When their $7.25B deal with Roche for their Telavant closes in ~1 month, ROIV will have ~$7.0B ($8.05 / fully diluted share net) in pro forma net cash and public stakes (overwhelmingly their 57% stake in IMVT), worth $3.5B ($4.12 / share), for a total of ~$12 in value. This implies that the current market price ($10.35) is ascribing everything else ROIV owns a negative ~$1.5B value. While many cash burning biotechs trade below cash, few have a recent pedigree as good as ROIV (having just delivered a 110x return on capital for Telavant in 9 months), or as much upside optionality.

 

We think ROIV shares could garner over 100% upside with minimal downside at current levels, an opportunity presented because biotech has become an investment hellscape where market participants are scared of their own shadows. It’s exactly the type of environment in which a value investor can thrive, and we believe ROIV is an extreme case of dislocation from fundamental reality.

 

Before expounding on the myriad of upside catalysts, we want to highlight some of the reasons you should read on:

1. We believe they are poised to return $1.0-2B in capital to shareholders, helping clean up existing holders like Softbank and Sumitomo while reinforcing their commitment to shareholder return and capital-light asset development.

2. IMVT (of which they own 57%) is more likely than not to be sold to large-cap pharma in the next 12 months in light of recent positive data and the ~$28B valuation of competing FcRN maker ARGX.

3. Claims construction on their LNP litigation will begin in February and could unlock significant value.  We estimate that ROIV has ~65% of the economics on the litigation, and that could be worth ~$5 – 10 per share, with royalty rates on the $150B of legacy COVID vaccine sales utilizing LNP technology.

4. Dermavant’s drug (Vtama) is already approved and will see significant TAM expansion when the Atopic Dermatitis indication is approved in 2024.

5. Brepocitinib, which is currently in phase 3 for Dermatomyositis, could represent a potential billion dollar asset opportunity.

6. Multiple smaller but still compelling opportunities in hematology (Hemavant), AI/computational biology (Psivant/Covant), immunology (Kinevant), and health data analytics (Datavant), plus others.

 

In short, we see little downside at current levels, and with upside to a double or more while backing one of the best teams in biotech and taking advantage of a sector undergoing a crisis of confidence following years of investor underperformance.

 

Valuation Summary and R/R

To highlight this compelling opportunity let’s walk through the base, upside, and downside cases.

 

 First, the base case, in which we arrive at $15.61 / share of ~51% upside:

 

 

The assumptions underlying this case are outlined below, but effectively it risk-adjusts a lot of the upside optionality using conservative estimates on the likelihood of success.

 

Next, the downside case – which really exemplifies how ridiculous the current valuation is since the resulting price is 2% ABOVE the current price. Now, a skeptical reader will say that’s impossible, but as discussed in the introduction, since the value of their stake in their pro forma cash and their stake in Immunovant is ~$12 today, thus even accounting for 2 years of cash burn ($1.5B) for which they fail to generate any returns on that investment, you’d still have a value higher than you have today.  This scenario assumes a discount of 40% on IMVT, which given their advantaged tax position and the strength of the data thus far we view as draconian.

 

As to the upside, we see clear upside to over $24 in the event the LNP litigation goes their way, IMVT is sold or garners further clinical success (+50%), and moderate incremental derisking of the other Vants.

 

 

A Note on Taxes:

You will note that we do not tax-affect any of the asset valuations in this analysis, which some might say is aggressive.  However even among seasoned ROIV investors, we think their tax structure is misunderstood and underappreciated.  The upshot is ROIV pays no taxes on the sale of any of the individual Vants. This is due to the fact non-UK shareholders are not liable for United Kingdom corporation tax on capital gains realized from the sale of common shares.  As ROIV (the parent) is domiciled in Bermuda (thus a non-UK shareholder) and holds the shares in each Vant through a UK subsidiary, they don’t pay UK capital gains and Bermuda has no capital gains tax.

 

TL;DR Version of Background on Roivant

 

Roivant was founded in 2014 by Vivek Ramaswamy (not involved anymore) with an idea to incubate a number of subsidiaries (“Vants”) in different therapeutic modalities while applying a consistent, mercenary capital allocation policy across all of them.  The process, which you can see in action as we walk through the various Vants, is depicted below:

 

 

Vivek stepped down in 2021, the same year ROIV went public via a SPAC transaction with Patient Square’s SPAC. Due to Vivek’s increasing political aspirations he stepped off the board in early 2023.  Since that time, the company has been led by Matt Gline who joined in 2016 as CFO and who has a somewhat non-traditional biotech CEO background, having been an investment banker at Goldman and Barclays/Lehman, with a focus on fixed income structuring and risk management.

 

We have diligenced and interacted extensively with Matt and find him to be thoughtful and pragmatic, notable in a sector whose CEOs appear to have checked their pragmatism at the door chasing lottery ticket wins funded by a belief in unlimited equity funding.  He transacted Datavant in 2021 through the merger with CIOX, has been instrumental in in-licensing the drug that is now IMVT-1402 in 2022, and most recently orchestrated the TL1a deal with Pfizer and subsequent exit to Roche for a 110x return.

 

The Major Vants 

 

Immunovant

The largest contributor to the SOTP (after cash) and the most likely to be sold, ROIV’s stake in IMVT gives the company significant strategic optionality.

 

The most financially important of the Vants (although not the biggest driver of the share price scenarios), IMVT is developing drugs that inhibit FcRn, a receptor that helps perpetuate IgG antibodies, a type of immune cell that in autoimmune conditions can attack healthy tissue.  By inhibiting a receptor that protects those cells, IgG levels decline, thereby lessening disease burden and improving a patient’s symptoms.  There are two approved FcRns today, VYVGART from Argenx (ARGX), which was approved in 2021 and is expected to generate over $10B in peak sales, and RYSTIGGO from UCB which was approved in July.  JNJ has a robust FcRn program they acquired in 2020 through the $6.5B acquisition of Momenta.

 

With that backdrop, let’s discuss the investment opportunity around IMVT.  ROIV owns ~57% of IMVT and has participated in capital raises to maintain that level of ownership.  In effect that means that for all decisions ROIV is the ultimate decision maker and the cost of developing drugs is borne roughly 60/40 with the public shareholders.  IMVT has had notable ups and downs since going public in 2019, most notable the safety concerns which derailed the development of IMVT-1401, their original attempt at designing an FcRn antibody.  While potent, 1401 was found to also bind to albumin, the inhibition of which leads to increased LDL cholesterol (which is bad).  ROIV and IMVT worked to license the molecule which is now IMVT-1402 and presented data in September that demonstrated 1402 has similarly potent IgG suppression but without any impact on albumin or LDL.

 

This chart from their multiple ascending dose trial demonstrates the magnitude of effect on IgG:

 

 

Now, this data is in healthy volunteers, but we have robust backup from ARGX that healthy volunteer data translates to patients. To backup that claim, see the following chart from the EU review of VYVGART which shows 3 trials worth of IgG suppression, spanning both healthy volunteers (in red) and patients with generalized myasthenia gravis, their first approved indication.

 

 

In short we believe the IMVT healthy volunteer data to be substantially derisking, and while VYGART achieves 50-60% IgG suppression in their trials, we believe 1402’s 74% (and deepening to 80% over time) response in higher doses provide the opportunity for it to become a more potent option for patients across a range of conditions.

 

To characterize the opportunity simply, many indications for IVIG (Intravenous Immunoglobulin) are effectively targets for FcRn.  That’s because IVIG therapy aims to suppress aberrant IVIG caused by an autoimmune condition by adding healthy donor IVIG to a patient’s blood, thus diluting the diseased IgG. If you look at the revenue generated by companies like CSL, Grifols, and Takeda in this field, the numbers add up quickly: it’s estimated IVIG generates $6B in revenue in the US and over $8.5B globally.

 

Finally here is ARGX’s landscape of indications they intend to pursue: the breadth of the opportunity is the reason IMVT has an opportunity to both move first on some indication and differentiate itself.

 

 

Today IMVT shares trade at ~$44, equating to a market cap of ~$6.3B.  ROIV owns slightly under 80M shares worth $3.5B or ~$4.12 per ROIV share.  We believe it’s more likely than not that ROIV elects to sell IMVT, particularly considering the current ROIV valuation, which could come at a substantial premium in light of comps and the success of VYGART in the market.

 

Priovant

A derisked asset partnered with Pfizer with multiple shots on goal to make a billion dollar plus business

 

Priovant was set up to develop Brepocitinib (Brepo), which was licensed from Pfizer in 2021, and is presently 25% owned by Pfizer (the same structure as Telavant).  Brepocitinib is a dual inhibitor of TYK2 and JAK1, both known to be active targets across a range of inflammatory conditions. Development to date has consisted of six positive phase 2 trials, as depicted below, plus the failed phase 2 in systemic lupus erythematosus (SLE) announced in November.

 

 

And here is how these results compare vs competitive TYK2 agents:

 

 

To take a giant step back: 1) inhibition of TYK2 and JAK1 is unequivocally effective in the treatment of autoimmune diseases, 2) Brepo is an active agent against both of those targets, 3) competitive molecules Sotyktu (TYK2) and Rinvoq (JAK1) are multi-billion dollar blockbuster drugs, and 4) there is evidence Brepo could be more effective than either in a range of conditions.  So why does Priovant get, effectively, negative value in ROIV’s valuation today? Because they are late to the party (Rinvoq approved in 2019, Sotyktu in 2022), it contains JAK1 which means it will carry a black box warning like all JAKs, and perhaps most importantly: despite the phase 2 successes, ROIV is attempting to differentiate Brepo by running phase 3 trials in areas where the competition is either non-existent (dermatomyositis or “DM”, the lead indication) or can be a fast follower to competitive approvals (Hidraenitis Suppurativa or “HS” and Non-infectious uveitis or “NIU”)

 

Their strategy is one of high risk / high reward. In DM, ROIV did not run a phase 2, instead electing to move directly to phase 3 based on a proof of concept shown by an open label study of 10 patients by the JAK1/2/3 inhibitor Tofacitinib (Xeljanz). If successful in the phase 3 trial in 2024, Brepo would become the first-and-only oral agent for DM.

 

In terms of what success means: ARGX presented the following patient numbers, and Cowen did some research below on sizing the opportunity:

 

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Assuming 25% patient share, and pricing in line with Sotyktu, Brepo could generate ~$540M in the US alone. With IP out to 2038, we believe Brepo would garner at least 3x peak sales, so that would be worth ~$1.6B.  Assuming 50% odds of success, the risk-adjusted value for DM would be $800M.

