital to grow. Capital expenditure is not incurred by them and no extra operating expenses are required for scaling. The only problem I may point out is that a fixed headcount will not allow for rapidly scaling store openings without sacrificing quality. A yearly ceiling may be reached, which may have already happened.

Winmark finalized 2023 with 71 signed agreements, most of which are expected to open in 2024. At the same time, a total of 146 contracts will be ending in 2024, all of which are subject to renewal. In the subsequent two years, 120 and 116 agreements will be expiring. The following table displays this dynamic for each brand.

Winmark provides people with the average revenue each franchise generates as well as the gross margin at which they operate. Further, it’s mentioned the product mix they had. This implies how much of the business was in buying and reselling ‘gently used’ closed, and how much was derived from new items.

Note: For Style Encore, the company provides the top quartile’s numbers, for which I decided to exclude it from the table.

Management reports that 42% of total Plato’s Closet stores reached or exceeded average sales and GPM. This may suggest the median is not very far from reported averages. Once Upon a Child, Play it Again Sports, and Music Go Round, had 41%, 37%, and 39%, of stores at-or-above reported averages.

Plato’s closet has consistently gained share of Winmark’s number of stores and sales. Incidentally, average revenue per store had been flat at around $1 million dollars for numerous years, but after the pandemic, it got to $1.25 million per store. It is unclear to me whether this is sustainable or not. I’d be inclined to believe it is not, for a neighborhood approach imposes some sort of ceiling to revenue per store. Management has tried in the past opening bigger ones in more crowded areas but with poor results. Consequently, they focus on this low key strategy.

Winmark’s royalty fee has been around 4.3-4.7% since 2010, though it includes a component of the initial fee for opening, for which it’s not entirely accurate. It is worth pointing out that Winmark’s royalty is in the low end of what’s typically charged in a franchising business model.

It is also fundamental to note how fast stores ramp up. The following chart shows how much revenue the average Plato’s Closet store did in 2022, and the year when they were opened. The average Plato’s Closet opened in 2021 had revenue of 1.1M dollars in 2022.

I cannot stress enough how fundamental this is for Winmark. The quicker stores get to their local addressable market, the better for everyone. Assuming 1.1M in revenue up from the second year and a 4.3% fee, Winmark would get 47.3k in high margin revenue per store every year for nine years, on average. Securing a franchisee would earn Winmark revenue around $450,000-$500,000 in the course of the decade.

Turning to another brand, I found interesting to observe that the number of Style Encore stores has stayed flat over the past 5 years, after rapidly ramping up. Notwithstanding this, revenue has continuously grown, exhibiting a 10.5% CAGR. Additionally, sales stayed flat in 2023, in spite of a 7% store count reduction.

Elements such as these point out the untapped revenue Winmark still has in already-built stores. Total gross sales for the Style Encore franchise have increased to 49 million dollars in 2023, implying an average revenue per store of 742,000, up 12% YoY. This makes me suspect that the closure of stores mostly consisted of those that were in the lower end of sales. The following chart addresses this as well as the implied royalty fee Winmark is charging, considering the opening fee as well.

Financials

In 2023’s fiscal year, Winmark had 83 million dollars in revenue, growing 2% Yoy and exhibiting a 17yr CAGR of 6.7%. COVID-19 had a severe impact on 2020’s operations, but things seem to have normalized shortly thereafter.

Winmark has historically reported results via two business segments, franchising and leasing. The former encompasses:

• Royalties, charged as a % of franchises’ gross sales.

• Merchandise sales, which include the sale of the PoS tech equipment to franchises and the sale of a limited amount of sporting goods to some franchises.

• Franchises’ one-time fee, which is recognized over the estimated life of the franchise. Deferred franchise fees stood at 7.08M at the end of 2022.

• Other revenue includes marketing (managing ads) and software license fees from the PoS.

In the last fiscal year, royalties represented 84% of total sales, up from 66% in 2016. Leasing income, merchandise sales, franchise sales, and other, represented 6%, 6%, 2%, and 2%, of total revenue, respectively. The following chart depicts royalty income and the percentage of total revenue it represented throughout time. Over the past 15 years, royalty revenue has grown at at an 8.1% CAGR.

In a recent interview, Brett made clear that the company’s focus is in the resale business, in dedicating all efforts on scaling it and working with franchisees. Winmark has made several attempts to get into new business lines to re-deploy the cash generated by the franchising business. Nonetheless, Brett mentions they have always returned to the core of Winmark. Focus is now completely placed on resale.

Consequently, numerous decisions were made. The most relevant was to discontinue their 15-year old leasing business in 2021. Winmark used to destine a large part of the resale’s cash flow in running a middle-market and small-sized ticket equipment leasing enterprise.

John Morgan had co-founded a computer leasing business in the 80s, scaled it successfully, and sold it for $340 million in the 90s. He was the one leading the leasing operations at Winmark, which started right after Morgan’s non-compete agreement expired. A large part of the company’s generated cash was utilized for leasing equipment.

The leasing portfolio rapidly ramped up to 30-40 million dollars and stayed thereabout for over a decade. In 2023, the leasing portfolio’s value was reported at $100,000, down dramatically over the past couple of years.

Capital destined to this endeavor consumed the completeness of operating cash flow ever since 2004 up to 2018. Thereafter, cash flow has steadily risen and investing activities required 200-300 thousand dollars in 2022-23.

This has generated a notorious headwind to Winmark’s reported topline. Morgan took the leasing business to $21.5 million in revenue at its peak in 2015, representing almost a third of Winmark’s total sales. Thereafter, leasing income has declined to $4.7 million in 2023.

Winmark’s margins have dramatically expanded over the past 16 years as a byproduct of the franchising business gaining share of total sales. The company’s gross profit margin was 82% in 2006 and 94% in the last fiscal year. The operating margin expanded from 20% in 2006 to 64% as of 2023. Finally, Winmark’s net profit margin stood at 48% during 2023, up from 12% in 2006.

Capital Allocation Policy

Winmark runs a very profitable business. In the past, as exposed, most of the generated cash flow was reinvested. After the leasing business was discontinued, the company adopted a very simple capital allocation policy. Firstly, management does not intend to retain excess cash in the balance sheet. They continuously look for good opportunities to deploy cash flow. Ideally, cash would be re-deployed in the core resale operation, but Brett mentions that, historically, “there have been very limited opportunities to do so.”

If management does not find anything wise to do with capital, they look to return it to shareholders. Paying down debt is one of the ways for doing so. However, Brett finds debt to be locked at a very attractive yield and long maturity, for which he does not believe it worth to pay down.

Secondly, share repurchases are analyzed. The team is willing to buy back shares only at a price they consider appropriate. This simple approach has caused repurchases to be highly opportunistic. Over the past 20 years, Winmark repurchased shares every year except 2023, though repurchases are concentrated in specific quarters. In total, 4.3 million shares have been retired from the market for $350 million. As of Q1 2024, 3.48 million shares are outstanding plus another 160 thousand if we take option plans into consideration.

After deliberate meditation on the above avenues, management considers paying out dividends to shareholders. Winmark pays a small quarterly dividend. Management prefer it to stay at a low level, giving room for flexibility. If no investments are found and repurchases aren’t deemed as attractive, the team very willingly considers paying out excess cash in the form of a special dividend.

Over the past four years, which is when this policy seems to have gained traction, the majority of the dividends paid were via this mechanism. In total, since 2020, Winmark paid 8 dollars per share in quarterly dividends, and 22.9 dollars per share in special dividends.

Brett and Winmark’s Current Standing

In a recent interview, Brett mentioned that Winmark already has a model that works. It was built by a very capable man and it’s now up to management to simply follow the model. Incidentally, the same is requested to franchisees. Brett joined Winmark in 2002 as CFO and treasurer. He saw how the culture was shaped and how Morgan ran the business.

Brett highlights a fundamental idea in business. Winmark is in a position where it engages in win-win-win relationships. Everyone benefits from Winmark’s existence. Neighbors who need money and want to dispose of used items can go to a store and sell them. Last year, each store paid out $1,100 per day to neighbors, on average. Over the past 24 months, Winmark returned more than $1 billion in cash to communities wherein franchises operate.

Furthermore, Winmark is a leader in the circular economy. Most items that are purchased and sold through their franchise system would end up in landfills, damaging the environment. Since 2010, the company has found new use to 1.7 billion items. Brett mentioned why it is so important to only award franchises to skillful operators, which adds to this fundamental idea:

“And it's why it truly breaks my heart when a store closes. It's not because of the financial impact to us, we have 1,300 stores. Like one store closing from a financial standpoint, it's not going to impact us. But you have young families that now don't have access to our clothes, which is a problem. You have a couple going on a date that are teenagers for the first time that they want a new outfit and they can't go. Or young kids playing hockey that can't get those new skates anymore”

All of this is achieved by establishing win-win relationships with franchisees. The company trains them, provides them with the software to operate a store, and ensures their success. The fee Winmark charges seems low to me, when taking into consideration how much value it adds to franchisees. Nonetheless, Brett recognizes the importance of letting operators run the store independently, making the calls they think are best. It is their capital at the end of the day.

This converges into a web of decentralized operators, all of whom can utilize their creativity to sell more. Management is continuously in contact with all of them and leverages franchisees’ talent. If one of them comes up with a new clever mechanism or insight, the team pushes it to all stores. In fact, Brett said that “all the best ideas that have happened at the company and operational ideas and local store marketing and – they’ve all happened from franchisees.”

As of the most recent numbers, the secondhand apparel market was over $40 billion in the US, while resale accounted for $23 billion. Winmark’s share stands at 7% and is one of the biggest players in the resale market. Heffes interestingly mentioned that landfill still represents the largest competitor. Most people don’t know about resale options and don’t pursue that route.

Conclusively, Brett is fully aware of the low growth Winmark has experienced over the recent past. It is certainly his hope to grow faster. However, he highlights discipline as a vital trait in this business. They already have a model that works and that is improved every year. This focus on building a sustainable company has been crucial since Morgan took over.

The most important metric to look after, which Heffes suggests illustrates whether management is doing good job or not, is the renewal rate. A healthy renewal rate implies that franchisees are happy with their store. This is the keystone upon which all the ecosystem is built. Over the past five years, 622 out of 627 contracts were renewed.

Personal Commentary

I find that each company requires a different format for research. I’ll continue experimenting on this front. Hope you found the research useful.

Burford pays for companies’ legal fees in exchange for a share of the proceeds the underlying case might generate. Legal fees flow through the p&l, diminishing earnings and hence businesses’ market value. Litigation finance has the positive side-effect of countering this. Additionally, the market assigns no value to ongoing litigations companies have, although they may generate cash in the future. Burford offers corporations to monetize these claims, paying upfront in exchange for a portion of the proceeds, converting an intangible award into actual cash. Legal finance is a tool that allows management to allocate time and capital in business-related activities, where their circle of competence resides.

The company has a 4.8bn dollar portfolio and manages 2.3bn through private funds. Three elements have allowed Burford to scale, all of which were consequential to management’s proactivity, namely: (i) portfolio of claims; (ii) monetization of claims, without which a natural ceiling is reached in single claims, imposed by legal fees; (iii) claim families.

Litigation claims are unique in that the underlying asset is idiosyncratic. Courts operate independently, providing Burford with uncorrelated returns. Historically, Burford has deployed 1.48bn into concluded cases and has generated 2.7bn in cash realizations. Importantly, most cases settle, removing a great part of the risk and positively skewing returns.

Burford is the most well-known legal finance business and has provided capital for Fortune 500s. Brand recognition granted them a place at the high-end of the industry, one which I think they’ll retain. In consequence, their average deal size has increased significantly since inception. Incidentally, bigger cases have been reportedly generating higher returns than smaller deals. I suspect this will continue to be the case due to the impossibility of an auction-style competition and claim families. Finally, litigation finance carries an initial binary risk, with tangible possibility of total loss, making this capital very costly. Financiers, such as Burford, will most likely always demand a premium for their capital.

Link to all of my research on Burford: Burford equity research.

• How Burford values their assets

• GAAP rules for fair value estimation and levels of securities

• What is the risk premium component in the discount rate and how case milestones impact it

• A letter filed to the SEC in which management answers doubts regarding their valuation procedure

Fair Value Accounting

When Burford invests in a litigation claim, the asset’s fair value is initially equal to the deployed cost. For the underlying asset is expected to generate cash flow in the future, the alteration in the reported fair value depends on management’s estimate of this future cash flow. The likelihood of its occurrence and the extent to which it could evolve into different scenarios are considerations embedded in the calculation.

This is an inherently subjective task. Certain clauses, however, might help increase the certainty of the valuation. Arrangements between Burford and the corporation or law firm highly determine it. For instance, imposing a minimum of capital returned to Burford under any scenario in which the backed party receives proceeds can help foresee how the minimum retribution for Burford could look like.

Two further elements that are invariably associated with fair value assessment are: (i) discount rate, in which I shall expand accordingly, and; (ii) duration. The moment in time when the underlying asset is expected to produce the cash flow affects its respective present value. In Burford’s annual report, multiple sensitivity analyses are included as to how would the group’s income and net assets be impacted by: (i) an increase or decrease in interest rates; (ii) a lower or higher expected duration; (iii) a 10% deviation from the estimated fair value.

US GAAP discriminates assets in three different levels. A specific framework is employed for ranking assets’ fair value assessments. The observability of market prices depends on numerous factors, namely: (i) the type of financial instrument; (ii) the peculiarities associated with the instrument; (iii) the “state of the marketplace”. The latter implies the transparency of the market, liquidity, and reliability. Augmenting all three of them helps, theoretically, think the market price resembles the asset’s fair value. The lack thereof is compensated for with higher degrees of personal judgment for fair value assessment. Among the three levels, there is:

• “Level 1 assets and liabilities are comprised of listed instruments, including equities, fixed income securities and investment funds.”

• Level 2 assets and liabilities include non-actively traded debt and equity securities. The valuation taken goes in accordance with the last traded price.

• Level 3 assets and liabilities have unobservable inputs. Their fair value is estimated as the dollar amount that would be required for the asset to be transferred in a transaction; the money the owner would have to receive or pay.

In Burford’s annual report, the company breaks down their capital provision assets by type of investment and level of security. The vast majority of Burford’s reported assets are level 3.

To estimate the value of this type of asset, US GAAP offers several mechanisms one can utilize for getting observable inputs: (i) obtain information from third parties; (ii) obtain “valuation-related information from the issuers or counterparties; (iii) perform comparisons of comparable or similar assets and liabilities.”

Additionally, the asset’s risk profile and status need to be taken into consideration. Management employs an income-based approach, which consists of inferring the time in which the cash flow might be perceived and adjusting it by a risk factor and discount rate.

“The expected entitlement is generally a readily calculable figure based on the contractual terms between Burford and its counterparties and a legal expert’s view on the potential damages”

The risk-adjustment factor varies depending on objective litigation events. As expressed at the beginning of research, taking a claim through a legal process involves numerous stages. Occasionally, motions can be presented for the judge to dismiss or accept. Some events negatively or positively impact Burford’s probabilities of reaching a favorable conclusion. I find the following example very illustrative of the prior note.

“In practice this works as follows: the risk premium at the inception of a new asset is solved for by quantifying, as a percentage figure, the haircut that needs to be applied to the expected proceeds in order to arrive at a net present value equal to the transaction price. This risk premium percentage is then adjusted when milestone events occur by the applicable milestone factor. For example, assume the risk premium at inception is calculated to be 65% which is held constant until there is a milestone event. If we assume there is a favorable trial court ruling one year later for which the applicable milestone factor is 50%, then the risk premium would be adjusted to 32.5%, effectively releasing 50% of the original 65% risk premium haircut that was applied”

The risk-adjustment factor takes the following milestones into consideration, among others:

• “A significant positive ruling or other objective event prior to any trial court judgment

• A favorable trial court judgment

• A favorable judgment on the first appeal

• The exhaustion of as-of-right appeals

• In arbitration cases, where there are limited opportunities for appeal, issuance of a tribunal award

• An objective negative event at various stages in the litigation process

When any of these milestones are reached favorably, Burford will acknowledge it and recognize unfair value gains derived from the asset. The reduction of risk associated with the underlying cash flow increases the likelihood of occurrence and, therefore, its present value.

Burford declares an asset to be concluded when litigation risk remaining becomes nonexistent. The latter stage generally occurs by settlement or final judgment. Thereafter, the legal asset’s corresponding cash flow is reported to have been realized. Realizations results in Burford getting cash or a receivable, which is recorded as due from settlement.

SEC letter

Burford released its 2021 annual report in March of 2022. After reviewing it, the SEC made several comments and suggestions. They intended for Burford to clarify certain elements, inquire about why some financial disclosures were made that way, and to ask pertinent specific questions. Burford filed their response in August 2023, a month after receiving the letter.

Burford had historically done their fair value estimates based on deployed cost and observable events, including milestones and transactions. The revised approach implies for Burford to discount the expected cash flow to the point in time where it stands. Hence, the passage of time has an effect now. Notwithstanding this, fair value adjustments are still mostly explained by case milestones.

In 2023, management wanted to give investors a sense of the velocity the portfolio was acquiring, after slow years due to courts closure. Consequently, they shared more color on positive case milestones and their impact on the portfolio’s value, though it was a temporary “metric.” Cristopher stated they do not intend to continue providing the data in this manner. Although qualitatively relevant, “I want to be clear that I don’t think it’s a financial metric. I don’t think that people should be all of a sudden trying to tie these milestone factors to other numbers in the business.”

After reading the report and going through Burford’s quarter, the SEC staff asked Burford to separately report these milestones. Management commented on the futility of breaking them down. For this would only imply sharing numbers, it would not add relevant information to investors. Burford cannot disclose pertinent case information given their confidential nature. Doing so would do more harm than good to the business and shareholders.

At the same time, the SEC asked Burford to quantify the number of positive and negative milestones that occurred. Management pointed out this would not be helpful either. Milestones differ in the impact they might have, some of them possessing much heavier weight than others. As a sidenote, it was mentioned that some milestones may also affect other factors that impact fair value, such as the duration and entitlement forecast.

Moreover, fair value calculation of each capital provision asset is a “bespoke multi-variable calculation.” A quantitative disaggregation of separate drivers of fair value is, therefore, a very complex matter. With no reasonable explanations to be provided alongside, due to confidentiality, the endeavor is pointless.

When asked to quantify and speak about other elements with material impact on fair value assessments, management expanded on their use of discount rates. These consist of two factors, namely: (i) market-based cost of capital; (ii) asset specific inputs. The former has lately oscillated around 7%, reflecting the market’s broader cost of capital.

However, “the weighted average risk premium adjustment applied to the forecasted cash inflows from capital provision assets increased to 38.1% at December 31, 2022 from 36% at December 31, 2021.” This risk premium tries to quantify the cost of capital that’s associated with the asset class, provided the fact that litigation finance is riskier than other capital allocation initiatives.

Risk premium tries to adjust for remaining litigation risk. For the higher it is, the lower the likelihood of receiving the proceeds at the end. Milestones play a direct role on the evolution of litigation risk. Although the latter diminished during 2022, caused by numerous net positive case developments, risk premium increased due to the writing of new business. Assets tend to be at their riskiest state at the start of their life.

As a final note, I would like to highlight that Burford’s accounting is following uncharted territories. Litigation claims are a new type of asset. There was no standard methodology for fair value assessment nor for financial disclosures. One of the advantages Burford obtained through brand recognition is that it has allowed them to work alongside the SEC to develop best practices. However, perfection has not yet been achieved, as the following commentary from the SEC will show:

• “On undrawn commitments as assets: Please provide us any proposed changes to be included in future filings.

• On carrying value and fair value: Provide us any proposed revised disclosure to be included in future filings.

• On deployed cost and realized proceeds by vintage: Provide us proposed revised disclosure to be provided in future filings that more clearly describes the nature of these expenses.

• On sensitivity analysis: Provide us any proposed revised disclosure to be included in future filings.”

Personal Commentary

This is the last research article I’ll write on Burford in the short term. Following this, I’ll be publishing a one-pager on the company, and an earnings review on the last quarter.

• Everything related to Burford’s commitments and deployments.

• How Burford’s portfolio value has evolved.

• Portfolio diversification.

• Management’s approach to unrealized gains.

Origination of New Business

Commitments impose the ceiling for near-term capital deployment. In 2010, the first full year of Burford’s operations, the company committed 102M dollars in capital. During 2022, commitments were in excess of 700M, on a Burford-only basis.

Burford also reports commitments made on a group-wide basis, which contemplates their asset management business as well. Since the acquisition of GKC in 2016, some balance sheet investments started to flow through the managed private funds. This dynamic brought temporarily down the percentage of capital provision-direct commitments as a % of total.

Another implication is that it becomes obvious that not all balance sheet capital is deployed in core legal finance. Part of it has been, in the past, invested through the Strategic Value Fund and the Advantage Fund. The former is focused on complex strategies, though Burford has directly invested in some of these as well, while the latter on pre-settlement litigation. The following image displays Burford’s balance sheet investments in the different assets utilizing 2018 as an example.

Burford mentioned in their 2023 annual report that the Strategic Value fund was closed. Hereafter, complex strategies investments would be done directly on the balance sheet. Similarly, a successor for the Advantage Fund is unlikely to come. Management stated that pre-settlement investments that meet desired hurdle rates will be taken on the balance sheet as well.

Undrawn commitments represent the company’s commitments where capital hasn’t been deployed yet. Burford finished 2023 with 1.408bn in undrawn commitments on a Burford-only basis. In the previous year, undrawn commitments were at 1.307bn, out of which 75M were in legal risk. Legal risk undrawn commitments declined to 49M in 2023.

Discretionary undrawn commitments as a percentage of total were 57% at the end of 2023. The share is expected to be volatile period over period. Notwithstanding this, Burford is largely in control of their deployments due to most being discretionary. On the flipside, definitive commitments tend to be longer-term and have an associated timetable indicating when will Burford deploy the capital. This gives room for management to efficiently manage cash. 

Burford’s capital deployments have also rapidly escalated throughout the past 15 years. What we tend to observe is that deployments have a certain lag with respect to commitments. In contrast to the latter, indirect capital-provision deployments as a percentage of total shows a stronger decline. I suspect this is due to management’s thesis for acquiring GKC. Essentially, they noticed there were multiple attractive assets in the broader legal finance spectrum, some of which might have presented more attractive IRRs than core legal finance. I suspect the team biased deployments on that end because of that and, now that they have yielded the returns on the “obvious” investments, deployments in core legal finance again dominate. There’s a further element of management’s increased focus on balance sheet investments, wherein I’ll focus in a future write-up.

Historically, as of 2022, Burford had deployed 42% of committed capital in the first year after the commitment was made. The percentage deployed increased to 70% after three years. In total, Burford has deployed 85-90% of capital committed to concluded matters, both partially and fully. The following image illustrates average deployments on commitments made for each vintage from inception until 2019.

Deployments of committed capital have been more gradually evolving. Initially, it appears as if capital was more rapidly deployed, whereas capital deployed in more recent vintages’ commitments has been less abrupt. I’m inclined to suspect this is due to a mix of the following: (i) average commitment size increasing might cause management to act more slowly in this regard; (ii) although not disclosed until 2018, I believe commitment size increasing leads to definitive commitments increasing their share of total, hence associating a larger base of commitments to schedules; (iii) as commitment size increased, management’s expectations on the WAL of specific investments might have increased as well, giving more expected time for deployment; (iv) portfolio of claims should tend to encompass claims with no urgent capital requirements; (v) larger underwriting implies more exposure to settlements, which do not allow for full deployments.

As a partial consequence of delayed deployment after commitments, and a growing business, undrawn commitments have been gradually increasing as well. Burford reported in 2023 that deployments on undrawn commitments had a “median over the last five years of 18% at prior period end funded in the following 12 months.” That is, if Burford ended a year with 1bn in undrawn commitments, for example, 18% of that capital, or 180M, would be deployed in the subsequent one, considering it fell on the median level.

This is a metric that started being reported in 2019 and remained fairly stable. It’s worth highlighting that Burford’s business can be very volatile from period to period. In 2017, they deployed 30% of undrawn commitments from 2016 year-end. In 2019, 12% of undrawn commitments were deployed.

Burford-only Portfolio Value

Burford considers the value of its portfolio to be equal to: deployed cost + fair value adjustments + undrawn commitments. I find the latter to be somewhat misleading. The company will not necessarily deploy the completeness of undrawn commitments and, even under such eventuality, it might make more sense for it to be part of the portfolio’s value after deployment. Nonetheless, it’s useful to think of these as highly likely future deployed cost.

For YPF-related assets have been a hugely contributing factor to Burford’s portfolio growth, I opted to separate the two. Since 2009, the company’s portfolio has grown from less than 100 million dollars to a total of 4.84bn as of 2023 year-end.

The carrying value of YPF assets was estimated and reported at 1.37bn on a Burford-only basis, meaning these equate to 28% of Burford-only portfolio value. Deployed cost on YPF was reported at 60M in 2023, hence the majority of the carrying value is composed of unrealized gains.

Total fair value adjustments amount to 1.81bn dollars, with YPF being 72% of the total. In 2023, Burford reported an unrealized gain of 542.9M on their YPF-related assets, leaving ex-YPF fair value adjustments at 154M for the year. Total fair value adjustments represent 38% of Burford-only portfolio value. Undrawn commitments and deployed cost were 1.39bn and 1.57bn, or 29% and 33% of the portfolio value, respectively. 

Portfolio Diversification

Though Burford tended to mainly focus on law firms, relationships with corporations have massively grown after legal finance becoming a more widely known financial tool. In 2023, Burford had 55% of its commitments done to corporations and 41% to law firms on a group-wide basis.

The last time Burford cleanly broke down their group-wide capital provision-direct portfolio was 2021, wherein deployed cost and undrawn commitments are considered. On a case-type basis, the top 3 made up for 63% of the portfolio’s value. Measured by industry, “other” and “mixed” represented 65% of the portfolio.

On a similar note, their geographical and currency exposure was shared. The vast majority of their exposure is from North America and Europe, with the USD being the currency in which Burford mostly structures their deals.

Finally, Burford included their largest related exposure on a Burford-only basis, ex-YPF, in their 2021 Investor Presentation. The largest of them amounted to 9% of the portfolio’s value.

What I suspect is a fair conclusion from my prior remarks is that Burford’s operations are widely diversified in all respects. This is an element that should not be overlooked. Uncorrelation of returns are more easily attainable when there are no clear commonalities between underlying litigation cases. Although courts allegedly behave in an idiosyncratic manner, I find it more comforting to observe the fact that chances for human biases are lower.

Unrealized Gains

Legal claims being a new asset class has caused some difficulties concerning the method for valuation. The investment community has manifested skepticism towards Burford’s portfolio intrinsic value. Management has historically employed a somewhat conservative approach in this regard, though it’s hard to visualize at a first glance. YPF-related assets gained a great share of Burford-only portfolio’s carrying value since 2019 due to unrealized gains.

With the objective of analyzing the conservativeness of the mechanism utilized, I charted Burford’s carrying value excluding YPF-related assets. I found that over 80% of Burford’s carrying value has been systematically composed of deployed cost, excepting 2023.

This means that management are not focused on playing accountancy tricks. Given the perceived mystery still involved in legal finance, there exists a possibility of exploiting accountancy. Muddy Waters report tried to show some of these dynamics in 2019. However, valuing assets mostly at cost does not appear as extravagant to my eyes.

Further, the high returns on capital Burford has had, mixed with consistently valuing assets as mostly their cost, means that management mostly realizes gains once assets reach maturity. The following image displays the moments in time when Burford generally does fair value adjustments.

There is an interesting case study Burford provided to better visualize how a process like this might look in real time. The chronology of key case events was as follows (quote from FY21 presentation):

• 2013-2014: Burford deploys $2 million. Case held at cost until motion to dismiss rejected by the court, causing fair value gain of $370,000

• 2015: Further deployments of $1.9 million as case proceeds through discovery. Additional deployments held at cost.

• 2016: Further deployments of $4.5 million through trial. Case loses at trial and matter written down to zero.

• 2017-18: Appeal of trial verdict pursued with additional funding of $0.1 million. A parallel case was reversed making reversal in this case very likely and fair value moved from zero to $1.9 million.

• 2019: Appellate court reverses verdict, reinstates claims and sends case back to trial court. Carrying value returned to deployed cost. Additional deployments of $0.8 million.

• 2020: Further deployments of $1.1 million as trial court hears renewed summary judgment motions – results are favorable to claimant, giving rise to $6.1 million fair value gain.

• 2021: Case is trial ready, but new Covid-19-era rules requires mediation for cases to be calendared for trial – at mediation, parties agree to settlement of which Burford is entitled to $36 million, generating net realized gain of $25.1 million.

Personal Commentary

My last, for now, research article on Burford will be on their fair value methodology. It will then be followed by a 2023 performance review and a one-pager. The next company I’ll cover, though in not much depth is, I suspect, Winmark.

In this article, I’ll go over:

• Similarities and differences with VC/PEs

• Complete breakdown of Burford’s returns

• Durability of returns

• Claim families

Business Model

Burford business model resembles that of a venture capital or PE firm. Core legal finance is, essentially, purchasing an asset with an expected cash flow or stream of cash flows in the future. The asset in question is held until maturity, meaning case resolution, and returns widely vary.

That being said, there are a couple of differences between Burford and VC/PE firms, namely:

• Venture capital companies have an investment horizon of 7-10+ years. PE firms, a horizon of 5-7 years. In contrast, legal cases tend to resolve in 2-3 years, on average.

• VC and PE firms need to create an exit strategy to collect cash. For Burford, the legal process is in charge of that.

• Litigation claims are idiosyncratic and don’t follow any strict timeline. Returns for Burford are uncorrelated between themselves and the overall economy.

• VC and PE firms tend to suffer during economic recessions due to multiple contraction and cost of capital. Burford is hit by both as well. However, its business is counter cyclical. In economic downturns is when more disputes arise. And a higher cost of capital can be considered for pricing.

• Burford’s returns are positively skewed due to settlements.

• On the negative side, returns are somewhat capped for Burford, in absolute terms. They are necessarily tied to the cash flow generated by the win or settlement. VC and PE firms can have returns that tend to infinite, if companies do very well.

Burford Historical Returns

The metrics that are utilized to measure legal finance firms’ investments are: (i) IRR, which stands for internal rate of return; (ii) ROIC, or return on invested capital; (iii) WAL, weighted average life. The latter represents the average time it takes for realizations to occur, after capital deployment. Altogether, these three metrics help analyze how well capital is being allocated.

Burford’s historical IRR has been 27%. It’s worth noting that the YPF case, the biggest case outstanding on a Burford-only basis, at 1.3bn estimated fair value, added 5-6pp to overall IRR. On the other hand, return on invested capital stands at 87%. In contrast to IRR, Burford’s ROIC has trended upwards over time, though the YPF case has been adding 20-25pp.

Note: both metrics are computed on an accumulated basis each year.

The disparity is partly explained by how much time cases have taken to resolve, either by adjudication or settlement. Average deal size has steadily increased over the past decade. Litigation Capital Management pointed out that, as size increases, the reality is that people fight harder for cases. In Burford’s concluded cases, we observe that the WAL has been in fact increasing in accordance with commitment size.

Commitment size increasing does not necessarily mean that the underlying average litigation size increases as well. However, I suspect it is the case because a large part of this dynamic is explained by monetization of claims.

In addition to this, Covid has invariably affected Burford’s time-measured performance. The closing of courts and the slowdown of legal processes have delayed the resolution of cases that would’ve otherwise been resolved earlier. In addition to this, Burford has several old ongoing investments which, as they resolve, should tend to depress total IRR.

Settlements Cause Positive Skewness in Returns

Potential outcomes in legal finance are theoretically binary. But in practice, unlike private equity, there are three potential scenarios: win, lose or settlement. Burford has committed a total of 1.52bn dollars since inception and has deployed 1.32bn. In total, the business has realized 2.48bn dollars, implying gains of 1.15bn and a ROIC of 87%. Case resolution distribution was as follows:

• 21% of capital deployed ended up in Burford’s backed party winning the underlying cases, producing 965M in realizations.

• 8% of deployments were destined to cases that lost, generating a loss of 84% of the capital deployed, or 96M.

• 71% of capital was deployed in cases that were resolved by settlement. Burford realized 1.5bn dollars through this mechanism, with a ROIC of 60%.

The theoretical binary outcome and confidential nature of lawsuits makes one mis-appreciate the likelihood of a favorable settlement occurring, prior to the event. Hence why this capital is expensive. Cristopher Bogart stated that, due to this dynamic, it is unlikely for returns to come dramatically down. Investors will always demand a premium.

“You just don’t see that kind of binary risk in most financial assets. And I think investors, quite rightly, will demand a premium for that level of risk. If you had a choice of investing in Burford’s assets or some distressed debt pool, and the returns were exactly the same, you’d probably choose to invest in the distressed debt pool. Because you’ve got some underlying asset value there” Cristopher Bogart interview

Furthermore, litigation financing does not give room for auction-style competition. Pricing is complex and depends on idiosyncratic, generally confidential, factors.

“The pricing associated with contingency fee lawyering often creates a pricing benchmark or expectation entirely divorced from competition. Neither the litigation finance providers nor the lawyers are generally willing to spend the time necessary to facilitate auction-style competition for investments.” Burford 2016 Annual Report

“The better way to compete is by growing in market size, as opposed to competing in price” Cristopher Bogart interview

Considering that 60-90% of disputes end up in a settlement, I believe returns will be driven by these as companies scale. If the state of nature of settlements offers good prospects, it’s expected for them to continue skewing legal finance returns. More importantly, settlements “remove risk from the equation”. On top of settlements providing the basis for returns, leftover scenarios are highly similar to equity investments. They are highly asymmetrical.

Burford’s good judgment has produced a spectrum of outcomes that does not follow the average distribution. My sense is that, as Burford scales, the law of large numbers will tilt the percentage of outcomes towards more settlements.

What we observe from concluded cases is that, similar to what occurred at the broad level, IRR has been trending downwards, but ROIC and WAL upwards. Time for resolution is expected to keep trending in this direction, as older cases get resolved and courts catch up.

Settlements have produced a 50%+ return on invested capital. Coupled with the “removal of risk”, the skewness in overall returns and uncorrelation factor, these elements illustrate the attractiveness of Burford’s operations. Correct risk assessment and management are vital for them to be present (except the uncorrelation factor, which is always present). They are consequential to managements’ skill.

Something worth keeping in mind for return dynamics is that settlements may have, on average, lower WALs. Hence, higher IRRs but lower ROICs. This is due to the fact that settlements imply discounting the certainty of resolution, diminishing risk.

On a final note, here are management’s considerations on returns and the impossibility to control them:

“the $325 million deal we did in June settled in December, at a point when we had only deployed $225 million. We made a Burford-only profit of $46 million in six months, a 37% IRR – but a 0.36x ROIC (…) The point here is that this is the way our business works. How individual cases resolve, and thus the returns in any particular period, is out of our hands, although we do endeavor to structure deals so that we are protected from duration extending. Sometimes they will resolve quickly, with comparatively low ROICs. Sometimes they will go to trial and produce superlative ROICs.” Shareholder letter 2023

Returns on Direct and Indirect Capital Provisions

Segmenting investments into size buckets should help assess the durability of Burford’s returns. Larger deals are what should increasingly drive returns moving forward. In addition to this, considering the funds alongside which the balance sheet occasionally invests sheds further light on legal finance broader returns.

“Capital provision-direct assets refer to those assets that Burford has originated directly (i.e.. not through participation in a private fund) from its balance sheet Capital provision-indirect assets refer to those assets that include Burford's balance sheet's participation in two of its private funds — namely. BCIM Strategic Value Master Fund, LP (the "Strategic Value Fund") and Burford Advantage Master Fund LP (the "Advantage Fund").”

Among concluded cases, I find that:

• Overall, the weighted average ROIC has been 75%, while the weighted average IRR, 50%. The calculation was done excluding three cases whose IRR were multiple thousand percentage points

• 163 of concluded investments were in the 0-5M dollar range. Weighted average ROIC and IRR were 66% and 92% on these

• 38 concluded investments were in the 5-10M dollars range. Weighted average ROIC and IRR were 110% and 86%

• 33 concluded investments were between 10-20M dollars. Weighted average ROIC stood at 74% and IRR at 39%

• 18 concluded investments were in excess of 20M dollars. The weighted average ROIC was 70% and the IRR was 41%

The following chart was computed with deployments in concluded and partially concluded cases. Total deployments, obtained here, amount to 1.81bn. Indirect capital provisions included were done through the Strategic Value Fund and the Advantage fund.

Note: I excluded some outliers whose IRR or ROIC were well in excess of 1000%.

In Burford’s 2021 Investor Day, management shared a visual showcasing a similar dynamic on a commitment and capital provision-direct basis. On a cumulative basis, since inception, the company has seen its ROIC rising as commitment size increased.

Out of the total 1.81bn dollars deployed since inception on a direct and indirect basis, 1.27bn came from Burford’s balance sheet. Among these cases, I find that:

• 184 investments were above 100 thousand dollars

• Burford lost the completeness of its capital in 23 investments (12.5%) and got partial recoveries in 27 (14.6%); the company realized gains in the rest of them

• Overall ROIC and IRR were 88% and 24,126%. Excluding 4 outliers, ROIC and IRR were 72% and 42%

Investment distribution and returns by size was as follows:

Note: Keep in mind some capital provisions are done jointly, for which there’s an overlap element.

The remaining 542.7M were provided by the private funds, representing 107 investments. Overall weighted average ROIC and IRR for these investments stand at 84% and 64%. Burford lost all of its capital in 11 cases (10.2%) and experienced a partial loss in other 9 (8.4%). Investment distribution and returns by size was as follows:

My sense is that the disparity in returns, in spite of the overlap, can be largely explained by two factors. Namely, the nature of each investment and the exclusion of outliers on direct investments. Assets in which the Advantage Fund invests tend to have lower risk, lower returns, but shorter duration. This makes it have, on average, higher IRRs, but core legal finance offers higher ROICs.

Claim Families

Claim families is the element that, alongside monetization of claims, is helping Burford scale. Once Burford gets familiarized with a specific claim, the incremental cost of bringing a new claim of this sort, but from another client, is very low. Claim families allow management to increase the weight of an investment they have conviction in.

 “I'll give you an example of what I'm talking about. The European Commission has concluded that manufacturers of diesel trucks were engaged in an illegal price-fixing cartel. So if you're a buyer of diesel trucks, if you're a fleet operator, Tesco or somebody like that, you now have a claim against the truck manufacturers for that overcharge. That claim is going to be the same fundamental claim from lots of different fleet operators. But each claim is going to be a little bit different. Tesco maybe buys their trucks from Volvo. Somebody else buys their trucks from Mercedes. They negotiate different economic terms and discounts. So this isn't like a securities class action where all of you, if you've invested in Wirecard, have been injured in an identical way. These are all individual claims that need to be brought separately. But we can go into the market and amass a number of these claims and effectively treat them as one family of investments.”

Claim families allow Burford to diversify risk within cases of the same nature. They are a good mechanism to get the expected favorable returns. Additionally, this represents scaling with underlying operating leverage and provides agility, which might prove as a further advantage with respect to peers. Having done the due diligence accelerates the underwriting of similar claims.

“They needed to close that from the moment the phone rang, and we've been cultivating the relationship for a long, long time, 10 days from phone call to “can you write us a very large check”. We understood the claim family. We had to understand some of their underlying facts, and we were able to close that well before the 10 days.”

The following image illustrates Burford’s cumulative deployments and returns from engaging in this type of operation. Noticeably, incremental capital invested in this claim family experienced higher returns than prior deployments. For instance, asset 2 implied an extra deployment of $12 million dollars and brought in $26 million in gains.

Personal Commentary

My sense is that, out of my 5 articles on Burford, this is the one you’d get the most value from. In consequence, I opted to keep it open. This is a practice I’ll most likely repeat in the future. If you’d like to read more of my articles on Burford, here’s the link: Equity Research.

Disclaimer: This is not financial advice nor should be taken as such.

How does the competitive landscape look like? Could these legal finance firms cause trouble to Burford as they scale? What are some examples of other public legal finance firms? Is there competition for Burford at the high end?

Bottom End of the Market and Different Approaches

Lawsuit-related expenses, mostly consistent of legal fees, range from the tens of thousands of dollars to the tens of millions. Burford’s strategy has revolved around rapidly attaining a spot at the high-end of the industry, servicing big corporations and law firms, both of whom offer Burford the possibility of investing in portfolios of legal claims. Additionally, corporate relationships give room for monetization of claims. These two elements have been vital in allowing Burford to deploy more and more capital.

However, this caused management to skip multiple tiers of the market, leaving unattended demand. There are still SMBs who need capital, though in lower quantities, to pursue legal claims. There are still individuals who are in a similar situation, but lack the funding. Demand such as this has created room for multiple legal finance players. Tribeca, for instance, provides funding up to a million dollars for individuals. To this point, it is crucial to understand that both consumer and commercial legal finance are almost entirely different enterprises.

“Commercial legal finance as practiced by Burford and consumer litigation funding are as distinct as investment banking is from payday lending. The former comprises multimillion-dollar nonrecourse investments with law firms and corporations represented by world-class counsel, and the latter comprises cash provisions to individuals in economic distress who may not be experienced in or savvy about negotiating legal transactions”

Although there are similarities and some common patterns might arise between cases, they are idiosyncratic. The region wherein they originate matters. Legal systems vary. Burford notes in their annual reports that other firms might follow a completely customized approach to doing deals, which results in clients benefiting from more competitive terms. Local dominance can occur within regions, as legal finance firms gain brand recognition and some scale within it.

Similarly, the nature of lawsuits differs among different industries. Different knowledge is required. Hence, legal finance firms can leverage their experience and take an approach that is claim or industry-specific.

Legal finance companies have different sources of capital. On the one hand, firms can allocate capital from its balance sheet, as Burford historically did. But they can also be asset managers. Raise capital via private funds, deploy it, and charge management/performance fees, such as Omni Bridgeway. A mix of both is the approach Burford now takes.

As a reference, some of the players I found are: (i) Nera Capital operates in England and has invested over £125m since inception; (ii) Therium, funded in 2009, has raised 1.1bn to date through 18 private funds; (iii) LexShares was founded in 2014 and has deployed over $100M at an average deal size of around 1-3M; (iv) Longford Capital, which has AUM that exceed $1.2bn and has recently raised a $682M fund.

Finally, there is a public company that caught my eye. Briefly expanding on their operations will give a sense of how smaller players are positioned and provide some color on Burford’s business.

Litigation Capital Management

Litigation Capital Management is an Australian company that was founded in 1998. Patrick Moloney served as director from 2003 until he became CEO in late 2013. Importantly, the first fund was established in 2009. LCM reported assets under management of A$484M in October of 2023. The company operates in London and the APAC region, and has delivered an accumulated, 12-year, 78% IRR.

LCM follows the same business model as Burford. It invests its balance sheet and manages private funds. All investments that seem profitable are offered to both of these. As a general rule, 75% of the invested capital is provided by the funds, and the remaining 25%, by the balance sheet.

Litigation Capital Management has seen the number of applications rapidly rise as they scaled, in financial and branding terms. Their conversion rate has averaged 3-4% over the past couple of years. Management expects this to increase over time, as investment managers learn more and more about certain industries. Moreover, presence in specific claims tends to attract parties of similar characteristics to the funded one.