 

A note on the recent failure of SLE:  Lupus has remained a difficult disease to successfully demonstrate efficacy in, for 2 reasons: 1) it’s heterogeneous, meaning people with SLE manifest different vary symptoms from one another and 2) high placebo response rates in trials (and as was seen in ROIV’s trial).  In 60 years there have been just 3 approvals in Lupus and 2 of those have been in Lupus Nephritis, the kidney disease complication of SLE.

 

Assuming just those 50% odds of approval in DM, we get $800M in adjusted EV for Priovant and $200M in pipeline value for the other indications, while assuming it will burn $300M to see them to profitability, arriving at a net value equity of $700M.  ROIV owns 75%, which is diluted to 68% to account for options / equity for the team, so $476 to ROIV shareholders or ~$0.56 per share.  Upside to $1.5B if the DM trial is successful and therefore derisked.

 

Genevant

Drug delivery innovator whose patent cases vs mRNA vaccine makers could be worth $10B or more

 

To not bury the lede: Genevant (and therefore ROIV given their ~65% economics) could be entitled to $5-10B in damages from MRNA and PFE/BNTX if they win in court. So with that provocative headline, here are the details on Genevant:

 

Genevant is ROIV’s development subsidiary for lipid nanoparticles (LNPs).  In layman’s terms, LNPs are effectively tiny balls of fat (lipid) that act as the vehicle to carry nucleic acid (such as DNA or RNA) to the body, in order to protect that acid from being degraded as it makes its way to the body’s cells. The most famous and topical use case for LNPs is mRNA vaccines for COVID, as both MRNA and PFE/BNTX used the technology.  The crux of the investment case on Genevant is that while the companies rushed to develop a vaccine, thereby generating a cumulative $150B in revenue during the pandemic, they did so while brazenly using IP that rightfully belongs to Genevant.  Genevant is now suing both companies for compensation.

 

The structure of the LNP economics is somewhat complicated. Genevant and Arbutus (ABUS) split the economics 80/20 from the LNP patent estate. From there ROIV owns 67% diluted share of Genevant, while ABUS owns 13% of Genevant, and ROIV then owns 24% of ABUS. The upshot of this is that ROIV owns ~65% of total economics from the LNP estate.

 

Here is a somewhat outdated (Genevant has subsequently sued PFE) but generally accurate schematic of the parties involved in the litigation.

 

MRNA Complaint (filed 8/28/22):

https://investor.arbutusbio.com/static-files/193fff17-0bdd-4287-8dfd-3617d3bf7850

 

PFE Complaint (filed 4/4/23): https://investor.arbutusbio.com/static-files/8c1e9e82-296c-448b-b973-7ef908c99948

 

The patents at issue against MRNA here are as follows:

 

The key to the patent litigation is the molar lipid ratios covered by the ABUS Particle Composition patents. This slide from 2022 outlines ROIV’s logic and the evidence backing up their infringement claims against MRNA.

 

1. 2020 Preprint from the NIH/Moderna team regarding the development of MRNA’s vaccine, contains the following passage highlighting a ratio of 50:10:38.5:1.5 when discussing SARS-CoV-2 lipid formulation.

 

 

(found here: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7301911/)

 

2. 2020 NEJM: The MRNA/NIH publication includes cites yet another MRNA-authored paper published in Cell’s Molecular Therapy Nucleic Acids journal called “Optimization of lipid nanoparticles for intramuscular administration of mRNA vaccines” (https://www.cell.com/molecular-therapy-family/nucleic-acids/fulltext/S2162-2531(19)30017-4), which contains a preparation in the identical ratio:

 

 

3. The International Patent can be found here (https://patentscope.wipo.int/search/en/detail.jsf?docId=WO2021159130) and contains the following, yet again, identical, molar ratio.

 

 

The conclusion of all this appears to be that MRNA used that same 50:10:38.5:1.5 lipid ratio, which puts it squarely in the ratios covered by the 5 patents stated above.

 

The Pfizer lawsuit contains 3 of the same patents as the MRNA action (‘359, ‘378, ‘651) while adding 2 additional ones (‘320, ‘098).  The additional patents are newer, having been issued subsequent to the MRNA suit and therefore are included here.  One wrinkle on the PFE lawsuit is that in 2018 BionTech licensed LNP technology from Genevant but only for specific cancer and rare liver disease indications, not for infectious diseases.  The additional wrinkle is that prior to filing the lawsuit in 2023, Pfizer and Genevant had licensing discussions but those discussions failed to result in a settlement and now the matter is before the court.

 

On the two additional patents: Both the ‘320 and ‘098 patents cover the production method of using 2 solutions which are added to a mixing chamber from opposite ends.  Genevant effectively states that PFE’s demonstrated use of T-Mixers in manufacturing the vaccine infringes these patents. One additional explanation for the inclusion of these patents might, ironically, be the publication of PFE CEO Albert Bourla’s book MOONSHOT in 2022, which outlines the PFE manufacturing process.

 

In terms of damages, we use a range of mid to high single digits.  Gevevant has published its current licensing arrangements which support that range.

 

 

So for our analysis we use a range of 3 – 9% and calculate damages based on cumulative revenue in the table below. Obviously if they lose the case ROIV gets nothing and therefore that is our downside case.

 

 

Note, this doesn’t include value for future vaccine sales, which in any settlement or ultimate court decision, would likely be additive as the vaccine makers would be required to take a license on existing infringing materials.

 

Dermavant

ROIV’s only commercial business, viewed by the street as NPV negative given cash burn, but with a significant market opportunity we believe is underappreciated

Dermavant holds the sole commercial asset of ROIV today: VTAMA, a cream for psoriasis (approved currently) and atopic dermatitis (approval pending in 2024). In FQ2 VTAMA generated $18.4M in revenue in Q4 ($74M annualized) at a 28% gross to net (meaning they got a net price equal to 28% of the list (gross) price. The GTN yield is relevant because as a topical in dermatology the payors put a lot of hurdles in place to prevent rapid adoption since dermatologists are regarded as frivolous with their usage vs systemic therapies. Roivant has a stated goal of a 50% GTN yield over the next few years, which, to put another way, implies ~80% embedded net price growth from current levels, on top of whatever additional volume they are able to achieve.

 

 

So while it continues to grow significantly, like many pharmaceutical launches (especially in dermatology) this must be set against the fact they are spending ~$75M a quarter to launch the drug.  As they launch atopic dermatitis, near-term burn could increase, but ultimately the scale of the opportunity is immense.  This bridge shows the magnitude of the market VTAMA is attempting to address:

 

 

This chart sells a pretty straightforward story: for these conditions everyone uses topical steroids.  Topical steroids have a number of clinical downsides for patients: chronic use results in thinning skin, which often restricts their use on facial areas, and can also include rash, increased hair growth, easy bruising among other side effects.  VTAMA, as a novel topical, was designed to avoid the clear downsides presented by steroids.

 

Today VTAMA has ~1% market share of topicals for Psoriasis and AD, with >90% of those written today being steroids.  If VTAMA gets to 5% share and achieves their targeted gross to net improvement, quarterly revenue would increase from Q3’s $18M to $158M or $632M annualized.  Putting a 3x multiple on that, we get $1.9B in EV.  Assuming $400M in cumulative burn to profitability and including the NPV of their NovaQuest funding debt, we get an equity value of $1.2B in our base case or $1.21 per ROIV share.

 

Datavant

Minority stake in a fast growing and profitable software business

 

So Datavant is pretty opaque, both operationally (because its mandate is so broad) and in terms of current valuation (which is likely down from its last transaction). Datavant is a clearinghouse of health data with the aim of connecting patient data with payors, providers, drug companies, etc. to facilitate some sort of favorable health outcome (albeit mostly with a research focus). The most common use case is for the enrollment of drug trials – instead of weeding through individual databases to find patients who qualify for a trial, you can speed up this process using Datavant which stitches together a number of databases using compliant, de-identified patient records to help the company find potential eligible patients more quickly.  Patients benefit because they get access to trials outside of their specific institution, while drug companies benefit because all of the laborious data collection and processing is already done in a compliant manner.

 

In terms of valuation, in June 2021 Datavant merged with Ciox Health, a leader in clinical data exchange in a deal valued at $7.0B. Based on our research, the merged company (also called Datavant) is doing roughly $200M in EBITDA.  But we don’t know how quickly it’s growing, which makes putting a valuation range on it rather challenging.  With those 2 data points in mind, we use a range of $2.5 – $5.0B or 12.5x – 25x LTM EBITDA, with a base case of $3.5B or 17.5x EBITDA.  This base valuation is a 50% discount to the merger valuation which makes sense given a general contraction in multiples since then, and the fact VC valuations can be ephemeral even in the best of times.

 

Roivant owns ~17% of Class A units in the Ciox Parent, but as Ciox has multiple classes of stock that would dilute that total ownership, we estimate their true economic ownership at ~12%.  With that in mind, the Datavant stake is worth $375 – $600M, with a base case of $420M or ~$0.50 per ROIV share.

 

The Minor Vants

Significant market opportunities, but earlier in their development lifecycle = cheap optionality for ROIV shareholders

We will do an abbreviated summary for each of these, since they don’t contribute a ton of value to the SOTP, nevertheless they still have significant optionality that is completely ignored by the market.

 

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Kinevant – Kinevant is  developing Namilumab, a GM-CSF inhibitor for sarcoidosis. Sarcoidosis is an immune driven inflammatory disease suffered by ~150k people in the US, and typically affects the lungs but can affect other organ systems as well.  Treatment today consists largely of immunosuppressants (which has negative effects on overall health) and organ specific drugs to alleviate symptoms (such as joints).  Granulocyte macrophage colony stimulating factor (GM-CSF) is implicated in the development of sarcoidosis’s granulomas, so the theory is the inhibition of that factor will lead to a reduction in symptoms and tissue damage.

Kinevant dosed the 1st patient in their 100 patient phase 2 in 2022, with results expected in 2H 2024.

 

Hemavant – Hemavant is developing RVT-2001, an inhibitor of SF3B1.This one gets into some SCIENCE so bear with me.  SF3B1 is a spliceosome protein that is mutated in ~80% of MDS-RS (myelodysplastic syndrome with ring sideroblasts). While the mutation is actually associated with positive prognostic value (i.e. lower risk disease, which still has an expected survival of only ~5 years), it causes ineffective erythropoiesis, which results in both low sodium and low iron conditions in patients.  Today these conditions are treated by erythropoiesis-stimulating agents (ESAs), but eventually do progress to becoming red blood cell dependent over time (i.e. you require blood transfusions for life).

There is some data for Hemavant, which can be found here (https://ashpublications.org/blood/article/134/Supplement_1/673/426543/Results-of-a-Clinical-Trial-of-H3B-8800-a-Splicing) that shows in an early study 14% of patients treated with RVT-2001 (then called H3B-8800) had decreased requirements for transfusions.