The team mentions that a higher conversion rate can be achieved without compromising the quality of investments. This is an important detail, as we find Burford having a 4-8% conversion rate on 1000-1500 annual applications.

Historically, the investments LCM has made took an average of 28 months from capital deployment to realization. Management expects duration to increase to around 36-42 months as the company scales. “The practical reality is that people fight longer and harder over larger amounts”. This is something we are starting to observe with Burford as well.

Litigation Capital Management represents exactly the type of company Burford describes as able to out-compete them in terms offered. The company defines its arrangements as completely “bespoke and tailored to meet the specific needs of the funded party.” This is a feature that can make some legal finance firms stand out from their peers and larger firms, who might not find worthwhile to match the smaller player’s terms. I’m inclined to suspect this occurs at all scales.

Barriers to Entry

Significant capital is required, at whichever scale, for achieving proper portfolio diversification. Legal claims have a binary outcome. The plaintiff either wins or loses. Assuming the case will settle is too risky. If the investing firm does not manage risk accordingly, it can rapidly go out of business, which in turn makes the accessing capital much more difficult. Investors realize these are risky investments and are therefore not willing to provide funding lightly. Burford occasionally stated that $100M might be a minimum for operating in the low-end of the industry, but a larger sum of capital would be considerably more desirable. The high-end of the industry demands even more capacity for capital deployment.

“During the past year, we have seen some compression in the market as smaller operators have failed due to the tightened availability of credit.” LCM 2023 AR

The second variable that prevents competition is the relevance corporations and law firms give to branding. In a similar fashion as it works in investment banking and consulting, relationships matter. Firms that solicit litigation funding for the first time will look for financiers with a legitimate track record. On top of this, relationships have already been established. Law firms and corporations can function as originators. Both will approach the legal finance firm with which they have already worked. That’s what causes 70% of the Burford’s clients to come back to them for more business.

Legal finance works at the intersection of investing and law. Only peculiar characters excel at both areas, fairly limiting the number of potentially successful operators. For proper due diligence and the underwriting process to function correctly, more of these people need to be hired. A lack of judgment from the investment perspective in applications reviewers might cause large bottlenecks. In addition, headcount is a requirement for being competitive in claims worth several millions of dollars. As legal finance firms scale AUM, their headcount needs to increase, unlike private equity. Assembling this team, in parallel to raising capital and convincing investors, is a challenging endeavor.

Finally, legal assets are something that still portray novelty to the general market. In consequence, there is no secondary market for claims. Even if the public was fully aware of legal assets legitimacy, details about specific claims are confidential. The buyer needs to either find information on their own or trust the seller. Some liquidity might emerge as Burford scales, gets better known and gains reputation, but this is a market with no liquidity nor capacity to mark investments to market.

Burford’s Positioning

Management efforts to rapidly push the company upmarket should pay off. I cannot think of any way in which one could disrupt a capital allocation business model. The barrier for capital and relationships will always be there. Unlike investing in businesses, investing in a team that deploys capital in legal finance is much more uncertain. A specific skillset is required, the outcome is binary, and legal finance firms cannot disclose information about the assets they invest in.

“But in terms of where we sit at the high dollar commercial end of the market, there hasn't really been a dramatic change in the competitive landscape.” FY 2021 Transcript

Raising billions of dollars is what allowed Burford to start doing deals with large corporations. The prestige this grants to Burford’s brand is not to be overlooked. These large clients will return to Burford in the future. Lawsuits are recurrent. As companies work through litigations, more lawsuits are filed against them. Further, the visibility Burford has gained in the recent past should allow them to capture new business.

Being at this spot exposes Burford to the largest number of litigations through portfolios of claims. The proprietary dataset the company has built is unmatched in the industry and should continue to provide them with a competitive advantage. Having data about the outcome of multiple litigations, information only known to them, facilitates risk assessment and, in turn, pricing.

Finally, I came across the hypothesis that capital will tend towards commoditization in small cases. A significant variable that goes into corporations decision-making process is how much value can the funder add to their legal process. Larger stakes tilt clients towards partnering rather than simply receiving capital. Consequently, pure-play legal finance firms should dominate. In small cases, it is likely for supply, from legal finance firms, to increase indefinitely. At the same time, the economics for funding small cases might not allow for legally assisting the plaintiff. The payout might not support incurring expenses on headcount. This is something I don’t expect to happen at the high-end of the industry, providing Burford with the appearance of having the most durable returns on the industry.

“And in terms of the question about the competitive dynamics in smaller versus larger, we have found that when there have been new entrants over the years, and I have not really noticed an influx recently, they have started at the smaller end of the market, and they have not been institutions of Burford’s caliber and have had a harder time providing a full service solution to the large companies and leading law firms that are our lifeblood. On the other hand, the people who would target larger outlays, a hedge fund model, are more likely to be looking at lower risk, lower return portfolios. Equity investors generally do not have the risk orientation we do where we are willing to take binary risk because we put it in a portfolio to mitigate that risk and we generate higher returns as a result. It is just not necessarily the mindset of somebody who comes at it from the hedge fund side where they are looking for a more muted risk.” HY 2022 Earnings Call Transcript, August 2022

Competition Potentially Emerging at the High End

Fortress Investment Group, a private equity firm, acquired Vannin Capital in 2019, a London legal finance firm. A year later, the PE created its own legal finance funds, and integrated Vannin to operate under it in 2021. In October of last year, Fortress announced it was planning to raise a new fund for litigation finance.

“Since forming its litigation funding arm in 2013, Fortress deployed more than $4 billion into a “diverse pool” of legal assets globally. It currently has 20 employees on a dedicated team” Article

Fortress has not made much commentary on their operations nor on the returns they’ve had. This definitely raises several questions, all of which will be answered with time. Fortress Investment Group will act as a perfect example in the near term to observe how the dynamics will play out in the high-end of the industry. Although Burford claims capital is not a commodity here, only competition flooding the space is what will prove them right or wrong.

“We are in no way complacent about competition. But this isn’t a business where someone can show up with a checkbook and buy their way into the market simply by offering slightly lower pricing. Clients come to Burford— and keep coming back to us—because we add value” 2021 AR

Personal Commentary

I hope you found the article useful. The one will be on pricing and returns, how durable they are and what might be expected moving forward. The following one will be on the company’s portfolio and relevant metrics. Perhaps after that one, I’ll turn to a new business.

If you want to, I can alternate between Burford and other companies. The other two I’ll be covering in the near future are Winmark and Construction Partners. Bakkafrost and Topicus, unfortunately, are indefinitely postponed.

The company has achieved a 27% IRR with its capital provision since inception in 2009. Management deployed 1.3bn dollars and has realized over 2.48bn, considering concluded cases. Curiously, this is achieved by investing in assets that are uncorrelated with one another.

Although Burford has led the industry, competition is catching up. Capital in the industry is perceived as a commodity and people fear that excess returns will vanish. In this article, I’ll dive into what is Burford’s strategy to eschew competition.

Industry Context

Legal finance is an industry of capital deployment and reinvestment of the proceeds. Having emerged 20-25 years ago, players are still gaining scale, which can be accelerated by raising and managing private funds. As an indirect consequence of the industry’s recency, Burford is one of the only large public players.

Management stated that information concerning competitors is mostly limited. Most of them do not disclose returns publicly and, in multiple cases, not even assets under management. Nonetheless, the company was not the first mover in this space and has faced continuous competition since inception.

Although industry returns are very appealing to firms and hedge funds, given IRRs and uncorrelation between assets, there’s a caveat. It is not possible to predict with a high degree of confidence how cases will evolve nor how much time it will take for them to be resolved. Burford’s management claimed that, otherwise, you wouldn’t see these returns and competition would’ve more rapidly flooded the space.

In fact, being Burford the leader and “only” having 7.1bn in assets under management only confirms the hypothesis. I suspect firms’ AUM would be substantially larger if returns were of a higher likelihood. Private equity might act as a valid comparison in this regard. Although its inception can be traced back to the 1950s, proper activity emerged in the 1960s and further strengthened in the 70s. Private equity’s high returns, which might be perceived as highly attainable, has gathered trillions of capital in a couple of decades.

Legal finance addressable market is smaller, but it has been the case that raising capital has been comparatively slower. It’s estimated that assets under management for the industry in the US is at 13.5bn.

The last time Burford shared AUM data alongside its competitors contained end-of-2022 numbers. At the time, it had assets under management of 5bn (ex BOF-C). In contrast, its nearest competitor had raised a total of 1.9bn dollars, which, although not disclosed, I suspect corresponds to Omni Bridgeway. The latter has been transitioning from a balance sheet investment approach towards pure asset management. This implies its income will depend solely on fees, whereas Burford will benefit from the returns of its 4bn+ balance sheet investments.

As of February 2024, Omni Bridgeway has 2.5bn in funds under management.

The more capital a company raises, the larger its addressable market. Legal finance, as exposed, offers a broad range of assets to invest in, varying in expected risk, return, duration, and nature. At the foundation of everything, however, there’s litigation finance. Funding a single claim’s legal fees might require as little as 100 thousand dollars to 15M. However, as legal finance evolved, a trend made itself clear.

Aiming for the High-End of the Industry

As companies’ operations expand, they start impacting more people, and as that occurs, damages are spread wider. Therefore, the bigger businesses get, the more lawsuits are filed against them. In fact, this article reveals that, as of 2005, around 90% of US companies were dealing with at least one litigation, with the average company juggling 37 lawsuits at once. Companies with over 1bn dollars in revenue faced an average of 147 lawsuits.

In 2015, BusinessWire reported that the litigation budget for US companies was rising. Noticeably, “Respondents also reported an increase in the percentage of US companies with litigation budgets of US$10 million or more (25% percent, compared with 17% in 2012). Another report, from Legal Dive states that companies with 5-20 billion in revenue saw their median spending in legal issues rise by 45% YoY to 30M in 2023.

Statista’s chart shows a survey that was done to different businesses. They were asked how many lawsuits were commenced to them in the past twelve months.

What this translates to is more spending by larger corporations. For them to find use in legal finance firms, the latter should have a certain scale and be able to rapidly deploy tens or hundreds of millions of dollars. At the same time, corporations need to partner with a well-respected and capable legal financier. They need to not only receive funding, but smart funding. In response, Burford has focused on developing a breadth of skills and solutions, so that they can efficiently address the verticals of needs clients may have.

“Clients come to Burford— and keep coming back to us—because we add value” 2021 Annual Report

From the legal finance firms’ perspective, it is virtually impossible to scale operations without going upmarket, unless the company takes a decentralized approach towards capital allocation. The smaller the average deal they make, the more of them will need to be done to increase profit in absolute terms. In Burford’s 2021 Investor Event, management said their commitments were averaging $21 million, up from a previous $8 million size.

Portfolio of Claims

At the beginning, 100% of Burford’s business revolved around funding single case litigation. Very rapidly, management found that it is inefficient for large corporations and law firms to seek capital for each litigation they are facing. In consequence, the “portfolio” approach arose. Law firms ask Burford to finance a group of claims, ultimately favorable for both parties. This way, Burford spreads the investment risk across uncorrelated assets, decreasing the chances of binary loss and allowing the firm to offer more favorable terms. Additionally, it allows Burford to deploy more capital.

In its 2022 annual report, the company disclosed that their biggest relationship with a single law firm accounted for $334M in commitments on a group-wide basis and $201M on a Burford-only basis. These equate to 8% and 7% of commitments, on both basis, respectively.

The relationship consisted of: “(i) financing arrangements between us and the law firm, where the law firm seeks to monetize the risk that the law firm has taken with some of its clients, (ii) direct financing arrangements with counterparties that elect to hire the law firm where our financing funds the law firm’s legal fees and (iii) direct financing arrangements with counterparties that have hired the law firm but where our financing is used for other corporate purposes than for funding the law firm’s fees”.

The Key Element for Scaling: Monetization of Claims

Initially, what would normally occur is that corporations wanted to pursue legal action, but they did not want to pay law firms an hourly fee. In these cases, it was in the law firms’ best interest to find a legal finance business to fill the gap. This caused Burford to first develop good relationships with legal companies. After some time working together, law firms would act as originators for Burford, which in many cases ended up in Burford funding a portfolio of litigation claims.

The problem that derives from this dynamic is that providing relief only for corporations P&Ls, by paying legal fees, imposes a natural ceiling for capital deployment. Burford could only scale its business up to what legal fees cost.

“it's not uncommon for us to be funding $7 million, $9 million, $10 million, $12 million for legal fees and expenses in a case. But once you get above those numbers, it does become relatively uncommon to find a case both that needs $20 million, $25 million, $30 million of legal fees spent on it. And so, you simply don't see cases that large.” 2021 Investor Event

Once Burford gained brand recognition, corporations started knocking on its door. Generally, the starter deal is the same as before, given it’s the most well-known service that legal finance offers. It provides funds for legal fees, improving corporations’ income statements. As the relationship between the two evolves, companies notice they can utilize Burford’s funding for other purposes, the most prominent of which is monetizing their claims.

In addition to providing corporations with the funds for legal fees, Burford offers an upfront payment in exchange for a share of the proceeds, plus a return on the funded cost. The upfront payment is seen as the expected value of the litigation claim discounted to today. This allows clients to “convert an intangible claim or award into tangible cash on a non-recourse basis”. Importantly, the market generally assigns no value nor relevance to such intangibles.

The monetization business has rapidly grown as corporations realized how beneficial it is from an operating perspective. In 2019’s conference calls, management pointed out that demand for monetization was trending upwards. In 2018, monetization and claim family commitments represented 34% of Burford’s group-wide capital provision. For capital provisions made in 2021, their share grew to 53%.

This is ultimately positive for Burford for three reasons: (i) it allows management to deploy more capital on cases where they desire more exposure; (ii) monetization of claims help increase overall deal size, because, for example, legal fees for fighting a case with a potential settlement of $50M to $500M are the same, but the room for monetization is gigantic; (iii) it helped Burford build relationships with corporations, which are now providing the fuel for a new growth stage.

On the first point, once Burford gets involved in a specific claim, the team gets to know everything about it. Burford can utilize its knowledge in the claim’s respective circumstances to help other companies pursue claims alike. This implies not only more exposure to a desired asset, but operating leverage as well. Due diligence is already done and no expenses on headcount are required. Additionally, new customers will be sure they are getting access to smart capital.

The company reported that corporations made up for 57% of total commitments by the end of 2022, up from 35% in 2016. In Burford 2021’s Investor Event, the company disclosed that “72% of clients who have done one deal with us come back for more”. The following chart displays most of the features discussed in the previous paragraphs.

In the third quarter of 2023, management mentioned the fact that, in any given period, the firm’s commitments will be driven by large corporate deals. In the second quarter, for instance, Burford committed 325M dollars to a Fortune 50 company. Likewise, in 2019, Burford committed over 140M to Sysco, for the latter to monetize a series of claims.

Access to capital, and being able to rapidly deploy it, provides Burford with a competitive advantage with respect to most of its peers. Having foreseen this, management entered the asset management business in 2016, when it acquired GKC. To scale relationships with corporations, Burford has to commit sums of capital in excess of 100M dollars. When management does not want complete exposure, it funds the client with Burford’s balance sheet and capital from the private funds it manages. Similarly, the combination allows Burford to make deals they couldn’t afford on their own.

The Advantages of Scale: Data, Branding and Flywheels

In litigations, most information only becomes public when the trial verdict is reached. However, the latter occurs in less than 3% of civil cases, according to this Article, while Burford estimates that “about 90% of disputes settle”. When parties settle, the most likely thing is for the mutual agreement to include a confidentiality clause. Consequently, most case-related information remains private, only known to the parties involved. Outsiders can’t even tell the dollar amount for which parties settled. It therefore becomes difficult to build a large pool of actionable data. Burford has known this since day one and has focused on gathering this information.

Prior to underwriting, Burford leverages probabilistic modeling based on first party as well as third party data. Being the leader of legal finance since inception provides Burford with a unique advantage in this regard. It is the business that has historically funded the largest number of litigations. There is no other pool of data that closely matches that of Burford.

Additionally, this means that the bigger the scale the company operates at, the more exposed it is to different litigation matters. And because of the recurrence with which information remains private, Burford possesses and keeps strengthening its unique advantage with respect to smaller scale competitors.

Scale allows for funding portfolio of claims, which further enhances this. In the company’s 2015 annual report, it’s mentioned that “while Burford has 54 “investments”, there are now more than 500 separate claims underlying the investment portfolio".

Likewise, the larger the scale Burford acquires, the bigger deals it will do and with increasingly more reputable firms. Burford’s brand immensely benefits as a consequence. This turns Burford into the face of the legal finance industry. And, naturally, larger corporations will want to engage in deals with the most respected firm in the space.

“We believe that we are more visible than our competitive set in legal and business publications. For example, according to “share of voice” calculations using Muck Rack, a provider of public relations tracking software, we were featured in over half of the total articles about the legal finance industry that mention any pure play legal finance provider during the year ended December 31, 2022.”2022 Annual Report

Personal Commentary

Last Sunday, I communicated my intention of splitting articles and publishing shorter one, but on a more frequent basis. Any feedback on whether or not this is helpful is appreciated. Next article will be on the room that Burford has left for competition, and the industry fundamentals.

It is important to note that the animal health industry has spectacular fundamentals for incubating long-term compounders. There is no company that competes only with generics, competitors take a rational approach to pricing and most products have an addressable market of 1M dollars or less and require to go through an FDA approval, disincentivizing competition. Furthermore, it has huge upfront and associated R&D costs. Manufacturing plants cost hundreds of millions of dollars, it is very resource-intensive and a very large sales force is required for distribution. All of this translates into each vertical generating space for virtual monopolies and helps products’ have a long lifecycle. As a reference, Zoetis’ portfolio of products has an average life of around 30 years.

Tied with the company’s thesis, the animal health industry is extremely resilient. The reason for the latter is largely because of the human-pet bond, which severely strengthened throughout the past decades. More than 90 percent of pet owners view their pets as members of their families. Additionally, studies suggest they are willing to keep spending on their pets’ health even after a 20% income cut.

Management has shown great efficiency to operate their supply chain and allocate capital. Ever since going public (spin off from Pfizer in 2013), the company’s operating margin expanded by 2500bps, now being at 36%, developed 9 out of its 15 blockbusters, launched Simparica Trio and Apoquel Chewable, both dimension-wise innovations, and outgrew the industry.

Furthermore, they’ve proven phenomenal ability to engage in M&A operations. Zoetis has successfully entered the diagnostics space, which promises double digit growth, with a large acquisition in 2018. Several acquisitions were made in the fish segment, allowing Zoetis to enter aquaculture, an industry that’s expected to keep healthily expanding. Lastly, my hypothesis is that an 85M dollar acquisition the team did in 2017 drastically helped Zoetis release two products in 2021-22 with an estimated addressable market of 1 billion dollars.

In conclusion, Zoetis is a company immersed in a very resilient industry that’s set for decent long-term growth and holds a leading position. On this front, I would like to highlight that, during their 2023 Investor Day, management guided for above-industry growth in the next five years, with improvements in the bottom line. The company’s broad portfolio of products provides proper diversification and there are some of them, such as Librela and Solensia, which make up for these two products above mentioned, that should allow the business to keep growing in the mid-term.

Contact: giulianomana@0to1stockmarket.com

Disclosure: This is not financial advice.

For those who might be interested, I will include the draft I’m working on, which contains 31 pages of unstructured data. The actual write-ups are the articulation of the latter. However, a large amount of information included in the draft does not ultimately make it to these reports, for which it may trigger your interest. The draft will be included after the paywall.

History

Burford Capital is a litigation finance company that was founded in 2009 and incorporated in Guernesy. It began operating in the United Kingdom and the United States. With the passage of time, the company expanded operations throughout the rest of the world. Burford was founded by Cristopher Bogart and Jonathan Molot in response to a common issue that was taking place after the financial crisis, which devastated corporations and law firms.

Cristopher Bogart graduated from Western University with a Juris Doctor degree and exercised as an investment banker at JPM, for two years, focused on project finance and insolvency. He then worked for almost 6 years as a trial lawyer, a litigator, with clients such as IBM, General Electric and Time Warner. Christopher was afterwards hired by Time Warner to serve as General Counsel and manage its legal department. It was there where he first started noticing how inefficiently was the legal industry structured.

Two years later, Bogart was named CEO of Time Warner Cable Ventures, which had 9bn in revenue, and took charge of overseeing activity related to new technology, M&A, and all investments. After two years and a half, he left to work as a Managing Director at Glenavy Capital, former investment adviser to Burford and focused on technology investments. In parallel, he started and managed a tech/media investment fund, which lasted from 2006 until 2009. While Christopher was performing both roles, he started a side-business, which he labeled as mostly a “hobby”.

Bogart was talking to a friend, who had become a partner at Latham and Watkins, a large US law firm, when he realized that his friend was facing the same trouble he did when working at Time Warner. Law firms are structured in a way that makes them largely financially inflexible. This was causing Latham and Watkins to lose several international clients. In response, Christopher, alongside a couple of colleagues, raised a small amount of capital and started financing his friend’s cases.

When the financial crisis hit, a curious thing occurred. Corporations, now facing uncertainty, which triggers a high sense for liquidity protection, started showing reluctance to pay law firms in the same way as before, on a fee per hour basis. The problem is that law firms’ business model is designed in such a way that they require a predictive stream of income. They need to count with lawyers, who charge by the hour. Hence, a large discrepancy made itself present.

Law firms knew about Cristopher’s arrangement with Latham and Watkins. In the need of accessing capital, many of them reached out to Bogart. The latter, after witnessing how much demand there was for a proper litigation finance business, had a conversation with Jonathan Molot. Both of them decided to raise institutional capital. That is the time when Burford was created.