To summarize the current state of play, RVT-2001 is being studied to find out if lower risk but still transfusion-dependent patients with the mutation could benefit from SF3B1 with the aim of reducing their dependence on donor blood over time.  There are ~120,000 MDS patients in the USA and ~30k per year in new diagnoses, the majority (60-70%) of which are considered lower risk, implying ~60k current patients in the U.S. who are lower risk and have a SF3B1 mutation.  Using the price for BMS’s luspatercept ($200k/yr), which was approved in 2020 for in low-to-intermediate MDS with anemia, and assuming 20% peak penetration, we arrive at $2.4B in peak sales for the drug.  Given the modest results to date (luspatercept had a 25% placebo adjusted response as a point of comparison), we’ll risk-adjust this heavily, and therefore include only $200M in value for the drug in our base case SOTP.

 

Covant – We’ll keep this brief.  Covant was incubated at ROIV to accelerate drug discovery through the use of proteomics (basically next-gen mass spectrometry) to optimize proteins for covalency.  In March 2023 they announced their first partnership with Boehringer Ingelheim on the discovery of drugs targeting ADAR1, where Covant received $10M upfront, plus $471M in additional milestones and tiered royalties on global sales.  Covant is so early we only include a range of values from $0 – $50M today, but it could provide additional optionality over time as the opportunity becomes more clear.

 

Psivant – Psivant was created through the acquisition of Silicon Therapeutics in 2021, for $450M in ROIV stock plus additional milestone payments.  Silicon Therapeutics had built a platform for developing small molecule drug candidates using computational methods and their own supercomputer.  ROIV has indicated they would not do another deal of a “platform” like this, and while they are happy they own it and do think it will eventually result in attractive new assets, management acknowledges the price they paid was too high and the market no longer values computational discovery platforms like they once did.

In all scenarios we value Psivant below the price ROIV paid for it 2 years ago.  Our base case represents a ~50% haircut to that price and reflects 1) the lack of process towards an asset in a clinic thus far and 2) declining market valuations for public market assets utilizing computational biology (computational biology peer SDGR, for example, is down 67% during that same time period).

 

VantAI – VantAI is another asset which could be very exciting given they are in a hot area (AI-driven drug discovery with a focus on molecular design) and have high profile partners (JNJ, Boehinger Ingelheim, Blueprint Medicines). The flip side of this is without clear assets or economics behind these partnerships, it’s nigh impossible to value it with any level of accuracy. So while we have a placeholder valuation today, I believe ROIV is planning to raise venture funding at VantAI in the next 12 months which will hopefully put some numbers around what the asset could be worth.

 

Lokavant – Lokavant is effectively a software dashboard to accelerate and improve clinical trial enrollment.  Conducting an effective trial on time and on budget is critically important to any biotech, so ROIV developed their own tools to optimize how those are monitored (keep in mind, the trials themselves are largely conducted by academic hospitals, but the company works with those trial sites to ensure both speed and trial integrity are progressing according to plan).  We put a small value here, since while the software does address a real need, we just don’t know what it’s worth. To date they have raised $29M in venture funding, but that includes ROIV’s participation, so it’s hard to extrapolate with any precision.  ROIV currently owns 56% on a fully diluted basis.

 

Technical Dynamics

An overhang on shares but also near term capital deployment opportunity for ROIV

 

Normally we wouldn’t address technical dynamics as we believe a long term investor will focus solely on fundamentals and be rewarded, but there are some specific elements of ROIV’s capital structure that warrant discussion.

 

 

QVT – Vivek’s former employer, which has now converted into a family office.  They have board representation and appear only to sell when they need liquidity to manage the wind down of their remaining LP commitments (so far roughly 1x per year).

 

Dexcel – The largest private pharmaceutical company in Israel, the Co-CEO of which is the Chairman of ROIV’s board of directors.  They participated in the seed financing of ROIV and have never sold.

 

Viking – Invested in 2016 in their private fund.  Have sold modestly this year, but based on our understanding they did so for position size reasons and are not sellers at the current valuation.

 

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Softbank – Invested $1.1B in 2017 and have sold periodically, largely in keeping with the woes of the Vision Fund more broadly.  Ultimately we think they continue selling periodically, but apparently have not been sellers post the sale of Telavant despite the end of their lock-up in early November.

 

Sumitomo – The most obviously problematic shareholder today.  They have publicly expressed the goal of reducing leverage through the sale of up to ¥150B in cross holdings and equity method investments, the largest liquid of which is ROIV shares.  Sumitomo is locked up until February 2024.

 

Vivek – Personally we are of the view that Vivek only sells if forced, specifically if forced because he has been appointed to a Republican cabinet and therefore gets to avail himself of the same federal loophole (Section 1043) that Hank Paulson took advantage of when appointed Treasury Secretary: “individuals who are forced to sell stock to meet federal conflict-of-interest rules to defer paying capital gains tax, so long as the proceeds are reinvested in government bonds, diversified index funds and other similar instruments”.  While we appreciate this theory is slightly conspiratorial, the fact he defer taxes indefinitely might explain, in part, Vivek’s continued presidential ambitions.

 

There is good news about this dynamic for ROIV: they have $7B in cash to address these technical overhangs.  We believe ROIV is actively working on preventing chunky sellers from reaching the market (part of their “we’re being patient” capital stance today), which means we could see 10-15% of shares outstanding retired through chunky transactions in the near term, resulting in accelerated value accretion for shareholders.

 

Conclusion

 

ROIV represents a compelling R/R situation at current levels, with substantial optionality embedded across the portfolio, the cash to see that optionality through to value inflection points, and a management team that is pragmatically focused on asset light development and the eventual return of capital.  Perhaps the most underappreciated part of the ROIV story is that the unknown pieces very well might end up being the most valuable.  If you rewound the ROIV story a year from the announcement of the TL1a deal in October, ROIV would not have had TL1a or unveiled the existence of IMVT-1402, since IMVT was still recovering from the safety problems of 1401.  Today, those 2 assets ALONE are worth ~$10.60 to ROIV shareholders ($6.48 in cash from TL1a, $4.12 in IMVT shares) for which in that year they only paid $50M in development costs with no upfront to PFE and $30M upfront to HanAll in Korea for 1402, plus probably $100M in development to date, so ~$0.25 per ROIV share in outlays.

The point is, a year from now ROIV will likely look very different and the stock today offers a profound discount to the myriad of options, both known and unknown, which could prove valuable in the future.

 

Integra manufactures medical products used in neurological and wound-related surgeries

Segments include (1) Codman Specialty Surgical (CSS) (65% of Sales, 64% of Segment Profit) and (2) Tissue Technologies (TT) (35% of sales, 36% of Segment Profit).

Codman (CSS) produces neurosurgical equipment that helps treat brain lesions, traumatic brain injury and hydrocephalus.  Products include regenerative tissues for dura mater, ablation systems, brain pressure monitors, endoscopes, and valves & catheters.  Additionally, Codman offers instruments that are used in various surgeries (primarily neuro and ear, nose and throat).  Codman was purchased in 2017 by Integra, nearly doubling its neurosurgery sub-segment.

Tissue Tech (TT) produces grafts that are used to help wounds heal, including chronic wounds and post-surgery wounds.  Additionally, the company provides collagen products on a private label basis in this segment. Raw materials used in the tissue segment include bovine collagen, bovine skin, porcine urinary bladder, human amniotic tissue and synthetic mesh.

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Integra’s brands are requested specifically by surgeons, because (1) its products perform better for certain specific use cases, and (2) physicians have an affinity and familiarity with its products given their tenured history in the market.  Hospitals ultimately purchase Integra’s products, but on the back of surgeons’ demands.

Surgeries in which the products are used are non-discretionary.  At best, surgeries can be deferred (at most for 60 to 90 days).  Surgeries are largely covered by health insurance (primarily commercial and Medicare insurance).

Products are largely recurring and relatively low-cost.  Recurring consumable products represent ~90% of sales.  Hospital capex-driven items are only ~6% of sales

Prices vary, but are relatively low-cost versus other hospital items.  For example, the most expensive Codman product is CUSA Tissue Ablation at $2,000, and the Tissue products range from $600 to $3,000 per single application

Sales reps manage relationships with surgeon customers for 70% of sales.  The remaining 30% of sales that are indirect go through distributors to international customers.

The company was founded in 1989 by Dr. Richard Caruso, and was the first to bring to market a tissue regeneration product (to treat burns and scars) approved by the FDA in 1996.  Integra grew largely through M&A under Dr. Stuart Essig PhD (CEO from 1997 to 2012), an ex Goldman Banker.  More recently, CEO Pete Arduini (CEO from 2012 to 2021) divested assets and focused the company on its 2 current core markets (i.e., neuro, tissue) in higher-margin, higher value-added products.

Manufacturing is done across 14 sites and distributed through 4 DCs.  HQ based in Princeton, NJ. Employee count is ~3,700.

 

Thesis

1. Well-positioned player in recession-resistant, MSD% growth end-markets.

Integra founded the regenerative tissue industry, and is a well-respected brand amongst customers.  Codman is also an early mover and leader in its space.  With strong, leading market-share brands, and technological/regulatory barriers to entry, Integra is favorably positioned to at least grow in-line with the industry.

We believe the company’s share is protected by its core competitive advantages, including:

(1) Brand name:  Integra founded the tissue regeneration space, and Codman is a 185-year-old brand (owned by Johnson & Johnson since the 1960s) with a well-recognized, high-quality brand name as well

(2) First-mover advantage:  Products are physician preference, creating sticky customer relationships that benefits the first mover

(3) Technological know-how:  Not only are there high technological barriers to entry, but once developed, the products must meet strict FDA standards given they could be fatal if not designed and manufactured correctly.  This provides a natural barrier to entry, and ensures that only ~3 or so players compete across most of Integra’s product areas

(4) Sales representatives:  Integra prides itself on staffing a market-leading neurosurgery sales team, which provides stronger customer relationships versus peers.  Competitors are focused on a broader product set than just neurological and tissue, or have smaller scale if they are focused on these products, and so their sales teams are not as deep in these product areas

Industry growth of MSD% is driven by price, population, technological innovation and increased diagnosis of chronic conditions such as diabetes, stroke, breast cancer, etc.  Integra’s guidance calls for market growth of ~4.5% to ~6.5%.

 

2. Disrupted valuation due to exaggerated fears surrounding recent (1) recalls and (2) management changes.

Valuation has compressed from a P/E of ~20x+ to ~11x, due to a recent product recall (i.e., the Boston facility recall in May 2023).  Combined with a prior recall (i.e., the CereLink ICP Monitor recall in August 2022) and recent management changes (new CEO and recent CFO departure), the Boston recall caused existing investors to capitulate after a string of bad news.