In October of 2009, Burford did its IPO in the Alternative Investment Market of the London Stock Exchange, raising 130M dollars. A year and two months later, Burford announced a secondary placing of 100 million ordinary shares, raising an additional 175M dollars. Both turned Burford into the largest fund of its kind. In the company’s first annual report, filed in March of 2011, Sir Peter Middleton, Burford’s former Chairman, stated that the company had committed 140 million dollars for investments to date.

.Legal Process

The legal system in the United States began in 1789 when Washington signed the Judiciary Act, which established the basis for the American judicial system. American’s legal system would afterwards be based on the English Common Law, and it holds four principles as pillars: (1) Equal justice; (2) Due process; (3) The adversary system; (4) Presumption of innocence. At the same time, the American system imported the roots of English Common Law, which is in turn established upon the concept of stare decisis. This implies that courts must rule as has been done in the past, when a new case is similar to a past one.

Importantly, there are two types of general lawsuits: (1) Criminal, which is the vehicle the government utilizes to prosecute criminal action; (2) Civil cases, which encompass almost all other lawsuits. When an entity, person, or organization, finds a third-party’s action to be illegal and damaging to themselves, they are entitled to initiate a lawsuit. The initiator of the claim is called plaintiff and is usually seeking a money compensation to counteract the damage suffered. Types of civil cases include personal injury tort claims, contract disputes, equitable claims, class action suits, divorce and family disputes, and property disputes.

The process is as follows:

1. The first party files the lawsuits, known as the complaint or pleading. In the document, the entity needs to include the name and address of the plaintiff and defendant, the jurisdiction or reason to file in the determined federal court, allegations against the defendant and the relief the plaintiff is asking for. The latter is generally the sum of money expected.

2. Plaintiffs are required to serve the defendants, by law, meaning they need to provide them with the complaint and the court summons. It is not enough to send both via mail. They must be given directly to them or to a pertinent person in their office or home.

3. After the opposite party has been served, they are required to write an answer to the complaint and file it with the issuing court. “If you fail to answer, you could lose the case without ever having the opportunity to tell your side of the story”. Mass Gov

4. In the discovery phase, parties exchange relevant documentation. When one of them asks for information the counterparty is not willing to provide, the dispute is taken to court, where the judge decides whether or not such information is pertinent and if it therefore should be shared.

5. and 6) Both parties can request different sets of motions, including a ‘pre-trial motion for summary judgment’. Motions are utilized for requesting a determined judgment, and a summary judgment is done when the movant intends to show beforehand that there is no validity in the claim, or part of it. It is up to the judge to decide whether or not the motion is in place. Other motions might be utilized in the search of clarification.

7. During the trial, both parties must “present evidence to support their claims to a jury and/or judge”.

8. Post trial motions are requested in the same trial court and could have the intention of dismissal, asking for a new trial, setting aside the verdict, or they could be requested for other purposes.

Generally, if civil cases end in trial, they last around two years. Even though one could begin a lawsuit by oneself, it’s advisable to hire a lawyer even before the complaint is filed, for its proper writing. Clients are therefore required to pay for legal assistance all along the way until the case settles or the trial concludes. Finally, at any point in the legal process, both parties can agree to settle.

Mismatch in Desired Methodology for Payment

Legal fees tend to cost large sums of capital, ranging from tens of thousands to the hundreds of millions of dollars, depending on numerous factors. When the GFC hit and companies found themselves lacking liquidity, they couldn’t afford to continue with the fee structure that law firms prefer. In fact, many managers ended up letting go of potentially profitable claims due to the costs associated, something that still occurs.

In 2022, Burford’s report pointed out that “three of five in-house lawyers interviewed say that their companies have neglected to pursue meritorious recoveries in the prior year, with the cost of pursuing claims, judgments and awards a deciding factor.”

Law firms’ business models are very headcount intensive. They hire lawyers and pay them by the hour, making their costs mostly fixed when combined with the needed RE footprint. Consequently, their desired methodology for charging is an hourly fee, irrespective of the case’s development. To the contrary, clients/corporations, incline towards a contingency fee basis, where the payment is in accordance with the law firm’s merits. The crisis made them have no alternative at the moment, but thereafter, corporations’ preference for this approach strengthened. This occasioned a mismatch between both parties’ desired methodologies, and it is mostly the reason why litigation finance emerged.

Importantly, the term litigation finance is meant for single cases, whereas legal finance is how the industry is called now, due to the existence of numerous other avenues for investments within the sector. Litigation finance implies for an investor to provide funding to the plaintiff or law firm in exchange for a share of the proceeds if the case ends up being a success, plus some extra clauses. In this context, litigation claims are viewed as an asset that would provide a single or stream of future cashflows.

An industry-wise consequence this has had is that more law firms can now compete for cases that are set on a contingent/performance, or an alternative fee basis. On the corporate side, not having to pay for legal fees helps companies get liquidity and utilize it within their realm of operations, where their expertise lies. This way, businesses are liberating operating capital.

Moreover, legal expenditures are accrued as operating expenses, depressing companies’ profit margins and hence altering the financial community’s perception of value for the business. Lastly, accounting rules don’t allow for litigation claims to be included on the balance sheet, making the payment for them through the p&l a value destroying exercise from an accounting perspective.

“When you do litigation finance on the plaintiff side, you are providing the company with a permanent solution to its p&l. In other words, if you don’t do litigation finance, and I’ll attend to my 100 dollars example, that 10 dollars is going to flow through your income statement as an expense and it’s going to reduce your profits. And therefore it’s going to reduce your market value somewhat. If I take that expense away, because I take it, it never comes back to you. Either you lose the case, or you win the case, in which case you get a net recovery.

If you do this on the defense side and you win the case, I of course am going to be wanting my capital back. And that is going to flow through your P&L. And so, as a result, it is somewhat less appealing because you’re getting a deferral and risk management, but not a permanent P&L solution” Christopher Bogart

As legal finance grew, the compensation scheme for the funder evolved. Some might now include several other elements, such as, for instance, a clause for the recovery of the capital provided, or a multiple of it, plus a share of the proceeds. In Burford’s 2022 annual report, management mentioned that, upon the conclusion of a successful claim, Burford would receive its funded capital plus, generally, a combination of the following: “(i) a time-based return; (ii) a multiple of our funded capital that may increase over time; (iii) an entitlement to some percentage of the net realization that may increase or decrease over time or may depend on the size of the total resolution amount”. The latter makes management think of delays in matters as a “deferral of income rather than its permanent diminution”.

Contracts are specifically designed to address each particular case, which makes the use of all or any of the three points not a requirement. Moreover, the more complex the case, the more taylor-made the contract will be. The objective is for all contracts to not only provide Burford with a positive expected return, but to account for risks and align incentives towards rational action, which is differently targeted in each case, as cases are all idiosyncratic.

The entity in charge of paying for the litigation is generally: “(i) a government or a state-owned entity, (ii) an insurer or (iii) a large company in an industry less likely to be rendered insolvent by economic disruption associated with increases in interest rates”.

Within this context, Burford offers two specific products and services: core legal finance and alternative strategies. Even though the tasks performed under both of the latter differ in nature, they also differ risk/return wise. The ‘alternative strategies’ business supposes, in general, lower risk and potential return, and is mostly aimed outside of pre-settlement matters.

To effectively pursue each activity, Burford operates through a series of private funds, which are wholly owned subsidiaries and focus on a specific approach. Altogether, Burford operates under three areas, which management believes compose their addressable market:

1. “The value of litigation claims and the enforcement of settlements, judgments and awards

2. The amount paid to law firms as legal fees and expenses

3. The value of assets affected by litigation”.

Core Legal Finance

Burford’s core legal finance segment is in charge of providing capital and advisory to corporations and law firms. Fundamentally, it’s exclusively focused on pre-settlement matters. The company works with some of the world’s biggest law firms and corporations and has received inquiries from 93/100 largest law firms, by revenue, within the US.

Importantly, the range of investments that core legal finance encompasses is extremely broad. The risk and expected return from a case depends on the stage of the litigation process, the number of parties involved, the amount of litigation matters included and whether Burford funds the corporation or the law firm. The company can deploy capital into cases that have not yet been filed or into those whose final judgment has already been reached. At the same time, Burford provides capital both for funding legal expenses and for monetizing the future value of claims, offering an upfront payment to clients. In addition to Burford’s balance sheet, and as a general rule, the private funds they use to deploy capital into core legal finance are BOF, BOF-C, BCIM Partners II and BCIM Partners III.

In return for funding the cases, Burford contractually sets itself to receive a share of the proceeds the ultimate settlement generates. If the case is lost, Burford generally loses its capital. When funding multiple assets—claims—made and held by the same client, the agreement tends to contemplate the lower risk that a portfolio of claims entails compared to that of a single case.

The portfolio approach allows Burford to provide capital on a more efficient basis and clients to fund cases they would not be able to fund otherwise. I suspect that smaller cases might be more easily funded this way and that the law firm/corporation gains pricing power due to the lower risk for Burford, hence improving the overall deal for them. It might be otherwise difficult to convince a respected legal funder, with scale, to commit capital for a single-and-small case.

Note: A commitment is the capital that Burford has agreed to provide to a corporation or law firm.

Insurance Business

In addition to providing capital for the funding of legal claims, Burford also owns a legal insurance business, which they acquired in 2011. When cases finalize, the loser is generally obligated to pay for the winner’s legal expenses. To mitigate such risk, Burford offers customers to pay for these adverse costs if required. If the insured party wins, Burford is entitled to collect a premium, correspondent to a percentage of the cost’s risks.

“Our operating profits from this business have exceeded $81 million in aggregate since 2011 against an acquisition cost of $19 million” 2020 20-F

In 2016, a falling demand due to regulatory changes as well as increasing platform costs made management terminate their arrangement with MunichRE and stop writing new business. Premiums that remained in the portfolio kept being managed accordingly and producing profit for several years.

In 2018, Burford re-entered the insurance business with their wholly owned insurer: Burford Worldwide Insurance Limited. The latter is aimed at the high-end of the market, as opposed to before. Burford takes 20% of the insurance risk and contracts to take remaining reinsurance risk.

Note: Reinsurance is insurance for insurance companies.

Finally, in 2018, management claimed BWIL would only write coverage for matters they are financing, enhancing Burford’s suite of solutions and making it more appealing to clients.

“The insurance business has written almost 57,000 insurance policies to cover adverse costs risk during its life. Of those matters, 77% have resolved favorably and only 21% have suffered losses (and 2% remain unresolved). That represents an enormous body of litigation assessment data and experience in addition to our core business” 2018 Annual Report

Alternative Strategies

The second main offering Burford has is called alternative strategies. With this set of assets, management aims for lower risk and return than core legal finance. Alternative strategies are composed of:

• Lower risk legal finance: this business is focused on pre-settlement matters. In contrast to core legal finance, assets that are included here are perceived as carrying less risk and lower expected returns due to structural or other reasons.

• Post-Settlement: When both parties settle, the monetization each of both is titled to might take a considerable amount of time to come. Generally, the judicial process delays such monetization. However, the payment is due and is ‘certainly’ occurring. In an attempt to help corporations and law firms materialize the funding at an earlier stage, Burford provides them with capital in exchange for the completeness or part of the future claim. A similar logic is applied when speaking of a stream of payments that are due to a certain party.

  Additionally, Burford offers law firms the chance to purchase their receivables, especially at the end of their fiscal year, when legal firms require capital to pay to partners.

• Complex Strategies: When management encounters an asset associated with a claim they believe is mispriced, they acquire it. Thereafter, Burford takes full control of the asset, becoming the owner, and manages the claim actively. Complex strategies are carried out through the Strategic Value Fund, which focuses on merger appraisal situations. Depending on context, Burford might long or short equity securities as well. The Strategic Value Fund has deployed no capital in 2021 and 2022, and management expects it to continue this way in the short term.

• Asset Recovery: When a matter has been litigated through a final judgment, after which there are no longer more appeals possible, “the judgment is enforceable as a debt obligation of the judgment debtor”. Even though most litigants pay on time, some do not. In such cases, Burford offers clients the possibility to monetize the claim beforehand and puts effort on collecting the debt.

Asset Management

Although Burford had been historically able to grow its capital base at a rapid pace by issuing debt and due to the high returns on capital they’ve had, demand for legal finance was still in excess of their supply capacity. Taking this into consideration, management decided to acquire the largest investment management firm in the industry in 2016, called Gerchen Keller (GKC). For the latter, the company paid $160 million in cash, shares and loan notes.

GKC brought with it four private closed end funds with total commitments of 1.1bn dollars. Additionally, GKC’s investments were broader in nature than that of Burford. The latter was completely focused on core legal finance, investing in pre-settlement matters. Alongside GKC, Burford got to expand its avenues for investments, including things such as post-settlement thereafter. For managing private funds, Burford earns a management and performance fee, both of which depend on the fund and are detailed in the asset management image.

Burford has been utilizing its balance sheet to invest alongside these private funds ever since. At the beginning, Burford agreed with GKC that the first $15 million of commitments in pre-settlement matters would be split in half and half between both. Commitments that exceeded the first $15 million would be taken by Burford’s balance sheet until it reaches the risk tolerance level. After this point, the fund would be entitled to invest.

In their 2022 annual report, Burford stated that they generally utilize the balance sheet to invest in 75% of new core legal finance assets, while leaving the remaining 25% for the private fund called BOF-C. Importantly, the latter is a fund through which a sovereign wealth fund invests in pre-settlement matters. It is worth noting that the allocation distribution has varied over the years.

On the other hand, 100% of the allocation in lower risk legal finance assets is done through the Advantage Fund, in which Burford’s balance sheet is an investor. Allocation to post-settlement matters is 100% done through BAIF II, a private fund. Complex strategies are 100% done with the Strategic Value Fund, in which Burford’s balance sheet is also an investor. Finally, the completeness of asset recovery investments is done through the balance sheet.

“Although we manage each of COLP, BAIF and BAIF II and receive asset management and performance fees, we are not an investor in COLP, BAIF or BAIF II and, as a result, none of COLP, BAIF or BAIF II is consolidated for purposes of our consolidated financial statements.” 2022 Annual Report

Burford generally manages their private funds through limited partnerships. Private funds that are LPs have a general partner that’s Burford-owned. The latter is in charge of administering their respective fund, conducting operations and selecting the assets in which to invest. Importantly, “the limited partners of the private funds take no part in the or control of the business of the private funds, have no right or authority to act for or bind the private funds and have no influence over the voting or disposition of the securities or other assets held by the private funds”.

Origination and Underwriting

Burford continuously receives inquiries from corporations and law firms. Upon their receipt, the team performs a high-level screening process in order to filter potentially good opportunities and get them into the pipeline. After this occurs, the case is assigned to an individual underwriter who then performs exhaustive due diligence, covering both legal and factual standpoints. In parallel, Burford utilizes a quantitative probabilistic model that leverages proprietary and third-party data to infer a case´s expected value.

If the underwriter arrives at the conclusion that the claim is worth pursuing, they present it to the Commitments Committee, whose task is to accept or reject the opportunity. If the committee decides to proceed with the investment, the underwriter negotiates the terms with the counterparty in order for Burford to properly make the commitment.

This is a process that’s overseen by multiple people and teams within Burford, which forces potential cases to go through a chain of parties, all of whom review it and decide to proceed or not:

“There is someone that is going to be underwriting this memo that I described, but at the same time, we are not going to make an investment until a lot of people with a lot of experience have reviewed this matter and said yes to it. So, at the end of the day, I am responsible for every investment that we make. John is just as responsible” Cristopher Bogart

After the commitment is done, the method of funding varies. One of the possibilities is for Burford to make a complete upfront payment, or to provide the funding overtime. Further, undrawn commitments, meaning the not-yet paid part of the committed capital, are cataloged as discretionary or definitive. The difference between the two lies in whether Burford is contractually obligated to provide the rest of the capital commitment or not.

Personal Commentary

Burford is a fascinating business to read about. The next 2-3 articles will be on this company and perhaps I’ll publish a short write-up on Winmark in 2 weeks. I’m trying to increase production.

Contact: Giulianomana@0to1stockmarket.com

Disclosure: This is not financial advice

Meat has been historically scarce and, therefore, expensive. However, a growing global economy has helped increase average household incomes, at the same time as increasing meat supply, making it more affordable and accessible from both ends. Moving forward, the human population is expected to continue increasing, in line with meat consumption. Curiously, because of the scarcity of land-based protein production, how environmentally unfriendly is and its higher inefficiency compared to fish’ production, fish supply and demand are expected to fairly outpace overall meat.

As observed in the chart above, the average person eats almost 2x seafood as it did half a century ago. Global production of fish has quadrupled while human population doubled, explaining this gap. And, out of the total 492M tones of the global protein consumption (estimated by the Food and Agriculture Organization), fish equated to 161M, and salmon to 2.6M.

Within seafood, the two major methods for production are aquaculture and wild catch. The past six decades have been accompanied by a huge development of aquaculture, outpacing wild catch, and as of 2022, had a 56% share of seafood consumption. Specifically in salmon, about 80% of the worlds’ salmon harvest is farmed. This trend is to continue given the scalability each method supposes.

Moving forward, Mowi’s handbook states multiple trends that are expected to keep fueling salmon’s demand. Leaving aside population growth, which is the ultimate secular tailwind, there’s:

• Health and aging population. Healthcare’s focus is expected to switch to prevention, leading to nutrition becoming essential. Fish, and particularly salmon, are considered to be a vital source of protein.

• Growing middle class. As the average person gets richer, meat demand and kg per capita should continue to increase.

• Climate change. The world has become increasingly more aware of environmental issues. As a consequence, aquaculture in general has outpaced other agricultural processes due to the high efficiency at which fish can be farmed. The latter’s carbon footprint is much lower and it consumes less liters of water per kg of meat than other animals.

Note: the table includes salmon, not fish in general

• Resource efficiency. Protein retention measures ‘how much animal food protein is produced per unit of feed protein fed to the animal’. Feed conversion ratio measures how many kg of feed are needed to increase the animal’s weight by 1kg. Salmon is far superior to other animal protein sources.

Ultimately, aquaculture has fairly outgrown agriculture and, within aquaculture, salmon is one of the species that have benefited the most. Over the past 10 years, the value of salmon sold has increased at an 11% CAGR, while volume has increased at a 4% CAGR in the same period. The strong underlying and unattended demand for salmon allow for a fundamental pricing power.

“The total protein market in the world is 400M tons, out of which 2M tons is salmon. The average growth of this market could be something like 2-3%, while salmon maybe grows of 6-8%” Regin Jacobson, Bakkafrost CEO; 2018

The barriers to entry this industry are interestingly high and its natural characteristics have led to continuous consolidation. We’ll now get into the barriers…

Barriers To Entry

Salmon is not available everywhere and, moreover, not all waters where it’s available are suitable for farming. The countries that meet all conditions are Norway, Chile, Scotland, the Faroe Islands, Ireland, Iceland, Canada, USA, Tasmania and New Zealand.

To keep aquaculture’s environmental impact as low as possible, the industry has become extremely regulated. In fact, “license systems have been adopted in all areas where salmon farming is carried out”. Licenses’ implications depend on each country. Some of them have much more intricated systems than others, but the variables are generally the following:

• Annual and upfront fee to operate a site. The annual fee depends on volume

• Getting a license takes 5-10 years, they last for 10-20 years and can be renewed (mostly the case)

• Licenses grant a number of sites to farm (4 in Norway, for example), and determine de maximum volume of fish (MAB) that can be held at sea at all times. MAB is generally dependent on water, disease conditions and particular circumstances

In parallel to companies’ reliance on licenses, the fundamentals of the average salmon producer are far from ideal. This is a very capital and resource intensive industry, demanding:

• High upfront investments to get factories going. To equip one, you need cages (steel or plastic), moorings, nets, cameras, feed barge/automats and workboats

• Low average EBIT margins because of the high competition at the bottom-end of the market (I suspect this, need to further dive here)

• Licenses fees

• Biological implications require either high levels of R&D, or complete dependence on suppliers

• Continuous reinvestment to keep fish at sea at all times. Working capital investments are required for organic growth, as a larger “pipeline” of fish is needed to facilitate larger harvest volumes

Regulatory restrictions, biological issues, competition in the low-end of the market, low control of the value chain, the advantage of economies of scale, and the capital intensity of the industry have led to a continuous consolidation of players. The salmon producing industry presents all characteristics for a “winners keep winning” environment.

Note: The graph shows the number of companies producing 80% of the farmed salmon and trout in each major producing country. Notice that, for instance in Norway, the number of players dropped from almost 70 in 1997 to 16 in 2022.

Finally, here are the top 5 players in terms of volume:

Relevant Variables For Analysis

Salmon production, farming and harvesting, (the whole cycle), takes around three years. During this period, the product goes through several steps. From fertilization and early-stage growth in freshwater, to sea growth, to processing plants. Vertically integrated players will be the ones that would, theoretically, enjoy the best margins and returns, assuming a similar pricing.

The reasoning behind this is that vertically integrated companies have the possibility to attack all cost buckets and make the process as efficient as possible. The chart below aims to show how does the cost structure of companies looks like. For example, the feed they give salmon represents almost half the cost of production. Therefore, looking for companies that develop feed in-house and achieve lower conversion rates should prove rewarding.

Similarly, the yield per smolt is an important indicator of production efficiency. It represents the harvest weight per smolt transferred to seawater. The number of harvested kilograms yielded from each smolt is impacted by diseases, mortality, temperatures, growth attributes and commercial decisions. The higher the better.

The second thing that could be worth looking at is geographical diversification, or at least avoiding extreme concentration. Salmonids face several biological risks, with some of them having unidentified causes, for which epidemies can occur and wipe out particular sites. At the same time, having license concentration in only one country makes the company very susceptible to regulation changes, which seems to happen occasionally.

Thirdly, perhaps analyzing what are the results that R&D initiatives are yielding can help shed light as to which company has the most suited team and deploy capital more optimally (speaking only about R&D). Trends such as feed conversion, survivability rates and sea lice numbers can be some elements to focus on.

Finally, value added products (VAP) is a subsegment within the salmon industry. It consists on filleting, fillet trimming, portioning, producing different cuts, smoking, marinating, breading, and depends on the factory’s technology and people employed, as it is capital intensive as well. However, it provides some sort of diversification to revenue, consumers are willing to pay for quality and it also adds stabilization to the topline because the deals are based on fixed-price contracts. Trying to infer what are companies’ approach towards VAP might prove useful. Experience and a long-term strategy of expanding here might be a desired thing to see.

Most Appealing Public Players

Mowi

Founded in 1964, Mowi is a Norwegian vertically integrated company that’s focused on farming and harvesting salmon to then sell it in multiple formats. As of 2022, the company held an almost 20% market share of the global 2M tonnes harvested, more than double that of the second player (SalMar). It operates in more than 70 countries and employs 11,500 people. Mowi is organized in three business areas:

• Sales & Marketing includes secondary processing, value added operations and the sales & delivery of products. Operational EBIT in 2022 was 112M for ‘Consumer Products’ and 61.1M for ‘Markets’. Expanding this segment is part of Mowi’s long-term strategy of focusing on building the company’s brand value.

“The MOWI brand continued its expansion in existing markets in 2022 by launching in more brick-and-mortar stores, and also e-commerce which has been a successful channel for the brand. A volume increase of close to 400% from 2021 to 2022 is a testament to the rapid growth we are seeing”

• Feed includes feed plants in Norway and Scotland. Production was 515k tonnes for 2022, achieving a 10% 4yr CAGR. Mowi estimates that the current capacity is at 640k tonnes. In terms of operational EBITDA (the measure the company focuses on) generated, feed generated an inflow of 47M EUR, up from 34.5M in 2021. Mowi believes there’s room for cost improvement and, being feed the most important input for salmon production, companies that offer high quality feed enjoy decent levels of pricing power.

• Farming encompasses farming operations, some primary processing and filleting activities in seven countries. Harvest volume was 464k tonnes for 2022 with 63% of the total coming from Norway, and the remaining 37%, from 6 other countries. The five-year CAGR for harvest volume stands at 5.2% (industry CAGR was 4.1%) and operational EBIT totaled 817M.  Management mentions that Norway’s farming unit is at the top of license’s utilization and production efficiency, a byproduct of good operational performance. The plan to continue fueling farming is to aim for producing more and larger smolt, and to exhaust multiple remaining licenses in places like Chile and Canada.

Furthermore, Mowi has been engaging with M&A and plans to continue doing so to expand farming capacity and volume harvesting. Last year, it received approval to acquire 51% of the share of Arctic Fish. This helped them expand their geographical footprint to Iceland. Mowi paid 150-180M euros for the company, which has license permission for 27k tonnes and 4.8k in the application process.

One big thing worth mentioning is that the FCR was at 1.13 in 2017, at 1.14 in 2018 and now is at 1.15.

SalMar

SalMar is a vertically integrated Norwegian salmon producer that was founded in 1991 and is currently the second largest player in the market, with a 7-8% market share. The company has a similar operating structure as Mowi, with an S&M segment that includes secondary processing, and farming.

The biggest difference between both, aside from geographical diversification, is that SalMar does not produce its feed in-house, it relies on other suppliers. However, it ensures that ingredients are certified, and SalMar has ‘dedicated personnel who work with fish feed and its nutritional content’. In contrast to its counterpart, curiously, SalMar’s feed conversion rate improved from 1.21 in 2017 to 1.18 last year.

Management team at this company are undertaking huge initiatives that are transforming how SalMar works altogether. The two most relevant include:

• M&A. In January of 2022, Norway Royal Salmon merged with SalmoNor, creating the world’s sixth largest salmon farming company. The deal valued SalmoNor at 900M USD and, between both, they have a capacity to farm 100k tonnes in Norway and 24k tonnes in Iceland.

  In November of 2022, SalMar merged with Norway Royal Salmon. Interestingly, the deal was dependent on the prior merger. SalMar had conservatively guided for 277,500 tonnes for FY 23. However, management raised guidance in their capital markets day to 362k of harvest volume expected in 2023, with 300k being in Norway.

• Offshore farming. In 2018, SalMar put in place the first offshore farming facility in the world. Management believes open ocean farming is crucial for continuous development and supply growth. Furthermore, it could open up new areas for production and verticals for innovation.

  In 2021, the company partnered with Aker and created SalMar Aker Ocean, a new joint business completely focused on being a pioneer and developing offshore farming. The ambition is for it to become a global offshore aquaculture company with harvest volume of 150k tonnes. SalMar owns two thirds of the venture.

SalMar, according to their CMD, has a harvest capacity of 350k tonnes and 135k tonnes for VAP as of today. As Utilization and efficiency improves, capacity within facilities would grow to 420k tonnes of yearly harvest volume and 165k tonnes of VAP.

Bakkafrost

Bakkafrost was founded in 1968 by two brothers, named Hans and Róland Jacobsen. In 1971, their third brother, Martin, joined them in the enterprise. The company slowly started to build their farming facilities and is now being led by Regin Jacobsen, who is the son of Hans and has been CEO since 1989. Curiously, Martin’s son, Hogni Dahl Jacobsen, joined the company and has served as CFO since 2019. An interesting fact is that Regin owns 7.9% of Bakkafrost while his mother, wife of Hans, owns 7.8%.

Bakkafrost is a vertically integrated salmon producer with licenses in the Faroe Islands, where they harvest around 70% of volume. In 2019, they acquired a Scottish company that now does the remaining 30% of harvest volume. The thesis for this M&A was to turn around the Scottish business, as it was operating at very low efficiency. Part of Bakkafrost’s strategy is to engage with opportunistic M&A of these characteristics. They had also done this in 2016, when they acquired a small company with licenses in the southern part of the Faroe. Management’s intention is to replicate the business model they have for their main operations in these other facilities, and results seem to be pointing in the right direction.

What uniquely sets Bakkafrost apart from its competition is their completely integrated value chain, which they continue to enhance (ie. Acquisition in Jan of 2022). The company’s control of the entire farming, processing, VAP, and sales, allows it to attack all cost buckets possible and to ensure as high quality salmon as possible. The step of the chain where this is most noticeable is in their feed production. Due partly to Bakkafrost’s “rich access to marine raw material from the waters surrounding the Faroe Islands, Bakkafrost is uniquely positioned to maintain a substantially higher marine inclusion in the salmon feed”, which translates into one of the lowest feed conversion rates (1.03 as of 2022). Given the fact that feed represents approx. 40% of salmon’s production cost, it’s a crucial element to control. Furthermore, their complete control of the value chain puts them in a good position to engage with long-term contracts, ensuring delivery and quality.

With specific regards to salmon, management’s strategy moving forward revolves around the smolt’s size. Previously, the production process intended for smolt to grow from 100 to 250 grams and then release them to the sea. However, salmon are generally farmed at 4-5-6kg, for which almost two years were required for this growth to happen. The problem is that “two thirds of mortality occur in the second year at sea”. Consequently, reducing the time salmon is in seawater dramatically reduces costs, and this is what the ‘large smolt strategy’ gets to resolve. It will reduce time at sea to 12-13 months. The company has been growing it smolt successfully before releasing it to the sea and the target, 500gr smolt would be released in Q3 of 2023.

To this last point, the increased smolt size, combined with the Faroe Island’s natural peculiarity, also helps the company achieve higher kg per salmon harvested. And, due to the lack of supply at this high end of salmon weighting, higher kg salmon enjoy a premium in prices.

Recent tax implementation

After a period of a relatively stable regulatory environment, Norway’s government proposed a huge new tax for salmon producing companies in September of 2022. The foundation for such proposal derives from salmon producers’ apparent “high returns for the low risk they incur in”. Initially, the tax rate was intended to increase to around 60%, from the 22% companies were charged before. After an overwhelming consensual negative from the markets and salmon producers, warning against the measure, the following was agreed in May of this year:

“The Norwegian Government has secured a majority in the Norwegian Parliament to adopt a resource tax on the salmon farming industry of 25 percent on values created in the ocean phase of the salmon production cycle. This is significantly better than the original proposal of 40 percent,” said Grieg Seafood in a statement.

There will for sure be impacts on capital returns and companies’ expansion plans moving forward. However, it is unclear the degree at which salmon producers will suffer from a financial standpoint. The only clear thing is that Norway should turn much less profitable and that the industry itself might face some uncertainty clouds in the short run.

This tax mostly affects SalMar, which derives a large portion of its revenue from Norway, but also hurts Mowi and adds uncertainty to Bakkafrost’s operations in the Faroe Islands. The latter, in parallel to Norway’s government, announced a tax of its own last year. This new tax went into effect in August of 2023 and will be somewhat variable. The tax rate would go up to 20%, depending on the price of the salmon harvested, compared to its index price.

Conclusion

These are three seemingly similar companies, but they drastically differ in the strategies they pursue. On the one hand, Mowi is the largest player with the most diversified operations, which should continue to be the case moving forward. However, things like the FCR’s trend might show inefficiency and perhaps even the condemn of scale.

On the other hand, the company that could potentially offer the best results, though with the highest risk as well, is SalMar. If the company gets to correctly integrate the recent acquisition and successfully develops and scales their offshore operations, potential is immense. But again, integration risk is very high and so is scaling new and mostly unknown mechanisms. In addition to this, considering the heavy tax implementation, it is unclear how it will play out.

Finally, Bakkafrost seems to be the best company on a risk-adjusted basis. Upside potential is very high and I’m inclined to suspect that the company has high chances of achieving its guidance for 2028 (+80% harvest volume from 2022’s). Management has already proven it is capable of acquiring-and-optimizing, increasing smolt size, improving feed recipe and increasing survival rates.

Personal Commentary

Fascinating industry. It seems like an authentic incubator for long-term compounders. Hope you enjoyed the industry breakdown and got some ideas.

Contact: giulianomana@0to1stockmarket.com

Disclaimer: This is not financial advice and should not be taken as such

This is the last free research article I post. I will expand accordingly on why I decided take this route in Sunday’s article. In any case, hope you enjoy the attempt of industry breakdown and feel free to subscribe after a skim.

What is Building Information Modeling?

Within software as a service, there are two categories to which products can belong:

• Horizontal software refers to those services that are industry agnostic and hence spreadable among these. Spreadsheets like Excel, CRMs like Salesforce’s, are great examples of horizontal software. Their design allows them to be applicable in multiple industries and, on occasions, for a variety of purposes. Naturally, horizontal software’s addressable markets are immense.

• Vertical software is designed with an industry-specific solution in mind. By definition, their addressable market is limited to the extent of the customers’, within such industry, requirements.

  “For example, in the public transit market one of the mission critical aspects of the business that we help automate is the scheduling and routing of vehicles.” Constellation Software

Building Information Modeling (BIM) belongs to the latter categorization. Even though the latter is somewhat shady, assume that for now. Meant for the Architecture, Engineering and Construction (AEC), BIM is the digital process by which constructions can be created and managed. It consists of an intelligent model that enables architectures and engineers to create virtual representations of buildings, objects, envision the asset through its lifecycle and manage ongoing operations. In contrast to prior methodologies, BIM is based on parametric modeling.

Object-based parametric modeling was developed in the 80s. The intention for this new configuration is to not represent objects with fixed geometrical figures and properties, as was previously done. Instead, object-based parametric modeling revolves around setting parameters and rules, which could then be utilized to determine figures and non-geometric properties.

In essence, this involves defining the building blocks upon which objects can then be constructed. Understandably, taking the other route, by fixing and determining objects which would then be leveraged to build digital constructions, would naturally limit buildings' possibilities. Such a limit would be imposed by how vast the universe of defined objects is.

To the contrary, defining properties and parameters make up for a malleable recipe for building objects. This allows for a much broader range of building options. Furthermore, even though somewhat constrained by the set of properties and rules predetermined, users have the capability of customarily building the objects they desire.

Software Characteristics and Their Implications

Even though what we have just covered would imply for users to create any object they want, there is a problem. The purpose with which BIM technologies/platforms are developed mostly defines the end-market at which they will be aimed. Broadly, they can be created with a general or specific purpose in mind.

Given we are speaking about physics, there’s great depth as to how detailed building configurations could be. Depending on the location, the end-market, building/object’s purpose, and legal requirements, the platform that might be more convenient. Generally, niche-specific solutions are much more efficient and suited for specific tasks, compared to general-purpose ones.

The reasons for the above are mostly two. Firstly, the object-complexity each technology is capable of handling is inherent to the parametric rules and properties that are set. Therefore, some general-purpose BIM technologies might turn highly impractical and even useless for designing and dealing with complex objects. Emphasis on this aspect. On the other side, the platform and product themselves are very resource intensive. The problem, and case against a “super BIM platform”, is that companies employing BIM will not be willing to pay for capabilities and features they do not utilize.

Example of what happened with the steel fabrication process:

“BIM tools for building design focus on architectural-level objects, but a different set of authoring tools have been developed for modeling at the fabrication level. These tools provide different object families for embedding different types of expertise. Early examples of such packages were developed for steel fabrication, such as Design Data’s SDS/2, Tekla’s X-steel, and AceCad’s StruCad. Initially, these were simple 3D layout systems with predefined parametric object families for connections, copes that trim member around joining steel sections, and other editing operations. These capabilities were later enhanced to support automatic design based on loads, connections, and members. With associated CNC cutting and drilling machines, these systems have become an integral part of automated steel fabrication. In a similar manner, systems have been developed for precast concrete, reinforced concrete, metal ductwork, piping, and other building systems.” BIM Handbook: A Guide to Building Information Modeling for Owners, Managers, Designers, Engineers, and Contractors, 2008

There is in fact so much profoundness and depth that BIM technology can be customarily designed to address specific firms’ needs. An example of this is BIM Services LLC, a private company that provides consultancy and customized BIM solutions:

“Other industries have recognized the need for product model servers. Their implementation in the largest industries –electronics, manufacturing, and aerospace —has led to a major industry involving Product Lifecycle Management (PLM). These systems are custom engineered for a single company and typically involve system integration of a set of tools including product model management, inventory management, material and resource tracking and scheduling“ BIM Handbook.

This has led to a naturally fragmented industry, which has had several implications. Firstly, sub-vertical domination due to network effects. Most BIM platforms allow for custom-made solutions, plugins, and integrations from third parties and companies’ developers. This way, a community of contributors is created, and the more contributors there are in a platform, the more builders will the platforms attract. Consequently, not only do the industry fundamentals allow for the existence of many sub-verticals, but also for virtual oligopolies/monopolies in each of these. The following is an example from Autodesk’s 2023 Investor Day.

Network effects are present in most platforms, and platforms with embedded network effects are known for their “winner takes all” characteristics. 

At the same time, the fragmented nature of this industry has provided fertile soil for M&A operations. Given expertise and utility are mostly encapsulated within each vertical, companies can opt for acquisitions that could expand their platforms’ scope, by adding sub-verticals for example, increasing presence in sectors. In parallel, because of this immense depth each vertical software could have, plus integrations that would enhance platforms’ utility, managers can opt for adding depth. Examples from Bentley System:

For platform depth: “Adina R&D (2022), adds nonlinear simulation capabilities to users of our comprehensive modeling and simulation software portfolio for infrastructure engineering;” 2022 Annual Report

For breadth/scope: “Power Line Systems (2022), Power Line Systems substantially completes the reach of our comprehensive portfolio for the lifecycle integration of grid infrastructure across electrical transmission, substation, and distribution assets, and communications towers” 2022 Annual Report

To further illustrate how big of an emphasis is placed on M&A, the following chart was plotted for four players. At a 2022 revenue of 1.1bn, Bentley Systems has averaged spending 42.1% of its total sales in acquisitions, and has acquired 36 companies in the past 5 years (IPOd in 2020). Nemetsheck, with 2022 revenues of 858M, averaged spending 16% of sales on M&A for the period 2014-22. Autodesk, at over 5bn in 2022 sales, averaged 13%. Lastly, Trimble averaged 13% as well at 2022 revenues of 3.6bn. Regarding the latter, an acquisition went through in early 2023, in which Trimble acquired Transporeon for 2bn.

Multiple companies’ platforms have become quite comprehensive, but customers, generally, don’t utilize a high percentage of the portfolio offerings. At the same time, customers do not yet find the completeness of their problems solved by the same platform. Therefore, BIM businesses have addressed this issue by engaging with M&A operations to continue enhancing their solutions and ultimately capture a larger share of customers’ budgets.

“Our relatively numerous and frequent programmatic acquisitions, which most often “fill white space” within our ecosystem and add their particular value principally by virtue of our existing platform” BSY 2022

Additionally, companies might leverage acquisitions to extend lifecycle comprehensiveness. BIM technology can not only be employed for construction design, but also for stages that come before and afterwards. It might be the case that a specific platform was developed purely for 3D modeling and, as time went by, management added more capabilities so that it helps constructing companies throughout the whole process. Stages or phases of construction are nowadays known as BIM Dimensions.

Prior to turning our attention to “where does growth come from” in the industry, a pertinent observation. BIM technology is far from easy to utilize, learning curves are extremely slow, and complexity is directly tied to the platform’s purpose. One that’s meant for handling complex surfaces, such as Digital Project (owned by Gehry Technologies), will require much more training than a general purpose one, such as AutoCAD, under the consideration that the latter is not even fully parametric, which contains building applications like Architectural Desktop. What this implies, essentially, is that once a team gets used to utilizing a specific software, it is unlikely they will switch provider. The latter is further consolidated by the fact of leaders benefiting from network effects, making peers less appealing.

Lastly, within a project’s lifecycle, managers have always encountered friction when it came to managing resources and the workforce at each step of the chain. To address this issue, Enterprise Resource Planning software was developed specifically for the AEC industry. A business whose offerings revolve around this software is Procore Technologies. The company has seen a lot of traction, and multiple businesses have been started with the intention of replicating Procore’s offering. Hence this creates another avenue for acquisitions, something which Autodesk and others have already taken advantage of, as this article shows. Moving forward, it should be expected for these types of software to become either organically more comprehensive or for managers to inorganically expand their offerings, ultimately leading to a single consolidated platform.

Where Does Growth Come From?

The architecture, engineering and construction industry (AEC) had long been due for efficiency efforts. While most industries have seen their core disrupted and costs dragged down, AEC has been resilient to change. However, it has and will probably always be the case that, when a new technology emerges that allows for massive cost reduction, players adopt it. Beginning at the high end of the industry and going down, as the technology gets more efficient and less costly, so that more and more companies can afford it.

According to the BIM Handbook, A Guide to Building Information Modeling for Owners, Managers, Designers, Engineers, and Contractors, published in 2008, there are multiple benefits BIM brings:

• Pre - Construction Benefits to Owner:

  • Before hiring an architect and putting things in motion, an owner needs to check if it makes sense to make the building from a quality and cost perspective.

  • Developing a schematic model prior to generating a detailed building model allows for a more careful evaluation.

  • Early evaluation of design alternatives using analysis/simulation tools increases the overall quality of the building.

• Design benefits:

  • Earlier and more accurate visualizations of a design

  • Automatic low-level corrections when changes are made to design

  • Generate accurate and consistent 2D drawings at any stage of de design

  • Earlier collaboration of multiple design disciplines; shortens design time and reduces errors and omissions

  • Easily check against the design intent

  • Extract cost estimates during the design stage; More accurate cost estimates at the end and during the process

  • Improve energy efficiency and sustainability

• Construction and fabrication benefits:

  • Synchronize design and construction planning. Allows to simulate and show what the building and site would look like at any point in time

  • Discover design errors and omissions before construction

  • React quickly to design or site problem

  • Use design model as basis for fabricated components. Accurate representation of the building objects for fabrication and construction

  • Better implementation and lean construction techniques. Minimizes wasted effort and reduces the need for onsite material inventories

  • Synchronize procurement with design and construction

• Post construction benefits

  • Better manage and operate facilities. Helps to check that all systems work properly after the building is completed

  • Integrate with facility operation and management systems. A building information model supports monitoring of real-time control systems, provides a natural interface for sensors and remote operating management of facilities. Many of these capabilities have not yet been developed, but BIM provides an ideal platform for their deployment.

The above benefits range from pre-construction to post-construction, helping minimize errors of miscalculations and increasing efficiency and efficacy at all stages of the project. Furthermore, BIM modeling and simulation capabilities allow for accurate design and representation of future projects, making owners better assess whether a project should be done or not.

“The productivity gain for the documentation stage of pre cast and cast-in-place concrete structures has been measured in case studies and researched in numerous contexts, and has been found to be in the range of 30% – 40%.” BIM 2008 Handbook

Even though the results that come from utilizing BIM technology are overwhelmingly positive, a combination of its complexity, cost and reluctance from AEC companies, have led to an initially slow adoption. Over time, however, BIM penetration has increased across the developed world, with countries like the US, Canada, Netherlands and Australia exceeding 40% penetration.

The following chart illustrates, on the left, how adoption has trended for specific countries, comparing BIM’s 2020 penetration to the one it reached in 2023. On the right, the map shows, as of 2023, how high BIM’s overall penetration is in each region and country, ranging from 0 to 60%, with their pertinent color. Notice how there is a large portion of the world to which the technology has not yet arrived, and another big part where penetration is still below 20-25%. Moreover, almost no country’s BIM penetration exceeds 50%.