We believe the causes underlying these recalls and management changes are not symptomatic of any larger structural issue at Integra, but instead represent self-contained, one-off challenges that will fade with time.  We believe the market’s short-term fears are creating a compelling long-term return opportunity.

Based on our field calls/primary research, we believe both recalls pass this framework suggesting limited long-term downside risk for the following reasons:

(1) Limited substitutes:  Expert network feedback on the Boston facility’s tissue products is that each product in the market addresses a unique patient scenario, which makes finding substitutes difficult.  PriMatrix, in particular, has nothing else that works remotely close to it; one surgeon said that he may be forced to amputate patient limbs because PriMatrix was not available.  It’s also difficult to find replacements for SurgiMend because of its unique thickness and biologics.  Replacements exist, but they are supposedly not ideal.  For the CereLink monitor, product substitution is less of an issue because customers are generally currently using the old iteration of the product.

(2) Strong brands:  Integra founded the regenerative tissue space, and so has a strong, well-respected brand according to our calls.  CereLink is under the Codman segment, which also has a long history in its markets and is well-perceived.  Product users said that Integra reached out to them quickly and has been a responsible actor in actually executing the recall.

(3) No injuries and swift outreach:  Both recalls did not lead to anyone being hurt, and Integra acted quickly to recall out of an abundance of caution.  Basically, the recall doesn’t seem to Integra in any way that could potentially damage its brand

(4) Recall is contained:  The Boston facility’s issues are rooted in it being 100+ years old, which makes it difficult to upgrade to modern standards without razing the site and building over.  All of Integra’s other manufacturing sites are modern, and Boston alone stood out as an antiquated facility.  Therefore, we believe the issue is contained to Boston, and not symptomatic of any larger issue at other facilities.  The CereLink monitor issue is very specific to that particular product, and did not represent any issue in Integra’s manufacturing or testing processes.  Experts suggest that all the proper testing had been conducted on the product prior to launch, and that finding the issue behind the recall during testing would have been nearly impossible due to the fact that the issue resulted from environmental interference at the hospital sites.  Thus, we believe this product recall is isolated, and not reflective of any larger issues.

(5) Fixes are secured:  The Boston facility expects to launch commercially by late Q2 ’24, and our expert calls suggest that this timeline is feasible.  By 2025, the facility will be replaced by the newly built Braintree facility, which is a permanent fix.  Integra discovered a simpler fix for CereLink that involves just replacing 1 accessory on it, which will hasten the fix.  The relaunch in international markets has already started and will expand to the US in fourth quarter 2023, so the solution is relatively immediate.

 

The management turnover is justifiable, and doesn’t reflect anything pernicious at Integra’s core.  Carrie Anderson (prior CFO) was given the opportunity to become the CFO of Campbell Soup, a much larger (~$9bn in sales) and more high-profile company.  Pete Arduini (prior CEO) took up an offer to become the CEO of GE Healthcare, also a much larger (~$19bn in sales) company than Integra, instead of retiring according to his original plan.  Glenn Coleman (prior COO) left when he was passed over for the job of CEO, given he had been promoted to COO as part of succession planning under CEO Pete Arduini.

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Just for context, here is some background on the Boston facility recall:

On 5/22/23, Integra (1) recalled all products manufactured in its Boston facility over the last ~5 years, and (2) halted all manufacturing at that same facility.  The Boston facility accounts for ~5% of Integra’s total revenues (i.e., ~$80mm in sales).  Primarily 2 products are produced at the facility, each accounting for ~50% of the facility’s revenues: SurgiMend and PriMatrix.  Both are bovine matrix tissue products.

The recall was due to the facility’s endotoxin testing process basically being deemed unreliable by the FDA.  The issue was not that the FDA found higher-than-permitted endotoxin levels, but instead that this could result from the inconsistent testing process.  Endotoxins, at their worse, cause a fever, presenting a relatively benign risk.  There have been no actual product complaints related to endotoxin levels.

Integra acquired this facility as a part of its TEI Biosciences acquisition in 2015.

Integra had been investing to address issues raised by the FDA at the Boston facility over the last 4+ years, but issues continued to pop up (one expert likened it to playing “whack-a-mole”).  The fundamental problem with the facility is that it is over 100 years old which makes it difficult to bring up to modern standards.  Here’s a regulatory history of the Boston facility: March 2019: the Boston facility received a warning letter from the FDA (after an inspection in Oct/Nov 2018), largely referencing corrective actions required for its endotoxin testing process; Oct/Nov 2021: FDA inspects the Boston facility again, and issues a Form 483 (which states that the company “may” have violated FDA laws, but can’t say so with finality); March 2023: FDA inspected the facility again; H1 ’23: to address the FDA’s continued concerns, Integra stepped up its investment to upgrade the Boston facility; May 2023: FDA issued a Form 483, leading to Integra’s recall.

A 3rd party firm has been hired to conduct an audit of the facility once changes are made, to assess whether the facility should restart.  It is important to note that Integra does not need FDA approval before restarting production at the Boston facility.  Restarting commercial production at Boston is entirely up to Integra upon receiving a satisfactory audit finding by the third party.

Timeline for reopening is: Manufacturing restart in late Q4 ’23; Outside expert audit report at end of Q1 ’24; Commercial distribution restart in mid-to-late Q2 ’24

Integra is building a new facility (in Braintree, MA) that will replace & expand the Boston facility’s current capacity, at which point it will shut down the Boston plant. The new Braintree plant is slated to come online in 2025, and will cost ~$50mm

 

Just for context, here is some background on the CereLink recall:

On 8/18/22, Integra recalled its CereLink intracranial pressure (ICP) monitor system.  This product accounted for ~1% of sales (i.e., ~$13mm), and had an installed base of 1,200.  CereLink ICP is a new version of an old product, and was only launched ~1 year prior to the recall (launched in October 2021).  The new product had an upgraded user interface and analytics capabilities

The recall was due to customer reports that the pressure readings were out of range.  The issue turned out to be that there was outside electrical interference that disrupted the readings.  Customer reports were at a limited number of sites, with an incidence rate of only 1.5%.

Integra has engineered a simple fix to the problem that will be relatively lower cost to execute.  The solution only requires sending an accessory (a cable) to customers, which makes it easier to fix.

The relaunch date is now set for Q4 ’23 in US markets, and has already relaunched in international markets starting in Q3’23.  This relaunch date is one quarter later than the original relaunch date, given Integra just recently discovered this easier fix, which necessitated restarting validation/verification testing.

During the recall period, Integra has provided loaners to customers of the prior generation of monitors.

 

3. Integra has transformed over the last ten years, positioning itself for growth and margin upside that is above and beyond our base case.

Between 2012 and 2021, the company has consolidated ERP systems, facilities, divisional structures, and operating processes.  Additionally, non-core assets were sold so that Integra could focus on its highest-growth and margin assets.

The aforementioned efforts are foundational to its long-range plan of driving significant new product introductions, expanding internationally, and achieving 70-72% gross margins and 28-30% EBITDA margins, versus current levels of ~67% and ~25%, respectively

We do not give the company credit for achieving these growth and margin goals in our base case, and given its disrupted valuation, we believe the market is giving the company no such credit either.  Nonetheless, we believe Integra is particularly well-positioned for upside potential.

Description

Recommendation: Short XPEL at $84; Target price of $41 within an 18-month time horizon (+32% IRR)

Executive Summary:

• XPEL is a global manufacturer of automotive protective films with a history of strong revenue growth (~31% 15-year CAGR).

• The market believes that XPEL has become a secular growth story and has assigned it a premium multiple (33.3x NTM P/E), pricing in nearly 20% of annual organic revenue growth compounded through 2030.

• This has created a compelling opportunity to short the stock given that preliminary work suggests that:

  • Recent growth in the Paint Protection Film (“PPF”) segment (58% of TTM revenue) was largely driven by tail winds that are abating, such as: (1) a large share of Tesla owners purchasing PPF to compensate for paint production challenges on earlier models that are being fixed going forward, (2) dealerships liberally applying PPF to new cars as a “freebie” on the back of record high dealer markups that are now receding, and (3) competitors catching up in terms of quality and brand, at a fraction of XPEL’s price and with more R&D spend to stay ahead.

  • According to the best stock research websites, margins have peaked and are likely to be pared back as the company doubles down on expanding in a less profitable China market, pursues lower margin installer businesses, and invests behind expanding their Design Access Program (“DAP”) software.

  • Despite the market pricing in durable secular growth, XPEL has historically been very cyclical, with 2008 revenue (-35%) tracking US car sales (-43%). In a moderate recession if revenues begin declining, the multiple may compress significantly as investors re-rate this from a premium compounder to an industrial cyclical.

• While bulls highlight numerous opportunities (such as growth in Architectural Film and lower margin volumes from Rivian), I believe that this misses the forest for the trees – volume demand for the core business (~60% of the business) seems set up to potentially inflect yet the market continues to give the entire business a premium growth multiple based on segments that make up a single digit share of current revenue.

• At more moderate growth levels in its core markets and normalized margin levels, I believe XPEL should trade at ~$41 (-51%) and in a recession could trade down to $21 (-76%). Even if we believe the margin expansion expected by some bulls, Base Case growth at a 22% EBIT margin (+420bps to TTM) would still result in a target price of $55 (-35%).

 

Company Overview:

XPEL is a global manufacturer and installer of automotive protective films. It has built a strong brand reputation amongst car enthusiasts for its Paint Protection Films (“PPF”; ~58% of TTM revenue) and has increasingly diversified into other products such as window film (~17%), installation services (~14%), and related software (~7%). It has sustained annual revenue growth of ~31% over the past 15 years and has been profitable since 2009, generating ~30-40% ROICs by executing on a capital light manufacturing model.

I won’t spend an enormous amount of time covering the business from scratch given the great previous VIC write-ups from mip14, devo791, and Ares, but will instead focus on recent developments in the business:

• The PPF segment continues to be the largest dollar contributor of growth for the business, expanding meaningfully during COVID from $97mm in 2019 to $206mm on a TTM basis through Q2-2023, implying a 24% CAGR in that business. This closely reflects the growth in Google Trends interest for PPF over that time period (24% CAGR).

• China has become a significantly smaller share of sales, falling from ~30% at its peak in 2018 to ~9% on a TTM basis through Q1’23. Management attributes this drop off to post-COVID related lockdowns, port closures, and general slowing of economic activity.

• Inventory levels have grown significantly, rising from an average of ~70 DIO historically to double that at 153 as of Q1’23, before beginning to recover to 129 as of Q2’23. FCF conversion has recently been limited as a result, with TTM CFO / EBITDA finally returning to its roughly ~60% historical level as of Q2’23. Similarly, ROICs have fallen to ~30%, though if you believe this is temporary (rather than structural) and normalize DIO to 70 days, the business continues to deliver ~40% ROICs. Management attributes this largely to their China distributor sending back inventory while expectations for economic growth have receded, but expect for this to normalize over time. Note that they took a $400k inventory write-off that they expect is a one-time event.

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• Management has continued executing on a number of smaller inorganic acquisitions that have helped them expand closer to the customer through PPF installers (PermaPlate, Protex Centre, 5 US/Canadian installers, and the PPF business of their Australian distributor), and launch new adjacent products (Veloce Innovation for architectural films, and invisiFRAME for bicycle PPF).

• Management has also executed an impressive partnership with Rivian, offering factory-direct installation of XPEL products on new Rivian orders.

• In July 2019 XPEL became listed on the Nasdaq and in June 2020 it was incorporated into the Russell 2000/3000 indices. Investors certainly took notice of its historical financial profile as it swelled to a max of 76x NTM P/E (+46x premium to the RTY) in 2021 and stayed at elevated levels for most of 2021, before receding to a more normalized Median of 34x NTM P/E (+10x premium to RTY), roughly where it trades today.

  • Despite this elevated price point, management has been disciplined and has not issued any additional shares (remaining at ~27.6mm), has kept a clean balance sheet with no net debt, and established a $125mm revolver.

  • I will note however that management ownership has declined precipitously. Despite owning roughly 40% of shares in late 2020, management has continued to be net sellers of shares in the open market dropping to ~18%. With the retirement of Mark Adams (an 8% holder) at the end of June 2023, shares owned by active insiders have fallen to roughly 10%.

• Consensus estimates 2024 Revenue to be $464mm (19.7% CAGR) at a 20.8% EBIT margin, resulting in a $2.74 2024 EPS. Using a 30-year reverse DCF, I estimate that the market is currently pricing in ~19% annualized growth over the next five years at a 17.8% EBIT margins (in line with TTM EBIT margins), with revenue slowing -3% every 5 years to a terminal growth rate of 3%, a 10x terminal multiple, and a 10% WACC (resulting in only 20% of the value being driven by the terminal multiple).

Despite the impressive historical performance, I believe XPEL faces a much more challenging near-term trajectory than the market is currently pricing in.

 

Recent disproportionately high interest in PPF products by Electric Vehicle (“EV”) customers has been a temporary tailwind that is unlikely to persist into the future.

Core PPF segment revenue growth is driven primarily by:

1. Global Motor Vehicle Sales: protective film is applied primarily to newly purchase vehicles

2. Attach Rates: share of new vehicle customers that know of the product’s benefits and purchase it

3. Market Share: XPEL has built a premium brand resulting in historically leading market share

4. Amount of Film Used: increasing over time from typically just the hood to the entire front of the car

5. Unit Price of the Film: has largely been unchanged to maintain growth and capture market share

Despite recent weakness in global vehicle sales due to supply chain issues plaguing the automotive industry, XPEL has continued to benefit from the rapidly growing interest in PPF products (+24% CAGR per Google Trends data mentioned earlier). Management has attributed this growth to a broader acceptance of PPF products amongst the non-enthusiast population and disproportionately higher attach rates amongst EV customers, which theoretically should drive significant growth for XPEL and the overall PPF market, given EV’s are expected to represent 23% of all new cars sales by 2025 and 35% by 2030 according to the IEA (1).

Tesla owners do seem to have been a substantial source of interest in protective paint films recently. Google Trends data shows that users searching the key term “PPF” also tend to search topics related to “Tesla”. SimilarWeb traffic data to the XPEL website confirms that site visitors also commonly spend time on the Tesla website. In fact, the Telsa website is such a popular destination for users that search for PPF, that it is listed among XPEL’s primary PPF competitors (3M and Llumar) as the most similar websites.

Tesla owner’s interest in PPF seems to have been driven by early paint production issues. On Tesla Car Enthusiast forums, a very common complaint is that “Tesla’s paint jobs are notoriously the worst in the auto industry. (2)(3)” Elon Musk himself addressed this in an interview where he attributes some of these paint issues to rushing production to meet vehicle quotas early on and not allowing the paint to dry the correct amount of time in the Fremont facility (4). Given the early adopter enthusiasts that sought to purchase a Tesla were doing so largely for the novelty of a fully electric vehicle (as well as a status symbol), this hasn’t necessarily stopped them from making the purchase – but they instead needed to supplement the purchase with paint protection film. Entire dedicated companies have been established to address this issue, such as TesBros, which offers a variety of DIY PPF installation packages and educational videos to help customers protect their Tesla (5).

As Tesla has continued to build out manufacturing capabilities and mature as a company, they have made investments in quality control, including installing the “world’s most advanced paint shop” in their Giga Berlin factory (6). While there are still some complaints on the forums regarding paint jobs, other customer issues that previously required window tinting / protective film have been resolved in newer Tesla models.

As Tesla continues to iterate on their products, they are likely to resolve these specific paint issues, and customers are going to be less likely to seek expensive PPF solutions to augment their purchase. Additionally, as Tesla continues to ramp up production and it becomes less of a novelty, I believe the incremental electric vehicle customer is unlikely to be willing to make such an expensive purchase if it requires also seeking an aftermarket modification to it, particularly as it grows to be a larger share of the total vehicle’s price given Tesla’s recent price cuts.

As some bulls have pointed out, Rivian could help support EV attach rates given the application at point of sale and the percentage cost relative to the car. Without taking a view on the longevity of an EV company selling vehicles at a loss, I believe that this is possible but will be both de minimus relative to total sales and abate over time (similar to Tesla).

Given these data points, I believe that PPF attach rates for EV customers are temporarily elevated (rather than a structural feature), and will converge to attachment levels for the overall population over time, acting as a headwind to growth in the future.

 

PPF sales have also been temporarily supported by dealerships offering it as a “freebie” on new car purchases given historical highs in car mark-ups, which are beginning to recede as car inventories recover. 

Bureau of Labor Statistics data for New Car Dealer Vehicle Sales PPI (proxy for dealer mark-ups) shows that mark-ups surged in 2021 and 2022, reaching a peak of nearly 3x since the pre-COVID lows. This was likely driven by tight new car inventories during the recent semiconductor shortages, and pent-up demand for new car purchases from consumers coming out of COVID. Conversations with dealers suggest that they were more likely to apply some kind of car feature (such as PPF or window tinting) to make the customer feel as though they were receiving something in exchange for the higher mark-up price. However, over 2023, dealer mark-ups have receded 30% from 2022 highs, and have significantly lower to go relative to pre-COVID norms. I believe that as these levels further normalize, this will put further pressure on PPF sales for brands that have focused on integrating with dealerships and installers, such as XPEL.

Furthermore, I believe this phenomenon explains the growing attach rates amongst the general population, and I believe this will revert back to largely traditional car enthusiasts regardless of how much XPEL spends on marketing. Anecdotal evidence from discussions with installers suggests that the typical customer inquiring about PPF continues to primarily be a car enthusiast and that there hasn’t been a meaningful change over time.

I’ve seen two arguments for why attach rates for the general population should grow over time, both of which feel like comparing apples to oranges:

• More mature markets including Alberta and Colorado exhibit significantly higher attach rates; as other markets mature, they are also likely to see attach rates grow to these levels as well.

  • Google trends data suggests seasonal interest that can be seen in the winter months, when roads are more likely to have been salted and be abrasive to motor vehicles.

  • Anecdotally, when we drove through Vail Pass in Colorado last winter during a storm (a top market for XPEL), we ended up with a dime sized nick in the window shield. When we returned the car, the Enterprise employee told us not to worry about it because every other car comes back with some kind of minor damage, and that’s par for the course for that time of year.

  • Higher attach rates in geographies with challenging terrain/weather are unlikely to be related to adoption in other more moderate climates, where the typical buyer tends to be a car enthusiast.

• More mature products such as window tinting have significantly higher attach rates for new vehicles; as the market for PPF ages, it should also experience growing levels of attachment to these levels.

  • Window tinting has become much more accepted because it is something that improves customers’ quality of life in terms of both heat management and glare prevention, and in some geographies is even a safety concern in the summer months. Conversations with window tinting customers reveal a much stronger preference for the practical benefits of window tints, rather than preventing minor abrasions and chips (which they viewed as a reality of owning a car, and something they don’t think very often about).

  • Additionally, window treatment options are widely available, are easy to apply in a DIY fashion, and relatively cheap (from ~$20 DIY options to $100-200 for a professional installation, compared to 10x that cost for a common full front installation of XPEL PPF).

Given these datapoints, I believe that the elevated PPF attach rate has been largely driven by historically high dealership mark-ups, rather than any success in marketing PPF products to non-car enthusiast users. I believe that as car inventories loosen and dealership mark-ups recede, PPF attach rates will fall and XPEL will face further revenue headwinds.

 

Competitors are catching up in terms of quality and brand, at a fraction of XPEL’s price and with more R&D spend to stay ahead. 

XPEL has a significant number of competitors who offer comparable PPF products. 3M (MMM US) is a pioneer of PPF and owns a patent that XPEL maintains a perpetual license to. XPEL got the jump on 3M in 2011 by launching Ultimate Plus which has “self-healing” properties that allow minor scratches to effectively be buffed out, but 3M followed shortly in 2014 with the Scotchgard Pro Series which offers a comparable self-healing feature. There have been some general comments on XPEL’s PPF being more resistant to turning orange and cracking over time vs. the competition, but with the latest iterations, it seems as though that has become the market standard across the board rather than being limited to just XPEL (e.g., 3M has updated the Scotchgard Pro line 4 times since its launch). Additionally, the 10-year warranty that only XPEL originally offered has now become the market standard (with SunTek even offering a 12-year warranty). SunTek & Llumar (separate brands both owned by Eastman Chemical, EMN US) and Avery Dennison (AVY US) are also established premium competitors, but there is a fairly wide list given there isn’t much of a moat around the underlying product itself.

XPEL continues to be by far the most expensive option, even amongst premium competitors. In comparing a 5×15 foot sheet, 3M is 58% cheaper, and both Avery Dennison and Hexis are 55% cheaper. XPEL pricing is directly from the website, while the rest are from distributors, which suggests the disparity might be even wider if ordered directly from the source.