The still-low overall global penetration and the objective benefits BIM brings to the AEC industry should translate into very strong secular tailwinds for the coming decades. According to Zion Market Research, the BIM market is expected to grow at a compound annual rate of 13.9% from 2022 to 2030, reaching 52.5bn. The latter is largely influenced by how much efficiency this technology brings to an enormous market. Nemetschek expects the construction industry to grow 42% by 2030, reaching 13 trillion Euros. Penetration will continue to be further fueled by sophisticated entities’ demand of BIM-based projects.

Keep in mind that the estimated addressable market varies depending on how many verticals, use cases and end-markets are included.

It should come as no surprise by now that applications of BIM software go beyond the AEC industry. The reason for this is that the technical characteristics with which BIM was designed allow for applications in more industries. Autodesk, for example, estimates an opportunity of 8.89bn in the design & make for media & entertainment by 2027. The expected 13.7% compound annual growth rate would be fueled by the increased demand for better virtual effects and 3D when producing content.

At the same time, and I’d say validated by Bentley’s recent actions, management foresees a 2.7bn market in the water design & operations industry, covering everything from drainage and water distribution to water treatment and retaining.

The last point I would like to raise is regarding how BIM technology allows for a better overall approach to construction. When it came to design, in accordance with the natural lifecycle of a project within this industry, companies had decided to overtake them by splitting the phases of development into sequential steps. Furthermore, when it came to designing the building, rarely were all future involved people included in the process. Alternatively, BIM technology allows for a much more collaborative approach, making more steps of the design chain be involved at a very early stage.

Having a more integrated approach towards design proves incredibly valuable for businesses since the moment at which managers have the highest ability to influence costs is at the beginning of the project. Afterwards, ability to do so becomes increasingly lower. The following chart illustrates how the design effort/effect curve shifts towards the left when taking an integrated approach, implying it offers managers not only higher ability to reduce costs, but also modify functional capabilities. Importantly, the later in the lifecycle this is tried to be done, the costlier it becomes.

“Leading architectural firms are beginning to recognize that future building processes will require integrated practice of the whole construction team and will be facilitated by BIM” BIM Handbook, 2008

Worth Mentioning Industry Trends

Lastly, before going into what I consider to be interesting companies to at least follow within this vertical, I’d like to point out some trends that have taken place during the past decade or more. These might be objectives multiple companies have been aspiring to attain or, otherwise, concepts that come up recurrently across investor days and annual reports.

Revenue Model

Initially, BIM software began being offered as perpetual licenses, similar to what happened in many parallel verticals. This model implied for customers to buy a perpetual license of the software and utilize it moving forward. If they wanted to keep up to date with updates, they would need to buy the new license. Else, it was allowed for them to continue utilizing the version they bought.

However, as time went by, managers started to notice that there was a world in which they could follow cloud giants by turning their business model into a subscription-based one. This is a recurrent pattern among businesses, including Autodesk, Nemetschek and Bentley Systems. The following image illustrates Autodesk’s case, which started to place from 2016 onward.

The SaaS business model offers companies a predictable stream of revenues, which they can leverage to better plan and invest. Moreover, customers are somewhat benefited due to the fact that subscription-based software allows the offeror to update it regularly, and for customers to get these marginal improvements as soon as possible. In Autodesk’s Investor Day, management shared how the new business model has led to resilience, which, given the software is mostly meant for a very cyclical industry, is somewhat desirable.

On the other hand, we saw that, even if companies now offer very comprehensive platforms, not many customers are opting for consuming everything from a single provider, or simply not at all. Nevertheless, it is in businesses’ best interest to capture a larger percentage of customers’ budget. Cross-selling tends to be a very attractive endeavor, from a financial perspective. To this end, a recurrent theme is to offer the BIM product and adjacent features on a flexible basis. Alike cloud computing, many of these are offered on a consumption basis, famously known as “pay as you go”.

“New commercial formulations. We continually innovate with new commercial formulations to align the use of our software to the needs of our users. Presently, we offer our subscription solutions by the day, month, quarter, and year. Additionally, we offer options enabling unrestricted access to our comprehensive software portfolio. We believe the flexibility in our commercial models and deployment options will allow our accounts to grow usage continuously” Bentley Systems 2020 Annual Report

Digital Twins

First and foremost, it is worth stating that the concept of “digital twins” is, broadly speaking, not new. The term has been utilized for a couple of decades now. Digital twins, essentially, imply for the virtual replication of a physical object and the dynamics encompassed within it. In some sense, it allows for not only a static replication, but also for simulations to foresee how would such object interact with its environment, hence why the “dynamics encompassed within it”.

Building Information Modeling, due to its functionality, has been understandably confused with what the term “digital twin” entails. The difference lies in the fact that the latter would suppose the virtual creation of the future (or current) building, and a model that should allow for the simulation of this building throughout its lifecycle. Further, how it interacts with the infinite variables of physical space. Foundationally, BIM models were developed with the intention of 3D design, not necessarily for simulation and prediction capabilities, nor for facilitating ongoing management.

At the same time, BIM platforms have evolved according to the increase in computing power capabilities, but this was implemented vertically. A parallel market, as mentioned earlier, was created. The software for project and asset lifecycle management have been developed almost independently from one another. Ultimately, a digital twin, as a consequence of its comprehensiveness, could in some way merge these separated markets to offer a more integrated one.

Autodesk

The company was founded in 1982 by John Walker alongside a group of programmers. The first product, which John helped create, is called AutoCAD (computer-aided design). The latter was a 2D software that allowed for the building and design of structures. The offering’s novelty and potential rapidly propelled Autodesk into success, selling tens of millions of dollars’ worth of software in a couple of years. As time went by, AutoCAD was improved. It now supports drafting in more dimensions and counts with hundreds of integrations.

Nowadays, Autodesk (43bn market cap) is the global leader in 3D design, engineering and entertainment technology. Customers utilize the company’s products for designing, visualizing and simulating potential outcomes of their project. Among the offerings, Autodesk discriminates among industries:

• In the architecture, engineering and construction industry, Autodesk offers:

  • AutoCAD Civil 3D for ‘surveying, design, analysis, and documentation for civil engineering’.

  • Building Connected, a preconstruction solution.

  • Autodesk Build, ‘a set of project management and collaboration tools’.

  • Revit (Autodesk bought it in 2002 for around 130M), BIM for buildings

  • AutoCAD and AutoCAD LT. The latter makes it easier for sharing documents and collaborating on projects.

• For manufacturing:

  • CAM (computer-aided manufacturing) Solutions includes a range of software that help manufacture, model out, and inspect complex products

  • Fusion 360 “is the first 3D CAD, CAM and computer-aided engineering (CAE) tool of its kind. It connects the entire product development process on a single cloud-based platform”.

  • Inventor is a set of tools that allow for 3D mechanical design, simulation, analysis and documentation. AutoCAD drawings can be integrated and, followed by further instructions, it allows for the virtual final representation of the product, prior to building.

  • Vault is Autodesk’s data management software

• For media and entertainment:

  • Maya is a software that provides 3D modeling, animation, and effects, helping to create high quality content (films, videogames, animations).

  • ShotGrid is a ‘cloud-based software for review and production tracking’.

  • 3ds Max is for modeling, texturing, shading, lightning and rendering. Could be seen as a complement to Maya and both are offered in the Collection.

Autodesk is a business that has a great breadth of products, with exposure to most industries and end-markets. This allows the business to “pack them” and offer them as “Collections”, which encompass a great deal of solutions, addressing all of customers’ problems. This general-purpose approach is what differentiates it from most competitors and, given the technology’s characteristics, Autodesk should continue to lead.

Given its first-mover advantage in many sub-verticals, it holds the leading position with around 60% market share in the CAD market and 65% in the BIM software market, according to 6sense. This translates into the business having finalized their FY23 with over 5bn in revenue. Autodesk’s dominance is natural due to the aforementioned industry and technology fundamentals, which allows the company to have high degrees of pricing power.

“The companies interviewed (from a letter from architects to Autodesk) claim that their costs for licensing Autodesk products increased by 70% between 2015 and 2019 alone” Article

Furthermore, this is a company that has taken advantage of circumstances and continuously adapted to what were seen as positive trends. For example, in 2016, Autodesk made the ultimate decision of turning their business, in its completeness, to a subscription-based one. The decision temporarily depressed Autodesk’s revenue and margins (there’s still not complete optimization here), but led to much more resilience.

The final point, and what I believe should be looked at carefully moving forward, is Fusion. Historically, a big concern customers have had regarding BIM technology was its affordability and the lack of a unified offering. Fusion aims to fill both gaps in the manufacturing space. In 2013, Fusion 360 was launched and, since it is cloud-based, it also allows for seamless collaboration and document sharing. The unique value proposition Autodesk Fusion entails led to rapid adoption and growth. It now has 223,000 subscriptions, which have grown at a 40% CAGR over the past 5 years.

Nemetschek

Nemetschek Group was founded by Prof. Georg Nemetschek in 1963 and was initially focused on structural design. In 1980, the company presented the first software that enabled computer-aided engineering (CAE) on computers. With the pass of decades, Nemetschek expanded operations internationally, acquired several companies, and has broadened its scope of offerings. Nowadays, the company’s market capitalization exceeds 9bn dollars and reported revenues of 858M in its last fiscal year (2022). The company is comprised of 13 brands, which are allocated in four different segments: Design, Build, Manage and Media.

Even though the approach taken resembles that of Autodesk, in the sense that management’s intention seems to be to cover as many end-markets as possible, and to cross-sell with recent signals of a unification, the first difference lies at the corporate structure level. While Autodesk is a classic example of a hierarchical structure, Nemetschek takes a much more decentralized stance. The latter is the parent holding that encompasses these 13 different brands. Even though it makes sure synergies are exploited, each subsidiary is independent, having its own management and goals.

In line with its competitor, Nemetschek switched to focusing on a subscription-based business model. As of the latest fiscal year, recurring revenues represented 66% of the total, up from 43% in 2016.

When speaking about BIM technology, a characteristic that helps differentiate them is how interoperable they are with other software. A closed approach implies for the business to offer an interdependent and closed ecosystem, which is what Autodesk mostly does. On the other hand, Open BIM has been getting traction for the past 15 years, with Nemetschek leading the way. In the AEC industry, Autodesk’s Revit competes with Nemetschek’s Archicad, which got into the Group when it acquired Graphisoft in 2006. Industry efforts have led to developing standards for ensuring interoperability.

Finally, Nemetschek shared a chart and estimate that reveals the huge potential that there is to uncap in the media & entertainment industry. On this occasion, both Autodesk and Nemetschek take the open approach. What might define whether or not the winner is among the two is how well is Nemetschek able to integrate an M&A they did in 2019, Red Giant. The media market is the one expected to expand the most in absolute terms, potentially causing the winner to outperform peers.

“This merger is a major milestone, not only for Maxon and Red Giant but also for the design industry as a whole,” says David McGavran, CEO of Maxon. “Our combined technology and know-how have the potential to progressively reshape the content creation landscape for years to come.” Nemetschek press release

Mensch und Maschine

 Mensch und Maschine (MuM, 907M market cap) is a German company that was founded in 1984 by Adi Droftleff, who still serves as Chairman but is no longer involved in daily operations, with the original intention of distributing Autodesk’s CAD software, which had been just released. Nowadays, MuM Software SE is structured as a holding company, which, underneath, has MuM Management AG, that overtakes management and service tasks. The active operations are performed by approximately 40 direct and indirect subsidiaries, with 1031 employees and 75 locations worldwide.

Mensch und Maschine is composed of two different segments. On the one side, it continues to be a direct distributor of Autodesk’s software to customers. It is important to note that MuM’s distribution encompasses value-added features as well, which is why it’s called Value Added Reselling (VAR):

“The second growth driver are customer specific digitization projects, in which standard software modules are connected to individually tailor-made project solutions, adding functionality where necessary.” 2022 Annual Report

At the same time, it develops and distributes proprietary software. As of 2022, the Value-Added Reselling business generated 70% of total sales, whereas the proprietary software the remaining 30%. Interestingly, the software operates at a 26% EBIT margin, while the VAR segment at around 8%. MuM’s margins have been expanding for the past couple of years due to the software segment gaining share of overall sales.

Alike its peers, Mensch und Maschine has been engaging in M&A operations during the past couple of decades. In some cases, the company built stakes over time. This way, MuM has expanded its portfolio of proprietary sold software and continues to do so. For example, in 2019, it increased its 13.3% position in SOFiSTiK to 51%. Nowadays, the group’s software segment is composed of four subsidiaries:

• Open Mind (Computer Aided Manufaturing). Their solutions are for the “process control of milling, drilling and turning in various industries”. Open Mind is MuM’s biggest software business, with annual sales of over 50M. The average workstation costs around 30 thousand dollars. It is sold at a high price because of the extreme precision and efficiency at which it operates, helping customers get a “quick payback of their high machine tool investments, which are typically in the six to seven digit range”. Open Mind software is compatible with leading CAD products.

• DATAflor. Its solutions are utilized “by landscape architects for the graphic and financial planning of green areas”. DATAflor has been around since 1982 and is one of the leading providers in the German-speaking area.

• M+M Mechatronik specializes in solutions of control, robotics and mechatronics for the market of automated industrialization.

• SOFiSTiK serves the construction industry by developing and providing software. Some of its products are extensions to other companies’ software. For example, SOFiSTiK Bridge + Infrastructure Modeler is an extension to Revit. Furthermore, it is “the only solution for BIM design of bridges and tunnels in Revit”.

In contrast to its competitors, it is unclear whether Mensch und Maschine is placing emphasis on turning their business into a subscription-based one or not. Their VAR business necessarily implies the continuous re-selling of Autodesk’s products to new customers. In MuM’s 2015 annual report, they disclosed that around 30% of their VAR sales were recurring services they needed to provide. Moreover, their proprietary software segment seems to be sold both on a perpetual license and subscription basis.

Conclusion

BIM technology and products that have derived from 3D modeling are utilized in a wide array of industries, not only AEC. The company that almost completely dominates the market is Autodesk, which holds over 50% market share in the main verticals. However, it is important to note that the details with which the software can be developed are infinite in some sense, therefore allowing for the existence of very niche products.

Autodesk’s general-purpose technologies would be the clear winner if we are speaking at a broad level. The network effects they carry should, I think, continue propelling and maintaining their dominance. Moreover, the fact of Autodesk’s portfolio being so comprehensive is what allows the business to take a “closed” BIM approach when it comes to the main verticals in the AEC industry. 

Nemetschek is a business that, like Autodesk, possesses a broad portfolio of offerings. However, generally speaking, the group is aiming for open BIM technology, allowing for cross-interoperability with other software. The strategy should yield handsome results if more solutions are developed. Historically, industries have naturally tended towards modularity, for which there’s a slight probability that this happens in this one as well.

Mensch und Maschine operates as a distributor and value-adding partner of Autodesk, and it is a software provider. The first of both businesses has very low margins given the fact that they re-sell (charged for the license) and adapt Autodesk’s software to specifically address customers’ needs. Business models with this custom-made characteristic are known for the high associated costs. On the software side, MuM owns several players in niche markets.

My sense is that the safest company to bet on is Autodesk, though I suspect the three of them will inevitably capture a great deal of the expected industry growth. I think Autodesk seems the safest, on a modest time horizon, because its products are mostly the ones developers continue to learn in universities. The perhaps riskiest one, without being risky, is Nemetschek, given the completely different approach taken. Time will tell whether or not the industry tends towards the open approach.

Finally, I believe the best risk/reward investment might be Mensch und Maschine. This is due to the fact that I do not think Autodesk will replace it as a distributor nor it will do the job itself. Going after MuM’s low margin business would make no sense for Autodesk, considering the complexity element of doing so. Furthermore, margins should continue to trend upwards for MuM as the software business continues to take share of total sales. Finally, I think niche products like the hyperMILL, offered by Open Mind, will not get displaced at the high end of the market from products such as Fusion 360.

Keep in mind I’m speaking at the fundamental level, not about current prices.

Personal Commentary

This is the last research article I post for free. Most likely, I’ll cover one of this companies in depth in future research. Thank you very much for reading.

Contact: Giulianomana@0to1stockmarket.com

Disclosure: This is not financial advice and shouldn’t be taken as such.

Thesis

Complexity can be either a curse or a blessing. Fortunately, Zoetis thesis is quite straightforward. The company discovers, develops, manufactures and commercializes animal medications. The latter consists of vaccines, medicines, biodevices, diagnostic products and services.

The ultimate goal of such products is to keep animals healthy, and the reason for doing so varies from specie to specie. Nonetheless, the objective is, almost always, to cure, prevent, slow down and/or diagnose diseases. Understanding this is crucial as it is directly linked with the company’s thesis. Zoetis differentiates among two different group of animals; companion and livestock.

Companion animals are dogs, cats and horses. This segment is fueled by economic development, increases in disposable income, increases in pet ownership and spending on pet care. I’ll approach this from two perspectives, the economic and a more philosophical one. Interestingly, the percentage of US households with pets has dramatically increased over the past couple of decades, going from 56% in 1988 to 67% as of 2020, according to the following source.

 It is my view that there is a fundamentally deep driver behind this trend. There’s a book (which I do not recommend) called Homo Deus and wrote by Yuval Noah Harari. Its thesis goes around analyzing humanity’s scientific progress. Ever since our race evolved to its current form, the vast majority of time alive has been destined towards solving global and complex issues, like sickness and poverty. However, these previously giant concerns have been somewhat ‘solved’, with extreme poverty going from 80-90% in the 1800s to less than 5% nowadays. A similar scenario has been playing out in the healthcare dimension. Consequently, humans’ minds are freer than before, allowing us to take a closer look at happiness and things alike.

At the same time, there’s a chapter from Zero to One dedicated to ‘secrets’. Thiel believes secrets are those ideas that are attainable only through very hard work. However, it would be logical to assume that secrets are, even though infinite, more difficult to uncover as more secrets are solved. The past five centuries conform a very successful story of secret-solving in all fields. Therefore, the remaining secrets are more difficult to solve than before, meaning less people will be able to do so.

Dedicating one’s life to something that’s outside the category of a secret could be considered meaningless. The other two set of ideas are conventions, easy to know, and mysteries, impossible to solve. Dedicating to both endeavors could be seen as meaningless due to, in the first case, its easiness and, in the second, its impossibility. Conclusively, there’s an ever-increasing psychological burden on humans.

There’s a book called ‘The Good Life’ which is based on the most longitudinal study of what makes up for a happy and fulfilling life. I have not read it, but heard about it several times. The discovery of the authors is that the best predictor for happiness over the long run is good relationships. The theory has been spreading all over the world now and I believe it not only applies to human relationships. Pets, or companion animals, can also be a fountain that fills people’s lives with meaning.

All of this translates into people’s willingness, with youngsters taking the lead, to spend as much as necessary to alleviate their pets’ pain. This made companies like Zoetis place more emphasis on pets, investing more money for addressing some of their untreated diseases. Consequently, overall pet’s health improved severely and, similarly to what happened with humans, pets life expectancy continues to trend upwards. This means that not only will (in my opinion) be more families adopting pets, but also increase the spend per dog, cat and horse, because of their extended life. A virtuous cycle emerges here. The more the pet lives, the deeper the human-animal bond created, and the more will owners be willing to spend.

According to World Animal Foundation, there are around 900M dogs worldwide and slightly over a half of them are kept as pets. Statista offers a more detailed view on the US, stating that there were 68M dogs as of the year 2000 and 90M in 2017. In the same line, pet dogs in Europe, according to Statista, increased from 73M in 2010 to 92M. The pattern repeats itself across regions.

Dogs are just an example, but the same happens with cats. As a consequence of the continuous reproduction and adoption of pets, clinic visits naturally rise. Veterinarians act as a form of distributors of Zoetis’ products, for which keeping an eye on their business makes sense from an investor perspective. Moreover, it’s curious to see the spend per visit is rising as well, perhaps as a byproduct of the better solutions companies like Zoetis are developing, their greater awareness or even the human-animal bond, which might make owners consider more expensive or simply more medications for their pets.

Moving past companion animals, Zoetis discovers, develops, manufactures and commercializes products for livestock as well. The company’s focus here is “on building and maintaining the health of animals that are in this space”. These help prevent and treat diseases, which enable cost-effective and sustainable production of high quality protein, for example. The demand for high quality protein goes hand in hand with the number of people alive. The more there are, the more mouths to feed.

As a reference, there were around 3bn people in 1960 approximately and 8bn as of 2023. Correlation does not imply causality, but because of the above-provided premise, it’s logical to assume at least some level of causality in this regard. Moving forward, if population continuous to grow, which seems like a valid base case for at least a couple of decades, so should meat and protein consumption.

“Livestock constitute 40% of agricultural output by price and meat production”

Moreover, GDP growth, which drives average household income up, is also a major indicator of what people consume. It has always been the case that lower income families had to eat what was at the lowest point of the food chain, in terms of price. Consequently, expensive things tended to be less consumed. With the high GDP growth the world experienced throughout the past two centuries, average household income went strongly upwards, allowing people to eat more meat, a product that has historically been somewhat scarce and expensive.

A public concern about this is that raising livestock is, according to innumerable studies, hurtful to the environment:

“Raising livestock for human consumption generates nearly 15% of total global greenhouse gas emissions, which is greater than all the transportation emissions combined. It also uses nearly 70% of agricultural land which leads to being the major contributor to deforestation, biodiversity loss and water pollution.” University of Colorado

Nonetheless, over the next couple of decades, in response to an increasing human population, overall food production must increase as well, and here’s an area for improvement. The Food and Agriculture Organization claims that over 20% of animal production losses are linked to animal diseases, which in turn affects the environment, as these are animals whom provided resources are not being utilized. Therefore, there’s this area in which Zoetis can make special emphasis on, innovation products that help increase productivity and improve livestock’s health.

“The FAO recognizes that animal health can also play a key role in both reducing greenhouse gas (GHG) emissions from livestock systems and improving food security. Healthier animals are more productive and generate lower emissions per unit of food produced.”