Additionally, XPEL spends significantly less on R&D than competitors, leaving an avenue open for competitors to potentially get ahead with upgraded features while XPEL falls behind over time. While XPEL spends only ~$400k annually on R&D (0.1% of revenue), 3M spends $1.8bn (5.4%), Eastman Chemical $254mm (2.6%), and Avery Dennison $136mm (1.6%). I suspect this is why XPEL needs to spend so much on marketing the brand. I also suspect this is why XPEL is increasingly pursuing purchasing installers outright – they need captive installers to intake the XPEL products, because independent installers may be going with competitors.

One potentially concerning trend is the emergence of Chinese PPF products on the global stage. Google Trends shows “HOHOFILM” as a rising key phrase for PPF searches, growing significantly over the past year with significant interest out of both Australia and California. Doing a quick google search for the product shows direct distribution through Amazon, eBay, and AliExpress, at significantly cheaper prices than the US competitors. For a similar 5×15 film sleeve to the comparison made earlier, HOHOFILM retails at an 84% discount to XPEL film. While management has attributed the slowdown in China due to an overall post-COVID economic slowdown, I believe it is entirely plausible that the Chinese market has been competed away by cheaper upstarts like HOHOFILM. Given the recent uptick in interest from Australia and California, there is a real risk that cheaper “good-enough” competitors enter the US market and begin to take XPEL’s market share.

One potential counterpoint is that XPEL has created an attractive ecosystem for its installers by offering discounted access to its Design Access Program (“DAP”) software, which benefits installers primarily in increasing the accuracy of the cut (satisfying end-customers), reducing associated film waste, and reducing labor time spent on the installation process. We can estimate the economics of two installers applying a PPF wrap to the entire front of a Tesla Model Y: Installer A that applies XPEL Ultimate Plus film with a $300 monthly DAP cost, vs. Installer B that offers Avery Dennison Supreme Defense (54% discount) but pays 50% higher labor costs (due to additional time to manually cut the film) and 20% additional material (due to more film waste). By my estimates, Installer B can still achieve the same level of gross profit while selling it at an 11% discount to Installer A, driven by significantly lower materials cost. This of course ignores the additional benefit of Avery Dennison also offering Vehicle Design Template (“VDT”) cutting software for a third of the price of DAP (though admittedly offering only “thousands” of available pre-cuts, vs. 80k+ for XPEL). DAP is also set to expand its feature set, including invoice services, appointment scheduling, payroll management, and leads tracking, but conversations with installers suggest that the only feature they tend to use DAP for is the pre-cuts and that they would be unlikely to migrate from existing service providers for other DAP features.

An additional counterpoint is that XPEL offers attractive lead generation for its listed certified installers on their website. However, conversations with installers suggests that the majority of customers opt for PPF installation after seeing it live in person, while online reviews indicate that the most important thing for customers seems to be the quality of the installer rather than the film.

While XPEL has had a premium brand historically, I believe that the competitor set has already caught up and is much better positioned to stay ahead. While installers have benefited from the growing demand in XPEL, as customers seek similar quality at more affordable prices, I suspect that installers may be less likely to sign up to be an exclusive XPEL dealer, if it means lower volumes at similar profit levels than they could get from competitor offerings.

 

Margins have peaked and are likely to be pared back as the company doubles down on expanding in a less profitable China market, pursues lower margin installer businesses, and invests behind expanding their DAP software.

Gross margins are at all-time highs and are unlikely to expand meaningfully from here. Recent supplier renegotiations have been a driver of reduced materials cost, and I believe that has already been fully reflected in the gross margin to date. Product margins have also expanded recently driven by shrinking sales from China (where there is a higher cost paid to the distributor). Looking forward, TrendForce estimates that ~33% of new car sales will come from China (particularly EVs), and on the last earnings call management has said they are planning to dedicate significant new resources and building a China dedicated team to go after that market (7). Competition is very high in this geography and online reviews point to existing history with fraudulent activity and intellectual property theft, suggesting the higher margins and ROICs may be a target for increased competition, pressuring gross margins further (8). We are beginning to see that with HOHOFILM’s uptake in California and Australia since 2021. Additionally, product margins have also benefited from price increases in certain markets, which given the growing competition, are unlikely to be repeatable going forward without impacting volumes. Service margins are also likely to compress, as management increases spend on additional DAP features and continues to grow installation labor as a segment.

SG&A is also likely to continue trending upwards. Sales and marketing have grown meaningfully in order to drive new installers on to the XPEL platform and management has focused on increasing brand awareness to grow attach rates. As XPEL has to direct marketing spend across an increasingly diverse product set (autos, marine, architectural windows, and bicycles), across many targeted parties (traditional enthusiast consumers, non-enthusiast consumers, installers, dealerships, OEMs, and distributors), and geographies (US, Canada, China, Europe, Australia, EMEA, and Latin America), I expect sales and marketing spend to grow over time rather than benefit from volume growth.

 

Despite the market pricing in durable secular growth, XPEL has historically been very cyclical, with 2008 revenue (-35%) tracking US car sales (-43%). In a moderate recession if revenues begin declining, the multiple may compress significantly as investors re-rate this from a premium compounder to an industrial cyclical.

New car sales generally correlate with GDP growth, consumer financial health, and car affordability. Currently, US real GDP is projected to fall over the next two years, with Bloomberg projecting a 60% chance of recession. Consumer savings have fallen dramatically despite growing significantly during COVID and now sit at levels last seen during the GFC. The Keley Blue Book sees vehicle affordability finally stabilizing but continuing to sit at historic lows, with the average consumer needing to pay 43 weeks of their household income to pay off their new car (relative to 33-36 in the decade prior to Covid) (9).

During the last significant recessionary period, the Global Financial Crisis, US new car sales fell (-43%) and Google Trends shows that PPF interest also fell significantly (-41%). During the ensuing recovery, as US car sales began to recover, PPF interest took a significantly longer period to reach pre-GFC levels. XPEL was not immune to this and saw its revenue decline (-35.3%) in 2008 and only grew at low single digits in the two years that followed.

While I don’t have a differentiated view on the odds of a recession occurring, I do believe that it would impact XPEL significantly more than the current valuation would imply. In a moderate recession, I believe revenues could decline (-10%) a year or more, and during that time the multiple may compress significantly as investors re-rate this from a premium compounder to industrial cyclical.

 

Valuation:

As mentioned earlier, the market fully appreciates XPEL’s historical combination of durable revenue growth and returns on capital. It has historically traded at a wide range to the Russell 2000, on balance achieving a +10x NTM P/E premium, and currently trading at 33.3x NTM P/E. This is likely driven by consensus expectations for XPEL to grow NTM Revenue at 23% vs. 2% for the RTY.

While direct PPF competitors on average trade at a more modest 14.0x NTM P/E, they generally are expected to grow less quickly and have weaker historical ROICs. Additionally, they tend to be more diversified conglomerates which potentially make using their multiples as a less useful valuation tool relative to a DCF projecting expected cash flows at different growth profiles. Generally plotting both direct competitors and other “Automotive Parts & Equipment” sub-sector companies along their NTM P/E vs. NTM expected fundamentals, stronger revenue growth and EBIT margin seem to be most correlated to higher NTM P/E and largely explains XPEL’s heightened valuation relative to peers.

Using a 30-year reverse DCF, the market seems to be pricing ~19% compounded revenue growth at XPEL’s TTM EBIT margin of 17.8% through 2027, and ~17% growth through 2030 (which we will define as long-term revenue growth and attempt to estimate in the “Scenarios” section below).

 

Scenarios & Risk-Reward:

I believe the risk-reward is skewed towards being short XPEL at this time.

• Bull Case – $138 (+64%) – 20% Long-Term Revenue Growth & 21% EBIT Margins:

  • Assuming XPEL can sustain 20%+ long-term revenue growth over the next 5 years before moderating to high-mid teen growth for the following decade, and eventually settling at 2x GDP growth (6% terminal rate), and that it can further improve its EBIT margins to 21% into perpetuity (+320bps from TTM and >500bps relative to history), I estimate it would deserve a fair value of $138. While I don’t particularly believe this case given all of the reasons highlighted above, I think it makes a reasonable estimation of what historical trends projected into the future might look like.

• Base Case – $41 (-51%) – 11% Long-Term Revenue Growth & 17% EBIT Margins:

  • Using an industry model that leverages the 5 key PPF industry drivers mentioned earlier (Global Motor Vehicle Sales, Attach Rates, Market Share, Average Amount of Car Covered, and Unit Film ASP Increase) and calibrated against the ~20% growth expected in the Bull Case, I believe that XPEL’s Global PPF revenue is more likely to grow at a normalized 8.3% CAGR through 2030, when accounting for my more pessimistic view for terminal attach rates for EVs, market share, and inability to raise ASPs. Given window film is continuing to take market share driven by cross-sell at existing PPF installer locations, I expect it can sustain growth in the mid-teens in the near term despite being in a more mature, slower growing market. I also expect installation labor to continue growing at a higher rate than PPF. As a result, the best stock screeners expect the blended business to grow at ~10.9%, with a more historically normalized EBIT margin (though still elevated) of 17%, which results in a $41 target price.

• Bear Case – $21 (-76%) – 3% Long-Term Revenue Growth & 15% EBIT Margins:

  • If we assume a moderate recession that reduces revenues by 10% for 2 years then normalizes to HSD growth afterwards, and EBIT margins compress to ~15% (which was the case as late as TTM Q1’22), I estimate a target price of $21.

Risks/Mitigants:

• Better than expected attach rates amongst the non-car enthusiasts and/or otherwise better than expected growth for PPF

  • XPEL is priced at a significant premium to a wide array of competitors; as competitors continue to invest in higher quality, lower priced offerings, I believe that market share will materially shift away from XPEL even if the PPF industry continues to grow significantly from here.

• Other business units are able to outgrow any potential slowdown in PPF

  • It’s important to note that despite a wide variety of ancillary revenues growing around PPF (including window film, software, installation labor, etc.) all of those revenues are fundamentally tied to healthy PPF volume performance in the current state.

• Better than expected penetration in China

  • If XPEL is able to find growth in China, it is likely to be materially more expensive and offset any recent margin gains that it has been able to establish, reducing the valuation premium it is receiving.

Description

This is a boring idea, and I believe that most of you would have reasonable objections to buying things managed by other people, but this is the largest holding in my kid’s accounts and I’ve used it for years and I’m retired anyway, so I recommend MOAT, an ETF.

Background

I’ve never forgot that in Beating the Street (published 1993), the world’s most successful active manager at the time (Peter Lynch), suggested that in assembling a mutual fund portfolio:

“You could throw in a couple of index funds to go along with the managed funds.”

This was especially interesting considering that, in my personal opinion, the market was still very inefficient back in those days.  Now, indexing is accepted as common wisdom, and as a retired investor with less time on my hands I continue to hold index exposure though I’m always on the lookout for a potential edge.  MOAT has provided that edge, especially as a compare vs. the SP500.