Conclusively, and to put a number to it, all of this translates into an animal health industry growing at a 4-6% CAGR for the next decade, according to Zoetis estimates. For their five years outlook, stated in the Investor Day of 2023, Zoetis ‘guided’ for mid to high single-digit growth with margin expansion.

Financial soundness

Once expressed the industry’s characteristics and Zoetis’ thesis, it’s easier to conceive why is the animal health industry resilient and non-cyclical. As shown in part 1, it got to even grow during 2008/09, the Global Financial Crisis. People’s willingness to continue paying for the well being of their pets and for food provides some sort of cushion to Zoetis income.

Moreover, many of the products manufactured and sold by Zoetis are of recurrent usage by nature. Cytopoint is a monthly injectable, Librela and Solensia are also for monthly alleviation, Simparica lasts for a month, etc, and they are bought on the basis at which they are utilized. As a result, Zoetis ends up with a large component of recurrent revenue, even if not in the strict sense.

Moving on, there has been this idea in my mind of ‘generational buyers’. In healthcare, once you find a solution that works for your pet, there is no reason why you wouldn’t simply buy such product every single month. This transforms pets into lifelong customers. Most of these diseases are always present, always a threat and almost never completely cured. Once they try Zoetis products, owners will buy from Zoetis until their pet dies.

One thing to keep in mind is the existence of generics in this market, similar to human healthcare, but of lighter presence. Once patents expire, like we’ve seen with Draxxin, competitors launch their generic medicines and can push down prices at the point of their convenience and steal customers away. These events, which whole impact is generally seen in the first 5 years, depresses the leading firm’s revenue and position. However, after and prior to this event occurring, acquired customers are most likely to become lifelong customers.

Anyhow, Zoetis revenue has grown at a 7.01% CAGR since 2010, being 8.08bn in FY 2022 and 8.2bn in the last twelve months (Q2 of 2023 results were a couple of weeks ago). The company’s historical growth goes in line with their outlook moving forward, having outgrown the industry and expecting the same thing to happen. In terms of revenue, Zoetis expects to exceed the industry’s 4-6% CAGR and grow at mid to high single digits.

Before moving down the income statement, I’ll try to distill revenue at the deepest level so that we know how it is generated. As a first parameter, revenue per geography. Zoetis directly markets its products in 45 countries and they are sold in over 100 countries. In 2013, a decade ago and first data available, Zoetis generated 61% of its total revenue from their international segment, which encompasses everything except for the US. However, last year, the company derived 3.68bn, or 46% of its revenue, from non-US countries.

This behavior is something that is further clarified when comparing the nature of Zoetis operations within and outside the United States, which we’ll address below. But some interesting dynamics I’ve observed when comparing 2013 to 2022’s revenue per country.

• Australia’s revenue increased from 176M in 2013 to 289M in 2022

• China’s revenue was 88M initially and 382M last year

• Brazil did 313M in 2013 and 330M in 2022

• US gross margin is at 80.8% while international margin is at 69.3%

Zoetis focus on selling companion animal products has been rapidly translating into their actual revenue. As of 2013, revenue generated from this animal group represented 38% of total sales, while last year, their share was of 65%, which increased 400bps on a yearly basis. In 2022, Zoetis companion animal business did 5.2bn in revenue. This puts the segment’s 12yr CAGR at 11.9%.

Geographical revenue shares, then, is not unintended. In 2013, 55% of US’ revenue came from livestock solutions, while the remaining from companion animals. Nonetheless, in 2022, 77% of US’ revenue was generated by companion animal products. On the other hand, international revenue generated something like 60-70% from livestock in 2013 and 49% in 2013. The larger input from livestock in international markets might be related to their agricultural production, caused by countries like Brazil and Australia.

Moving into revenue per category, there’s been an interesting change during the past decade. In its first annual report, Zoetis disclosed revenue generated by 6 product categories, whereas in its last one, and ever since 2017’s, disclosed 8. The two categories that the company started disclosing later were dermatology and diagnostics. Dermatology’s first disclosure was in 2017, which makes sense given the first product to hit the market was Apoquel in 2013, and diagnostics’ disclosure was in 2016, which did 38M dollars that year.

Here are the sources that generated the 7.74bn in revenue over the fiscal year 2022 (there’s a small percentage that Zoetis derives from other non-pharmaceutical products and contract human manufacturing):

Specifically:

• Parasiticides did 1.86bn in revenue in 2022, growing 13.7% YoY and driven by the three strong brands with Simparica Trio being key. This puts the business unit’s 12yr CAGR at 9.9%, having done 602M in 2010.

• Vaccines were responsible for generating 1.71bn in revenue, growing 2.6% YoY and exhibiting a 12yr CAGR of 4.5%.

• The dermatology’s business unit ‘began’ in 2013 and started being disclosed in 2017, when it generated 428M in revenue. 5 years later, it did 1.32bn, growing 12.6% YoY and achieving a 5yr CAGR of 25%.

• Anti-infectives generated 1.04bn in revenue during 2022, but have been fairly stagnant over the past decade. The business unit’s topline declined 11% YoY, affected by Draxxin’s loss of exclusivity, and has had a -0.3% 12yr CAGR.

• Other pharmaceuticals, where Librela, Cerenia and Rimadyl are included, generated 1.04bn dollars in revenue last year, growing 8% on a yearly basis and mostly driven, I think, by Librela and Solensia’s launch and momentum. Measuring CAGR here makes no sense as there are continuous external shocks to the things included, like the removal of dermatology and diagnostics.

• Diagnostics started being reported in 2016, when the business unit did 38M in revenue. Last year, Zoetis’ diagnostics business did 353M, down 5.6% YoY, but still exhibiting a 6yr CAGR of 45%.

• Medicated feed additives generated 360M in revenue during 2022, down 14% on a yearly basis, yet still having a 12yr CAGR of 12.7%. Nonetheless, this has been a business that was at 347M in 2011, peaked at 505M in 2015 and then declined to today’s levels. Overall and removing 2010 from the equation, stagnant.

Below follows what could easily be the brightest spot of this article. In 2010 (still part of Pfizer but disclosed in their 2012 10-K), Zoetis had a gross profit margin of 63%, an operating margin of 11% and a net profit margin of 3%. In its last fiscal year, the company reported having a 70% gross profit margin, a 36% operating margin and a 26% net profit margin. That implies margins have expanded by 700bps, 2500bps and 2300bps, respectively.

Alongside margin expansion, Zoetis has continuously increased the amount of cash it brings in from operating activities. In 2022, the company had 1.91bn cash generated by operating activities, down from 2021’s 2.2bn and from 2020’s 2.1bn. Last year’s cash from operations were down due to an increase of 120M in inventory expenditure, as the company ramps up their Librela’s storage for its launch in the US. At the same time, there was an extra 206M outflow due to deferred taxes. Contributing to this FCF’s downfall, capital expenditure was 586M, the highest ever, in line with the ‘guided’ manufacturing capacity expansion. Free cash flow was 1.32bn, down from 1.7bn in 2021.

Note: I expanded on the manufacturing capacity expansion in the previous part, you can go there for more details.

I’ll double click in the transition from 2016 to 2017, when Zoetis cash from operations grew 80%+ year on year. Since its IPO, the company had been incurring in multiple costs related to their operational efficiency initiative, ironically, and the supply network strategy. Furthermore, it was completing its separation from Pfizer which was also very costly.

“we're completing our standup from Pfizer, and that's been expensive and lengthy; we are completing – or generally completing the payments for implementing our efficiency initiative and we hope to put those behind us by the end of 2016.”

However, since 2013, management knew and had been claiming Zoetis was not operating at its natural profitability levels. On these types of claims, it is crucial to check management’s legitimacy when stating them. It helps foretell whether they are reliable or not when speaking. In any case, they called for it and it turned out to be true. Thereafter, Zoetis cash from operations never got below the new threshold.

“2016, we don't really demonstrate through our quarter results the real cash-generating properties of our business. 2017 will be the first opportunity for the market to see in our reported results the ability of this company to generate significant free cash flow.”

Going back to capital expenditures, Zoetis has been thoroughly focusing on companion animals both from a CapEx and R&D standpoint because of the segment’s expected outperformance. To this end, for instance, Zoetis developed and is now expanding its manufacturing capacity of Librela and Solensia. However, it’s not only growth what the company is after. Management recognized that products for companion animals can be sold at higher margins, which is the reason why they believe and are still guiding for margin expansion. Librela and Solensia are a perfect example of this, as well as the US business margins, compared to international.

Finally, Zoetis holds in its balance sheet 1.7bn in cash and equivalents, down from 3.5bn at the end of last year. The reason for this drop was “primarily attributable to the repayment of the $1.35 billion aggregate principal amount of our 2013 senior notes due 2023 in February 2023” and perhaps the increased inventory. Out of the 6.5bn long-term debt remaining, 1.35bn will be maturing in 2025, 750M in 2027 and 4.55bn thereafter.

“When you look at the current level of operating cash flow that we have and the strength of our balance sheet, we're able to fund almost the full consideration and still stay within our targeted gross debt to adjusted EBITDA range of 2.5 to 3. So that still leaves us the financial flexibility to fund future strategic investments and also return cash to shareholders through dividends and share repurchases” Q2 2018

A diversified business model

To wrap it all up, the following image aims to illustrate where does Zoetis derive revenue from. It breaks it down as we did above; per major product category, geography, and animal group.

Zoetis sells around 300 product lines that cover 5 major product categories and multiple more but with a smaller reach. It sells to more than 100 countries and 8 species. Moreover, Zoetis’ two largest customers are distributors, and accounted for 14% and 9% of the company’s revenue in 2022. It seems safe to conclude that, even if within the animal health industry, Zoetis has very diverse sources of income and not much exposure to single clients.

Capital allocation skills

A large component of capital allocation in this industry is in line with research & development and CapEx. We’ve thoroughly covered Zoetis R&D model and its results in the first article. A couple of bullet points that help visualize management’s ability to allocate capital:

• Zoetis built the dermatology market up, launching Apoquel in 2013. It now has a 1.3bn monopoly still growing at double digits.

• Launched Simparica Trio, a first of its kind triple therapy, which is now at multiple hundreds of million in revenue.

• Launched Apoquel’s chewable version in 2020.

• Launched Librela and Solensia, disrupting the OA pain market and going from 0 to a 250M run rate in 2 years, with an expected peak of 1bn in sales.

• Developed and delivered 9 out of its 15 blockbusters after IPO.

• Received over 2,000 patent approvals in a decade.

• Expanded gross profit margin, operating margin and net profit margin by 700bps, 2500bps and 2300bps, respectively.

• Outgrew the industry and expects continued outperformance due to the investment focus on companion animals.

• It expects continued margin expansion due to its investment focus as well.

In a more concrete manner, Zoetis had a 47% return on equity, 13% return on assets and 18% return on invested capital in 2022. Over the past decade, it has averaged 49%, 12% and 16% respectively. It is worth mentioning that the high ROE is partly due to the decently sized debt position Zoetis has. Lastly, management mentions in all 10-Ks how crucial of a role does return on invested capital plays on the decisions they take.

“We are making these investments that are prioritized with the highest returns on invested capital… , but also at enhanced margins that drive ROIC accretion as we have done historically” Investor Day

Besides return on investment and initiatives that would drive higher-than-industry growth, Zoetis has a simple framework for deploying capital. Management firstly prioritizes internal opportunities, which consist mainly of R&D, reach expansion with things like direct-to-consumer advertising and increasing manufacturing capacity. All of these help drive organic growth for Zoetis. We could add their occasional inventory build-up, but this works more of a cushion for expected demand. I don’t see it as a way to achieve sustainable growth. Secondly, once high ROIC internal investments have been exhausted, the company looks at M&A which we’ll go over below. Finally, once Zoetis got to create the most amount of value, it looks to return it to shareholders. Each step of this framework was repeated by management in almost all conference calls by both the former and current CFO.

When returning value to shareholders, management stated in multiple years their preference for share repurchases rather than dividends.

“we continue to prefer share repurchase as it does give us flexibility to execute on our other capital allocation priorities” Q1 18

The reasoning behind it is the flexibility these offer, which helps them better decide where to allocate capital. If management believes internal investments make more sense, then they destine less capital to buybacks. On this point, Zoetis approach to buybacks appears to be mostly about consistency with occasional spikes. It’s not the best strategy in my opinion, but not the worst either. Ideally, management would only buy back shares below intrinsic value, but the following chart might somewhat illustrate their willingness to step up if necessary.

Note: Zoetis paused its buyback plan during Q2-Q3-Q4 of 2020 due to COVID’s uncertainty.

“So what drives that flex? It's a combination of the rhythm of the internal investments. So in a year where we see CapEx at a billion dollars for the company, that might translate into slightly less share buybacks. In the years where it's not, you may see a little bit more, but we also look at the timing of M&A transactions and we look at the intrinsic value of our stock compared to our internal long-term growth aspects and the broader markets to drive when we opportunistically flex on the level of buybacks that you see from us” Investor Day 2023

Before going into the last part of this capital allocation analysis and of the article, a chart illustrating buybacks done and dividends paid to shareholders over time. Both help better depict levels and management’s intention.

Acquisitions

Mergers and acquisitions have always been a solid option for Zoetis’ capital deployment. The company utilizes M&A to enhance its current portfolio with more offerings and to expand market reach, mainly. Nonetheless, Zoetis also acquires companies with the intention of horizontally growing its portfolio, setting foot in new areas, like it did with diagnostics.

“External partnerships and acquisitions are also important for innovation and providing us new capabilities to predict, prevent, detect, and treat disease in animals.” Q2 18

“So we remain focused on M&A. We evaluate many opportunities, and we will look to continue to use that as a primary area for capital allocation moving forward.” Q1 21

“Our M&A approach is disciplined. It is focused on driving value creation opportunities within our core, giving us access to enabling technologies and driving innovation” Investor Day

Curious finding here. Management’s narrative is that their approach to M&A is similar to the one of buybacks, consistent buying with occasional big purchases. In Q1 of 2020, they said “our focus is on strategic tuck-in acquisitions, not large scale transformational M&A”. Since IPO, Zoetis has acquired something like 15 companies, with the three largest accounting for a combined 3bn out of the 3.8bn spent in total. However, it’s true that none of these have been transformational. Abaxis, the largest one, had 240M in revenue in 2017 (4.5% of Zoetis rev) and was a ‘pure-play’ in diagnostics.

To finalize this research article, we’ll go over some of Zoetis acquisitions, but before that, an image I put together to help visualize Zoetis acquisition history.

Abaxis, Zoetis move into diagnostics

Zoetis paid approximately 2bn dollars for Abaxis in 2018. The latter was founded in 1989 by Gary Story, Richard Leute and Vladimir Ostoich, from whom only Leute remains involved as a consultant, according to Wikipedia. Abaxis ‘develops, manufactures and commercializes portable blood analysis systems that are used in a broad range of medical specialties in human or veterinary patient care to provide clinicians with rapid blood constituent measurements’. Their two main products are point-of-care instruments and consumables for the medical and veterinary market. An important thing is that “our business and revenue model is focused on recurring revenue”. It was with this acquisition that Zoetis started reporting their diagnostics business in 10-Ks.

In 1994, the company introduced its first product, the VetScan. VetScan VS2, the newest version, ‘is a chesmistry, electrolyte, immunoassay and blood gas analyzer that delivers results from a sample of whole blood, serum or plasma’ that it’s sold to veterinary market segments.

Moreover, Abaxis manufactures and commercializes VetScan Profiles, which are the consumables VetScans use. In 1995, Abaxis launched its first product for humans, Piccolo. It is still commercialized today and, for what I see in Abaxis’ 2017 10-K, it’s more or less the same thing as the VetScan, but for humans. In the same fashion, Abaxis also manufactures Piccolo Profiles.

Zoetis management recognized the big addressable market diagnostics have and that it still offers a great opportunity moving forward. Since the company had no real presence in the market, management decided to make this large acquisition.

“During the year, we made our largest acquisition to-date purchasing Abaxis for $2 billion in the fast-growing point of-care diagnostics space. We see diagnostics as an important area to broaden our portfolio, and we have tremendous growth opportunity ahead, especially in international markets.” Q4 18

“We've used M&A as well to move into areas that are complementary to our core business, like we did with the Abaxis acquisition” Investor Day

To expand its presence, Zoetis started a lab acquisition spree, observed in the acquisition history image. In 2019, it bought Phonix Lab and ZNLabs, both of which were decently sized networks of full service reference laboratories. The market was previously a duopoly, where Idexx and Antech dominated. Allegedly, the former offered to pay 29M for ZNLabs, which was then overbid by Zoetis’ 35M approximately.

"This is huge in an industry that's been dominated by two players for far too long." Gardiner, co-founder of ZNLabs

“This acquisition brings Zoetis a company that has a proven, competitive diagnostic platform for growth that we can help to accelerate in the U.S. and worldwide with our global scale and direct customer relationships in approximately 45 countries,” Zoetis former CEO

In 2020, Zoetis acquired another full service reference lab, Ethos Diagnostic Science, for an undisclosed amount. Ethos performs testing for all veterinary species in wide variety of verticals. The acquisition helped Zoetis expand its reach even more and offer a more holistic portfolio of offerings to clients. Moreover, these 3 lab acquisitions are a fundamental complement to Abaxis.

“Reference laboratories and point-of-care diagnostic testing are highly synergistic, offering veterinarians a single source for a full spectrum of tests, as well as access to the expertise of board-certified specialists and pathologists to support test results.”

“In the last part of 2022, despite the COVID lockdowns, we opened two diagnostic reference labs in Beijing and Shanghai with 200 plus test capabilities available, open day one of our opening.” Investor Day

Finally, Zoetis diagnostics business unit is currently at 350M in annual revenue. Keep in mind that human-related offerings Abaxis had are not included here.

Pharmaq and Zoetis’ emphasis on aquaculture

In 2015, Zoetis announced it had reached an agreement to acquire Pharmaq for 765M. The company was privately held, based in Norway and had approximately 200 employees at that time while it now has around 380. Furthermore:

“PHARMAQ is the market leader in sales of vaccines for farmed fish, a market segment growing 10% annually. The company generated revenues of approximately $80 million in 2014 and has a presence in the major aquaculture markets in the world. PHARMAQ revenue grew at a compound annual growth rate of 17% from 2005 to 2014”

Pharmaq product categories are immune support, biocider, injectable vaccines, therapeutic products and bath/immersion shots. It has operations across 25-30 countries, mostly EU, and offers solutions for 9 species like catfish, shrimps, salmon. At the same time, Pharmaq has a diagnostic laboratory that offers pathogen detection and advisory services. With this acquisition, Zoetis set foot in the only significant area in animal health they were not participating.

In the third quarter of 2016, Zoetis’ management increased their 2017 guidance by 175M in revenue, ‘driven by the acquisition of Pharmaq’ and some other things. We could hypothesize that Pharmaq’s revenue was around 100M. More importantly, it is a company that as of 2015 “has been supporting a substantial investment in R&D and continues to be a profitable business”. In terms of what it brings to the table, Juan Ramón Alaix said the following.

“The acquisition strengthens our core business in three key ways. PHARMAQ expands our customer base into the farm fish segment, it adds to our diverse portfolio a leading vaccine for farm fish and innovative parasiticide as well. PHARMAQ is the market leader in vaccine for farm fish, a market growing 10% annually. And finally, it expands our R&D program in aquatic health, with a strong late-stage pipeline expected to deliver new solutions to the market in the near-term. Zoetis has an excellent track record of identifying and integrating their businesses, and this one meets all our criteria in terms of strategic fit and value” Q3 15, Zoetis former CEO

Most acquisitions are characterized by the cost of synergy they have, when being integrated. Integrating a company that doesn’t have proper S&M, R&D or some other activity requires the acquirer to provide such resources so that the acquired can excel. In this line, when asked, management recognized this is not the case:

“this is not like a classic cost synergy deal; this is a transaction that puts us squarely in a space that's going to grow quickly, that comes to us with a well-developed pipeline featuring near-term opportunities to continue the attractive growth that they deliver” Q3 15

To further consolidate Pharmaq’s position, Zoetis acquired Fish Vet Group in 2020 for an undisclosed amount, but approximately 20M according to internet. In fact, the company is based in Scotland, but also operates in Norway, and was announced as a direct addition to the Pharmaq business. Fish Vet Group offers diagnostic technologies, environmental monitoring and training, PCR testing and services in bacteriology. Additionally, it helps fish producers meet environmental standards.

“Farmed fish is one of the fastest growing sources of animal protein” 2020 article.

Fish Vet Group was then merged with Pharmaq and rebranded as Pharmaq Analytic in 2021 for both of them to proceed as a single entity. This segment would now operate diagnostics and reference labs.

Zoetis’ revenue coming from its fish business was 212M in 2022, growing 13% YoY and at a 15% CAGR for the past 6 years. It continues to show momentum and management has mentioned the business had great quarters in almost all conference calls.

“The fish portfolio benefited from the continued uptake of the Alpha Flux parasiticide in Chile” Q1 20

“Finally, our fish portfolio continues to perform well with double-digit operational growth driven by strong vaccine performance in Norway” Q1 23

Hypothesis

In 2017, Zoetis paid 85M for NexVet, a biologic therapeutics company with this on the pipeline:

“Nexvet’s pipeline product ranevetmab (a mAb targeting nerve-growth factor (NGF)) for pain treatment for dogs would, upon approval, be the industry’s first monoclonal antibody therapy administered monthly by injection for chronic pain”

In a scientific article, I found this:

“Monoclonal antibodies against something like NGF are species-specific. For dogs, the current versions are ranevetmab and bedinvetmab (brand name Librela), which have already been approved in the European Union for use in dogs. Studies have shown that one injection of these compounds leads to an improvement in comfort and mobility for at least eight weeks. The dogs are better off than if they had been given nonsteroidal anti-inflammatories (NSAIDs), which have been the mainstay drugs for osteoarthritis.”