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Consider:

1. Expenses – expense ratio for VOO for 0.03%, MOAT is 0.46% adjusted.  This is the best reason to own VOO over MOAT.

2.  Performance – clear win for MOAT; over all periods measurable, MOAT has outperformed VOO.  Given that VOO has beaten all other indexes and the vast majority of actively managed funds (hedge funds included), this is a stellar record

3.  Portfolio.  VOO is fully invested in stocks, MOAT is fully invested in stocks.   As most know, VOO is a bit odd these days, with the top 9 holdings accounting for more than 30% of assets, with Apple at 7.5%, MSFT at ~7.0%, and Alphabet at 3.9%.   Compare this to MOAT’s portfolio.

Biggest holding is less than 3%, with 54 holdings at present.  MOAT is overweighted with Tech at 21% but less than 28% for the VOO (using Morn’s figures), with similar exposures but different allocations (MOAT at 18% healthcare, VOO at 14; Financial Services at 16 vs 12%, etc.).  this is entirely personal, but on a quick scan basis i actually like the MOAT’s portfolio better right now, especially after the run-up due to AI excitement in the big tech stocks, but you can make your own judgement here.  I’d almost call this a pass, cause unlike VOO MOAT could look different again in 3 months or 6 months.  Lastly, MOAT’s holdings are exclusively  100% “wide moat” stocks while VOO is mixture of wide moat, narrow moat, and to a lesser degree no moat stocks.  Over long time periods, I am convinced these classifications lead to outperformance (FCF is higher with a moat), unless you are taking advantage of trading opportunties in the cruddy areas of the market.

4.  Will MOAT’s peformance edge continue?   This is really the only question that matters – MOAT has put up really strong numbers over its history, it is a fully invested stock fund, the cap exposures are somewhat similar to the VOO, but it is more expensive than the SP500 and that is the one factor that will always be true.  Plus, clearly MOAT’s recent outperformance has aided all subsequent multi-year comparisons, but on the other hand MOAT used to have a far more concentrated portfolio (20 stocks) which often left the ETF overly sector focused and I believe the selection and rebalancing changes led to a much better product, especially since it made the fund more easily able to grow the AUM.

You can read about how the fund puts the portfolio together here:

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I REALLY like the approach, like the fact that securities that might be booted out can stick around for another 3 months (benefit from momentum), like the mechanical nature of it, and unlike VOO I never worry that any single holding will become overly large – which happens from time to time with VOO.  In my history, it happened in a HUGE way in the early century (which resulted in 3 down years).  But in the end, it all comes down to whether you think the Morningstar system of moat classifications 1) makes sense, and 2) most importantly will be interpreted correctly by the underlying nameless faceless people ((with due respect!) the Morn analysts) who make those judgements but who are presumably undergoing consistent turnover.

I am, frankly, an unabased fan.  I use Morningstar reports for almost everything I look at (if available), and Morn is by far 10x more useful than the other numberous sell-side reports I have access to via individual brokerage accounts.   Reason is because Morn

-uses a uniform approach that

-analyzes the same factors each time, and

-the system of moat classifications as the underpining of how they value the stocks leds to reasonable assumptions as to the fair values of the businesses in question.

This doesn’t mean I don’t have violent disagreements with some of their conclusions (particuarly in no-moat areas and how they define that for specific industries; or with individual assumptions, but at least you can usually see those assumptions), but in the end IMO you are getting a uniform level of judgement across many people, which in theory means the analyst training is more important than the individual analyst.   This is all conjecture on my part, but I don’t see really dumb things in Morn reports.   It has to be the process itself.

So will performance continue?  I don’t know, but you don’t have to make a binary bet – you can buy both MOAT and VOO.

—

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Course, maybe now is a terrible time to buy any Sp500 substitute, but my kids have 40 – 60 year time horizons so I’m not worried about that (and I’ve owned MOAT myself for many a year).  Given that this is an active fund and changes the holdings, I don’t think getting worked up over timing is as important as it might be with a VOO, but that’s a small consideration during those times when markets are down big cause most of time most things are down big.  So I would frame this as I have in this writeup – if you consider VOO, think about MOAT.  If it matters, the only tiny advice that I would give anyone is that if you aren’t going to buy MORE when the market is down some sizeable amount, don’t hold anything now either, especially since unlike the past 15 years you can make a reasonably good return right now in various fixed income alternatives.

As a P.S.  I have always found the holdings in MOAT to be worthy of individual study ala what you can do with the Magic Formula site, but cause you have the Morn reports you can do reviews far more rapidly.  I’m also interested in SMOT, a small-mid cap ETF they’ve recently put together as an alternative to many small and mid cap index funds which contain unprofitable companies, but that one has a limited history (promising).  The moat approach doesn’t seem to have worked as well overseas, but the jury is out on that one.  Finally, larger investors could buy the MOAT holdings directly but it would be a pain and stealing stuff is not a good choice in life.

A final P.S.  i just looked at a portfolio done by a successor firm for one of my clients.  Honestly, I think MOAT will outperform the stock portion of their portfolio by a country mile at less cost, esp since with many advisors you have no earthly idea whether what their actual track record is cause there are no composites to review.  You might not like MOAT for you, but your college friend or 2nd cousin may benefit from things like this, esp. if they want to spice up the indexing…

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Description

Logistec is a leading marine services provider, with cargo handling operations in 90 terminals and 60 ports in North America.  They also have an environmental services business that provides underground water main renewal services, site remediation, contaminated soils management, etc.

 

The company has a very strong track record of growth, with both revenues and EBITDA growing at a 14% CAGR over the last ten years.  Growth has been driven by a combination of organic growth and the acquisition of smaller independent cargo handlers.

 

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Despite the company’s strong performance, shares trade at a low valuation of only 6x EBITDA and 10x FCF.  Importantly, less than two months ago in May, the board of directors announced a strategic review in response to the company’s controlling shareholder expressing their desire for a liquidity event.

 

I believe that Logistec is worth roughly $100 per share, which would value the company around 9x EBITDA and 17x FCF.  Furthermore, I believe that the strategic review represents a hard, near-term catalyst to unlock value for shareholders.

 

Shares trade as LGT.B on the TSX and LTKBF on OTC Markets in the US.

 

Marine Services

 

The company’s primary business is providing bulk, break-bulk, and container cargo handling in 60 ports and 90 terminals across North America.  This large network of terminal and port assets covers the Great Lakes, Saint Lawrence Seaway and both the Eastern and Gulf coasts. They are strategically located near major highways and rail infrastructures and represent the company’s largest competitive advantage.

 

The company also offers marine transportation services that are geared primarily to the Arctic coastal trade through their Transport Nanuk joint venture.  They operate five ice-classed vessels, and are primarily active in the eastern Arctic during the summer and fall.

 

Finally, they also offer marine agency services to foreign shipowners and operators serving the Canadian market.  Services include obtaining pilot services, coordinating port calls, attendance to crew requirements, and various other services performed on behalf of the owner and/or operator of the vessel.

 

In total, Marine Services comprises around 80% of EBITDA.

 

Environmental Services

 

While the Environmental Services segment is not quite as attractive as their crown jewel port and terminal infrastructure assets, it has still been a good business for Logistec and grown over time.  Importantly, they closed Q4 with the highest project backlog in their entire history, and so I believe they’re poised for a strong year in this segment.  Environmental Services was relatively weak for them last year as they had a number of projects canceled at the last minute which impacted profitability.

 

There are essentially two different businesses in this segment.

 

The first business is largely site remediation and soils and materials management through their subsidiary Sanexen.  I believe this work is fairly concentrated in the province of Quebec.

The second business is the renewal of underground water mains, where they essentially remediate existing water pipes by inserting a durable liner into them.  This serves to both extend the life of the water mains as well as protect the water from lead contamination and leaks.  Not surprisingly, it is cheaper to remediate the pipes in this manner rather than perform a large excavation.

 

In total, Environmental Services comprises around 20% of EBITDA.

 

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Valuation

 

I have valued the company by looking at forward (next 12 months) EBITDA and FCF.

 

Logistec just closed on the largest acquisition in their entire history – Federal Marine Terminals – at the beginning of Q2, and so my estimates incorporate a full year of operations of this business.  FMT is a port services business and expanded the network by adding another 11 terminals.  They acquired this business for $105mm USD and it generated $90mm USD in revenues last year with gross margins similar to Logistec’s marine services segment.

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I have modeled $24mm in EBITDA from this business, which corresponds to a 20% EBITDA margin.  I feel this is quite conservative as it does not assume any revenue growth and because the margin is 500 bps lower than the 25% EBITDA margins that Logistec’s Marine Services business generated last year.  Furthermore, management stated on the conference call that they expect both revenue synergies and margin expansion due to cost synergies.

 

Until management provides more financial details about this new business, however, I feel it is prudent to be more conservative than usual.  A $24mm EBITDA estimate also corresponds to an acquisition purchase price of 5.8x EBITDA which seems in the right ballpark to me.  If the revenue and cost synergies that management has hinted at are achievable, it’s not hard to see how EBITDA could be even higher and turn this acquisition into a significant home run.

 

I modeled $156mm in EBITDA for the rest of the business, which is ~12% higher than the $139mm they’ve generated in the TTM.  In total that gets you to $180mm in EBITDA.

 

As for FCF, I subtract $29mm in interest, $33mm in maintenance capex, $19mm in lease payments, and $21mm in taxes, which gets me to $77mm in FCF.

 

Using these estimates puts the valuation at roughly 6x EBITDA and 10x FCF.

 

I believe the business is worth around $100 per share, which would put the valuation around 9x EBITDA and 17x FCF.

 

Why Is The Stock So Cheap?

 

Logistec shares are unusually cheap for such a sizable business (~$180mm in EBITDA) that has already announced a strategic review.  I think there are a number of reasons that have caused this opportunity to fly under the radar for so long:

 

• It’s a family-controlled business with a dual class share structure.  This I’m sure gives many investors pause, but I have no issue with it here for the same reasons as ADF Group (and which I noted in my report on that company).  The family has economic ownership that is both significant in the absolute (45% of the company) and relative to their salaries.  I have not seen any evidence of management trying to abuse its voting control.  Finally, the company has been historically very well run IMO, and some might even argue that has been because of its family control rather than in spite of it.

 

• No sell-side coverage.

 

• Virtually no investor relations.  For most of the company’s existence there was essentially zero investor relations and no earnings conference calls.  It seemed like things were starting to change last year with a few conference calls and an investor slide deck, but in Q1 there was once again no conference call.

 

• The company has two very distinct and unrelated businesses, neither of which has many pure publicly traded comps to aid with analysis.