Hypothesis: It’s very likely that Librela and Solensia’s discovery and manufacturing was a byproduct of NexVet acquisition. This means that Zoetis paid 85M for a pipeline that’s now at a 250M run rate and it’s expected to reach 1bn in sales.

Personal commentary

I really enjoyed covering Zoetis, but I believe this will be the last research article for a while. I need to dive into other companies. Hope you enjoyed these 3-part research and it’s very likely that I follow a similar structure for future companies.

Disclosure: This is not financial advice.

Industry

Zoetis belongs to the animal health industry. It would be normal (happened to me) to think this industry is very much alike the human health. But it truly surprised me how much they differ from one another, having the animal health industry undoubtedly better fundamentals for incubating long-durable companies.

The first point I want to highlight is regarding patents. A patent is a governmental grant of a temporary right to exclude others from making, using or selling a claimed invention. In both industries, patents tend to last for around 20 years after the filing date. After the required bureaucracy for granting it, perhaps the patent is left with 17-18 years of utility. Even though this is similar in both ends, there is a huge difference after they expire:

“In human health when you lose patent exclusivity, your revenue erodes by 90 percent within the first year”... “In animal health when a drug loses exclusivity, it might take five years to have an erosion of between 20 to 40 percent.” Juan Ramón Alaix, Zoetis former CEO

I was truly amazed by the statement, which made me research further. Unfortunately, there is almost no information about the animal health industry, but I grabbed three keypoints of the human’s from three different papers:

• A study indicates that drug prices decrease significantly after patent expiration, ranging from 6.6% to 66% after 1-5 years after the patent’s loss of exclusivity (LOE).

• Another study showed that the median drug price after patent expiration decreased by 41% after 4 years.

• The last one showed that after one year of patent expiration, an average of 17.2 producers enter the market. After two years, 25.1. This made the former leader lose a lot of market share and profitability in a brief period.

On the other hand, the lack of players in the animal health industry make a patent expiration event not that crucial. Furthermore, relationships between competitors are mostly rational. The ones that enter a market with a generic drug generally don’t push prices too low because of the industry’s dependence on margins. There’s not a lot of volume in the animal health industry, making drug prices a vital contributor to the bottom line. Additionally, Zoetis management claim this to be a market where pet owners, veterinarians and livestock producers loyalty is very determinant as well. When a patent expires, they tend to stick with the same company. Therefore, companies that earn their trust and goodwill enjoy a long period of recurring selling to them.

Here’s an example of recent patent expirations regarding Draxxin, Zoetis’ largest product in cattle and, to some extent, swine. Prior to Draxxin’s lost of exclusivity, the product was at roughly a 300-350M run rate.

“with respect to Draxxin, we expect it to have about a 20% impact to the top line in the first year, and another 20% in the second” Q2 2022

“The first year was slightly better than our expectations, coming in somewhere around 16% decline, but the second year was little bit worse. So I think we're sort of in that ballpark. I think second year was about 25%” Q4 2022

“We continue to see some impact on Draxxin, but not meaningful, not at the level that we've seen previously,” Q1 2023

Going back to the competition front, one peculiarity of this market is that, unlike human health, there is no large and well-capitalized company that globally competes by focusing on generic products. The reasons for this are the relatively small market size of each product, the importance of direct distribution (direct to consumer, covered later), the self-pay nature of the business and that these products are often directly prescribed and dispensed by veterinarians.

“Phillips said 75% of animal health products have market sales of $1 million/year or less, which isn’t much incentive for a company to go through the development and approval process”

“many were surprised when Alaix described the animal health business as having nearly zero involvement by third-party insurance payers. “Our customers are veterinarians and livestock farmers, and when they make the decision to buy, they are also paying for their purchase”

On a final note, gross margins in the animal health industry are around 60-65%, much lower than in human health. This makes companies that want to compete with generic products more interested in the human health industry because there is a lot of space to compete on price and still be profitable. There is not that same opportunity within the animal health industry, margins don’t allow it.

The lack of competition makes disruption a rare event. Big markets are generally oligopolies and Zoetis leads and has monopolized many small-mid ones. Consequently, products tend to have a very enduring life, helping Zoetis get abnormally high rates of return from its investments.

“our top 25 products have an average time in our portfolio of 27 years, demonstrating our ability to build enduring product franchises.” Annual report 2014

“The average market life of our product is 30 years.” JPM conference, Jan 2023

Moving forward, the R&D process in the animal health industry is much less costly than in the human industry. When beginning research of a particular disease that could affect several species, Zoetis opts for the one that drives the highest success rates. At the same time, clinical trials are shorter in time, leading into lower costs and faster development timelines. Cycles tend to be 2-3 years faster in animal health. Additionally, there is a lot of room, as seen in article 1, for lifecycle innovation, which also contributes to higher success rates. Nevertheless, Zoetis first researches what it could develop and ask customers if they’d pay for such thing, leading to a much lower development risk. All of this translates into the following:

“It's not unheard of to spend hundreds of millions of dollars, over a billion dollars to bring a new product to the market in human health. For the animal health R&D element of our work, we are more in a range of about tens of millions of dollars to bring those new products to the market” Investor Day 2023

Both industries further differ. From what I’ve seen, human health companies focus mainly on product development and drug discovery, which can take a long time:

“Our R&D Pipeline. The process of drug and biological product discovery from initiation through development and to potential regulatory approval is lengthy and can take more than ten years.” Pfizer 2022 10-K

Even though there are mentions of things like increasing product’s ease of consumption, the focus is on pure discovery. Zoetis, on the other hand, has a high percentage of investment destined towards lifecycle innovation. This is much more predictable, which helps the animal health industry grow at steady and continuous rates. Lastly, it is extremely resilient. Part of the reason for this is that, increasingly, more and more people are viewing pets as family and studies show these people would almost always pay what it’s needed to keep them healthy. Even in scenarios where they saw their income decimated.

Another difference between both industries is the required infrastructure to reach customers. This one can also be seen as a huge competitive advantage Zoetis has, and a tall barrier for competition to cross. In the animal health industry, companies need a very extensive sales force. Their role includes:

• Visiting customers to provide information, promote and sell products and services.

• Technical specialists provide scientific consulting to veterinaries, training and education on product use. They also partner with customers to provide further support and training in areas of disease awareness and treatment protocols.

• Pet owners are taking a more active role in product purchasing decision, so Zoetis is investing in DTC marketing efforts.

Conclusively, this translates into longer sales and consulting visits, consequently leading to the need of having a large sales force. As a reference, out of Zoetis 13,800 employees, 4,200 (30%) belong to sales. Pfizer, on the other hand, had around 14% of their total employees on its global sales force in 2016 (last piece of data I found).

Opportunity for small monopolies

We covered in last article what Librela and Solensia were used for. An interesting takeaway from the osteoarthritis (OA) case is how old the problem was and how much it lasted without any solution.

“Curiously, the first registered case of OA is of a dino-bird that lived 130 million years ago. As for dogs, the oldest case traces back to 14 thousand years ago.”

Diseases, sicknesses, virus and all these infections that affect animals are not infinite, but definitely numerous. Furthermore, the amount of variations each of them has, not only within the same specie, but also from specie to specie, makes a large universe of ‘problems to tackle’. Because resources destined to healthcare have been mostly utilized to engage with human-related diseases, the animal health industry still has multiple unexplored verticals.

On dermatitis, treated by Apoquel and Cytopoint:

“Roughly 2500 years ago, the Ancient Greek physician Hippocrates was the first to describe the condition of the chronically itchy skin. “

Although this extract refers to humans, there’s almost no reason to think this was not happening with animals as well. This skin disease was not treated in animals practically until Zoetis launched Apoquel in 2013. Both of these cases illustrate how ancient some of animal health issues are. However, they’ve never been properly attended. For every unattended disease, there’s room for Zoetis to, first, go after a vertical with a known problem. Secondly, since there’s no current solution for these problems, that means there’s also no competition. If Zoetis correctly develops a substance capable of addressing these issues, they will hold an at least short-mid term monopoly over the vertical.

See how each of the following products are “the only”, “the first”:

In many businesses, it can be a problem to identify new problems to solve so that the company’s services create more value for customers. In the animal space, many problems have been identified for decades now, which, by itself, I believe adds some more predictability to R&D. It’s not blind R&D, there are clear objectives and rewards are monopoly-like positions in products that might earn revenue for decades.

Competitive positioning

“Our primary competitors include animal health medicines, vaccines and diagnostic companies such as Boehringer Ingelheim Animal Health Inc., the animal health division of Boehringer Ingelheim GmbH; Merck Animal Health, the animal health division of Merck & Co., Inc.; Elanco Animal Health; and IDEXX Laboratories. There are also several new start-up companies working in the animal health area. In addition, we compete with hundreds of other producers of animal health products throughout the world.”

Boehringer Ingelheim Animal Health

Boehringer is a family-owned, German and, unfortunately, private company. The company operates as a conglomerate of segments, like Pfizer. It was founded in 1885 and, as of today, it’s the largest private company within the pharmaceutical space with 47 thousand employees.

Their animal health business unit operates with 9,500 employees and serves 150 markets worldwide. They are one of the largest providers of vaccines, parasiticides and therapeutics, complemented by diagnostics and monitoring platforms. The company has a strong presence in both large categories of animals: companion and livestock.

Merck Animal Health

Merck is a global health care company that’s involved in prescription medicines, including biologic therapies, vaccines and animal health products. The animal health segment has 6,000 employees (ZoomInfo) and ‘discovers, develops, manufactures and markets a wide range of veterinary pharmaceutical and vaccine products, as well as health management solutions and services, for the prevention, treatment and control of disease in all major livestock and companion animal species’. The company also offers an extensive suite of digitally connected identification, traceability and monitoring products. As Zoetis, it sells its products to veterinarians, distributors, animal producers, farmers and pet owners.

Elanco Animal Health

Elanco was a business unit that operated under Eli Lilly. The spinoff took place in 2018 and Elanco has been independent ever since. As both previous companies, it offers products in many shared verticals and to the two largest groups of animals. The company has around 10 thousand employees.

IDEXX Laboratories

IDEXX was incorporated in Delaware in 1983. Even though it is mentioned by Zoetis as one of their competitors, Idexx is mainly focused on diagnostics and testing, making it not a whole-spectrum competitor. Given I found the company interesting, I’ll provide some more details. Most info is from their 10-K, which is beautifully put together.

Overall, the company develops, manufactures, and distributes products and services primarily for companion animals, livestock and poultry, dairy and water testing industries. Additionally, Idexx provides human medical point-of-care and laboratory diagnostics. Within each segment, the company offers:

• Companion animal group diagnostics: Idexx provides diagnostic capabilities that meet veterinarians’ diverse needs through a variety of modalities, including in-clinic diagnostic solutions and outside reference laboratory services. The curious thing about their diagnostics revenue is that a large part is recurring in nature. This segment generates a total of 3.05bn, out of which 2.6bn is diagnostics recurring revenue. CAG diagnostics operates at a 26% margin.

• Water quality products: Idexx provides testing solutions for detection and quantification of various microbiological parameters in water. The water segment generates 155M in revenue and has a 46% operating margin.

• Livestock, Poultry and Dairy: LPD provides diagnostic tests, services, and related instrumentation that are used to manage the health status of livestock and poultry to improve producers’ efficiency and ensure quality. LPD generates 122M in revenue and has a 16% operating margin.

Competitive landscape

The animal health market was estimated to be at 45bn dollars in 2022. Zoetis performed the estimate based on industry data for core animal health market and diagnostics, genetic tests and biodevices. Aforementioned companies generated:

• Merck’s animal health segment has 5.5bn in revenue

• Elanco did 4.7bn

• Boehringer’s animal health division, 4.6bn (in Euros and FY 2022)

• Zoetis did 8.1bn in revenue

• Idexx Laboratories generated 3.3bn

This results in the following market share as of FY 2022:           

The chart might be slightly off due to the amount of product diversity these companies might have, plus some services that large corporations might not directly include in their animal segment. Leaving this aside, Zoetis is the clear industry leader and seems as if this has been the case for the past decade.

Since going public, Zoetis has managed to continuously outperform its peers, growing its share in the animal health industry. In 2013, the company had an approximate market share of 15%, meaning it has increased its presence by around 240bps.

Competition on patents

A very straightforward parameter to estimate companies’ presence in the industry, beyond revenue, is patents. They give an indication of how big of an intellectual powerhouse these companies are. Moreover, since patents grant exclusivity over certain products/solutions/discoveries, observing how many they have can help get a grasp of how protected their revenue is. There’s a lot of nuance though, as patents differ in quality, but, overall, it is a decent proxy.

Out of the five core players, only two of them disclose the number of patents they have in their 10-K, Zoetis and Elanco. There are some websites specialized in patents, like Greyb, which provide information in this respect, but it is mostly false. There’s a mismatch between the number it presents and the one Zoetis itself reports in their 10K. Likewise with Elanco.

Both companies seem to have a decent portfolio of patents (independent of Elanco’s strangeness in data). Again, there’s a lot of nuances with respect to the quality of each company’s IP and, given my lack of expertise, I cannot get into such details.

Market-specific

From a market-specific standpoint, Zoetis leads in almost all of the ones it participates in.

Diving a bit further, Zoetis holds a 25% market share in the parasiticide market at a 1.8bn run rate; a 95% market share in the dermatology market at a 1.3bn run rate; a 39% market share in the OA pain market at a 200-250M run rate (expected to rapidly grow when Librela gets released in the US); a 13% market share of the vaccine market at a 1.7bn run rate.

A leading position in markets accompanied with the best sales network makes Zoetis a key provider to many veterinarians and third-party veterinary distributors. Consequently, further fueled by the particular brand value products adopt in the animal health space, Zoetis advantage translates into pricing power.

One last thing I want to mention with regard to competition is the scarce visibility companies have with respect to what others are doing. I believe that, because the nature of this game is to work in secret projects until they reach the patent-level (which is when they are revealed), Zoetis cannot know what competition is working in. Furthermore, the whole space is composed of only two large players dedicated 100% to the animal health space. Boehringer and Merck are large companies that have business units in the industry, but they still belong to these large corporations. This, combined with the fact that the space is filled with under-the-radar startups working in disease-specific solutions, makes Zoetis not capable of correctly assessing competition’s capabilities nor pipeline.

“Now, we're never sure about when competition's coming”

“First of all, the timing of competition is never certain, but we're not resting on that. We're continuing to innovate”

“we never have real precision in terms of when competition's coming”

Singular remarks

A high degree of Zoetis’ attention goes to customers satisfaction, with one of their values being ‘customer obsession’. Each company’s product signify a unique experience for customers. Therefore, satisfaction with the service differs across companies. Ultimately, people will buy what they like the most, the experience they enjoyed more, or buy to the people that treated them the best.

“Customer satisfaction or CSAT scores, which as you can see here, are incredibly strong, of 80 and 81. But I'm really most proud of net promoter score, which is if you ask a customer of ours, "Would you recommend us to your friend?" And we have some of the highest scores, 60 in the US and 60 outside the US, but importantly, we're significantly ahead of all of our animal health competitors.” Investor day

Management realizes how vital showing tangible signs of caring towards their customers is, and more so considering the role brand value plays within the industry. In pursue of customer satisfaction, Zoetis offers a refund or product replacement if the person is not ‘completely happy’. What I particularly like about the framing is that it definitely feels like a friendly message, meaning that the company pays attention to those details as well.

Simparica and Simparica Trio are one of the three products we covered in the first article, which belong to the parasiticides market. Simparica Trio is at a 600M revenue run rate as of Q1 of 2023, being one of the biggest contributors to Zoetis topline. Trio supposes a mix of disruptive innovation mixed with lifecycle innovation; a triple therapy is a novelty in the market, but one of the ingredients derives from Simparica. The other two big products Zoetis has in parasiticides are the Revolution and Stronghold brands, both of which we’ll cover in a future article.

The company was a first-mover with Simparica Trio. Here's what management said with regards to competition and what makes Trio unique:

“we've been expecting competition for a TRIO for some time, right? We're now into our third, if not, we're going to be crossing into our fourth year on the product that we've been in the market, we're first to market in the largest parasiticides market in the world, in the US”

“I will stress, though, that TRIO, given heartworm is among the parasiticides that it covers, heartworm is the deadliest. And we have 100% efficacy on heartworm after the first dose. That's an important factor that I want to stress with respect to our products. And again, we'll see what the competition comes out with, but we're very confident in our position and our ability to continue to grow TRIO.”

The second category we thoroughly covered is Dermatology, composed mainly of Cytopoint and Apoquel. Zoetis basically built the market up and now holds an authentic monopoly over it.

With regards to competition and the products’ momentum, here’s management commentary:

“Look, we grew 17% operationally, after a 23% growth year and the growth over the prior two years. I wouldn't expect that level of growth, but I would expect double-digit growth to continue to come from our derm franchise. And we're not expecting competition to be launched in 2023 across derm. So another year of continuing to drive. And even beyond competition, we expect to continue to grow the product. We continue to innovate across this franchise as well.”

The Osteoarthrtitis (OA) pain market is the last one we made special emphasis on. Zoetis developed and manufactured new recipes that brought innovation to a space that was quite sterile. With these new introductions and the ones in Zoetis’ pipeline, the market is now expected to rapidly grow for the next decade.

The company currently holds a 39% market share, but with a remaining expected run rate of 800M for only Librela and Solensia, meaning Zoetis aims to have at least 50-60% market share by 2032.

Manufacturing and supply chain

As aforementioned, one of the barriers that keep many companies out of the animal health industry is the necessity of a proper sales team, an orchestrated supply chain and manufacturing capacity. Zoetis products are manufactured at sites operated both by themselves as well as third-party contract manufacturing organizations (CMOs).

Zoetis self-manages a global network of 29 manufacturing sites. Twelve out of the 29 are located in the US, while most of the remaining in Europe, a few in Oceania, 2 in China and one in Latin America (Brazil). Out of these 29 sites, Zoetis owns the majority of around two thirds of them, while the remaining are being leased. Overall, Zoetis counts with 132 CMOs, including those centrally-managed and others locally done so.

In order to select each of these, the company considers:

• Their capacity

• Their ability to reliably supply products of high quality and at optimized costs

• Access to niche technologies and products

• How efficiently they operate

In pursuit of operational efficiency, Zoetis has been reducing the number of contract manufacturing organizations it works with. There is no mention whatsoever of why exactly this could be happening.

“As a result of a review of our global manufacturing and supply network, we have announced plans to exit or sell certain sites and have exited eight manufacturing sites since 2015, including Yantai (China) and Guarulhos (Brazil) in 2017”

“we regularly inspect and audit our global manufacturing network and CMO sites. As a result of a review of our global manufacturing and supply network, we have exited eight manufacturing sites since 2015.” 2018 10-K

Management has always communicated their intention of always maximizing efficiency. There are several reasons why I believe Zoetis could have reduced their CMO network:

• In 10-Ks, it has been sometimes mentioned the continuous audits Zoetis realizes to their manufacturing sites. As a byproduct of perhaps spotting inefficiency, the company might have been cancelling third-party contracts to concentrate production on sites that operate at high standards.

• A larger percentage of product manufacturing might be shifting towards in-house sites. Not being oneself who performs the manufacturing makes the company dependent on third parties, which is not always desirable. It makes Zoetis lose control over their products and perhaps it is in pursuit of higher vertical integration that they are doing this.

“We believe that animal health customers value high-quality manufacturing and reliability of supply. The importance of quality and safety concerns to pet owners, veterinarians and livestock producers also contributes to animal health brand loyalty, which often continues after the loss of patent-based and regulatory exclusivity. We depend on positive perceptions of the safety and quality of our products by our customers, veterinarians and end-users.”

• There was a slight change to how Zoetis speaks about the number of product lines they have. It seems as if, over the past decade, Zoetis has discontinued several of its product lines, which could ultimately affect manufacturing sites that were solely in charge of producing them.

“In order to sell our products, we must be able to produce and ship our products in sufficient quantities. Many of our products involve complex manufacturing processes and are sole-sourced from certain manufacturing sites”

Going back to Librela and Solensia, management mentioned something that really called my attention with regards to the industry’s fundamentals. For context, both products were released in Europe and received approval in the US, with Solensia having already launched there as well. The whole market showed extreme excitement towards Librela and Solensia everywhere. An excessive demand could be seen as something very positive, but it can be deadly for a company if managed incorrectly.

“you also want to make sure that you have all the supply to do that without having pets get on the product and not being able to sustain them on it.”

It is not enough to only provide an initial supply to the market because these products are of recurring usage in nature. Companies have to make sure they can recurrently manufacture and supply veterinarians and distributors accordingly. To this end, Zoetis has been ramping up capital expenditures to increase manufacturing capacity, mainly focused on Librela and Solensia. If Zoetis launches Librela in the US and demand exceeds supply, the brand (both of Zoetis and Librela) would be extremely hurt.

Zoetis management learned from Apoquel’s release. In 2013, when the product was released, market research showed that efficacy was not much higher than existing therapies. The company then built their manufacturing capacity and inventory based on this information. It turned out to be incorrect, efficacy was extremely high and demand highly outpaced Zoetis capacity to supply the market. Market reaction was very negative. Imagine being a vet or pet owner and not being able of providing the animal with something you know it works. It really damages the company’s image. If Zoetis wasn’t the only player with a product that worked, Apoquel could have been a dead product for consumers and, Zoetis reputation, seriously damaged.

Personal commentary

We now have Zoetis thesis, financials, their acquisition strategy and some more things to cover. I believe it will all be included in the last part of the company’s research, which will be published in two weeks probably. Make sure to subscribe below if you’d like to receive it!

Disclosure: This is not financial advice.