 

Strategic Review

 

Logistec was founded by Roger Paquin in 1952.  His three daughters (Madeleine, Suzanne, and Nicole) now have 45% economic ownership (equally split) and 77% voting control of Logistec via Sumanic Investments.  Madeleine Paquin is the CEO and all three are on the board of directors.

 

On May 19th, Sumanic Investments “informed the board of directors of the corporation of its interest in considering the sale of all or part of its shares in the corporation and desire for the corporation to initiate a process to pursue a strategic transaction in the best interest of all stakeholders to maximize shareholder value.”  In response to this request, “the board of directors of the corporation has formed a special committee of independent directors to consider Sumanic’s request to review the strategic alternatives available to the corporation, including a potential sale transaction, and make recommendations in that regard to the board of directors.”

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I believe this strategic review is very notable because it represents a hard, near-term catalyst to unlock value for shareholders.  While the outcome is obviously uncertain, I believe this strategic review has a high probability of resulting in a liquidity event.  The company appears to be essentially putting itself up for sale at a time of strength – their businesses are all performing strongly, and they just closed on what appears to be a large, highly attractive acquisition.  The vast majority of the value, which resides in the Marine Services segment, would have a particularly long list of potential suitors.

 

Risks

 

• The strategic review results in no transactions.  While this would be disappointing, I don’t think the share price reaction would be quite as dire as I’m sure many investors fear.  While shares appreciated in price when the review was announced, I believe they remain at a much larger-than-typical discount to potential sale price.  Furthermore, regardless of what happens, I think the genie is out of the bottle now.  Should a transaction not be reached, I think most investors would assume it’s due to the general economic environment and that they’ll just put themselves up for sale when the deal window opens again.

 

• Economic activity weakens and Marine Services revenues and EBITDA consequently decline.

 

• They encounter difficulties integrating Federal Marine Terminals and/or the revenue and cost synergies fail to materialize as expected.

Description

Investment Overview / Why the Opportunity Exists

 

Sylogist is a public sector software-as-a-service (SaaS) business whose stock has been orphaned due to its history of poor corporate governance along with a recently implemented strategy shift and dividend cut that caught investors off guard. The strategy shift, which the market hasn’t yet approved, was the result of the retirement of the former CEO concurrent with a board-initiated strategic review and was executed with the sole focus of driving shareholder value for the first time in the company’s recent history. Company specific issues, along with the massive selloff in small companies and software related businesses during 2022 has caused the stock to be left for dead, despite possessing some characteristics that point to an intrinsic value much higher than where the shares trade today. There is ample evidence that the company’s new direction is proving effective, but investors have been slow to recognize the shift, despite the company arriving at what I believe to be an important inflection point as of Q1 2023.

 

Since their hiring, the current management team has made tremendous progress, turning this previously low-growth cash cow that had no business being public into a high value prop software platform by launching and acquiring in-demand products, repairing customer relationships, and returning the business to organic revenue growth. CEO Bill Wood has run this playbook before, having spearheaded two successful private software company exits / sales, and is highly incentivized to drive significant value with Sylogist. Many investors seem to agree with this statement:

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Sylogist has not been written up on any investment forums, there are only two sell side analysts, and their IR presence leaves much to be desired. Shares trade on the TSX, over the counter in the US, and three funds as the largest shareholders own over 30% of the business. Daily average volume is less than CAD $200k/day. In line with my comments above about a checkered past, Sylogist’s previous issues remain in the rearview mirror, but from the market’s perspective, they still sting. These dynamics mean that despite the strong fundamentals, shares trade at 9.0x 2023E EBITDA compared to peers in the 18-25x range.

 

Public market peers such as Tyler Technologies, Blackbaud and The Sage Group, among others, have outlined the formula for success in this industry as well as the formula for significant long-term returns which consists of organic growth complemented with accretive M&A. Sylogist is now executing this playbook and has the opportunity to grow revenues organically at a low-double digit to mid-teens rate from here with EBITDA not far behind. As the company’s recently initiated internal investments continue to bear fruit, there is an opportunity for both margin expansion and multiple expansion. In a macro environment where two of the biggest worries are inflation and a recession, the combination of nondiscretionary recurring revenue and pricing power makes for an attractive setup. Over time, and with proper execution, I believe shares offer greater than 100% upside.

 

Background / Strategy Shift

 

Before moving on to the business, it’s important to set the stage for where we are today and provide some historical context regarding all the positive changes that have taken place recently.

 

Sylogist was founded in the late 1990s as an undifferentiated reseller of software products called Fintech Services Limited, where it remained, three CEOs later and into the early 2000s. In 2002, Fintech Services restructured their operations, enacted a name change to Sylogist and started focusing on selling SAP ERP products as well as municipal solutions. Jim Wilson (the former CEO), a large shareholder who had served as Chairman since 2001 was pointed CEO at the time following a series of strange transactions where Sylogist acquired two unrelated businesses owned and operated by Jim. Jim operated as CEO until Bill Wood’s hiring in 2020.

 

Shortly after Jim Wilson’s hiring, compensation, for which there was no formal program, started to get out of control, and in 2014, a new incentive structure was put in place that compensated management based on a percentage of free cash flow that the business was generating. That started the former management team down a path of reinvesting nearly zero margin, managing the business for cash flow, paying a hefty dividend and milking the company for compensation. Unsurprisingly, the result of this was a lack of investment in things like customer support, account management and the continuous neglect of customer relationships. Sylogist remained in this state, with their Net Promoter Score dropping each year, until 2020.

 

In September of 2020, the Board announced the undertaking of a strategic review, concurrent with Jim Wilson’s retirement at the end of the year, with the goals of the strategic review to evaluate alternatives to drive shareholder value (for the first time in a decade) while finding and hiring a new CEO who would be given a growth mandate. Boutique M&A advisor Shea & Company was hired to facilitate the strategic review (aka get the business sold). Channel checks indicated a significant amount of interest at the time, but there was a lot of low hanging fruit to clear (i.e. repairing customer relationships), so no deal was consummated. In October 2020, the strategic review was concluded with the Board determining that the best course of action would be to attack the many near-term market opportunities for growth as opposed to selling the business. Bill Wood was hired a month later. At the time of his hiring, Sylogist had nearly 60% EBITDA margins and a 5% dividend yield.

 

A few events that followed Bill’s appointment included:

• The hiring of key executives, including a CTO, CRO and new CFO as of Q1 2023
• An uplisting to the TSX from the TSX Venture exchange
• An NCIB put in place to acquire 10% of shares outstanding
• The upsizing of the credit facility from $40mm to $75mm
• The execution of three major acquisitions (Municipal Accounting Systems, MissionCRM and Pavliks, discussed below) that added products, revenues and EBITDA

 

On top of these changes, two other significant announcements took place. First, in mid-2021, Sylogist announced the continuation of increased investments in sales, marketing and product development to drive organic growth, which would have the result of lowering EBITDA margins from previously high levels, down to 30%, while still maintaining the Rule of 40 posture. Unfortunately, at the time of the press release, no specific investment levels were discussed, no clear use of cash was outlined, and no margin targets were given.

 

Second, at the end of 2022, in conjunction with their Q4 results, Sylogist announced a new capital allocation plan whereby they would be continuing to heavily invest in sales, marketing and product development and would also be cutting the dividend (a 9% yield at the time) to do so, freeing up $11mm in annual cash flow. The stock dropped 20% on the news but recovered a few days later to around current levels. In addition, a renewed NCIB was put in place, and the credit facility was again upsized to $125mm from $75mm, providing additional acquisition firepower. These calculators can be used to compute these metrics for Sylogist.

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Here’s a snapshot of quarterly financials going back to Q1 2018, leading up to the implementation of the strategy shift in Q2 2021. You can see the change in top line growth, EBITDA margins, and the dividend payout ratio.

 

 

The strategy shift, lower margin outlook and dividend cut weren’t well telegraphed or previously guided (causing the stock to drop 20%), but the quick recovery in the following days at least indicated the market understands that management is serious about driving shareholder value moving forward. But a lot of moving parts, some unexpected capital allocation moves, and the expectation that growth investments will have to deliver an ROI, means a discounted stock. In addition, like most small companies and software related businesses, 2022 was not kind to Sylogist shares, which were down nearly 60% despite the tremendous progress made during the year. The shares still haven’t recovered despite a clear inflection point in operational execution.

 

Today, Sylogist is executing an organic growth strategy centered on its three core verticals. The strategy shift will be bolstered by significant tailwinds including the large addressable market among their customer base, low digital penetration among the same customer base, the acceleration of software tools post-COVID, and a fragmented market for products and services that Sylogist can tap into for M&A. I think it’s a positive signal that the management team is willing to endure short-term discomfort in exchange for potential long-term value creation. Discussed below, their recent internal investments have been paying off nicely.

 

Business Overview

 

Sylogist is a public sector SaaS business that provides mission-critical software solutions to nearly 2,000 customers worldwide in three public sector verticals consisting of non-profits through their SylogistMission segment (36% of revenues), Government organizations through their SylogistGov segment (16% of revenues), and K-12 schools through their SylogistEd segment (33% of revenues). Within these verticals, software solutions consist of ERP, CRM, fundraising, education administration, and payments products, among others. I don’t believe detailed explanations for each segment are required, but one use-case example would be a growing non-profit that requires more advanced fund accounting and donor management software that integrates with the rest of the organization’s applications. This organization could implement Sylogist ERP to address their needs. Sylogist typically works with smaller and mid-market organizations in specific end markets such as school districts, faith-based organizations, museums and local non-profits. According to end users, Sylogist’s products carry high value propositions and sticky customer relationships as they serve a critical need for most customers by integrating into their technology stack and daily workflows. Sylogist and its peers are great businesses given their asset light nature, lack of cyclicality, durable recurring revenue streams and significant cash flow profiles. Even during a long period of significant underinvestment and customer neglect under the prior management team, Sylogist still maintained its nearly 60% EBITDA margins, and based on a historical examination of organic growth, was still able to grow recurring maintenance revenues between 2-3% per year for nearly the past decade.

 

Although Sylogist is not the cheapest solution (and is not attempting to be), I’d view their customers as both budget conscious and ad-hoc, which plays into the continued demand for cloud-based software to manage costs effectively and the need for them to utilize software vendors with subject matter expertise. For customers, Sylogist’s solutions typically represent between 15-20% of their budgets, and are critical to their workflow, so cloud based services reduces the cost burden especially when considering the move from large upfront license-based fees to monthly recurring payments. This is typically not an expense that is tinkered with much, especially given the benefits provided and willingness to remain with a provider even in the face of price increases. Channel checks also confirm that it’s very difficult to find cost savings in this area so typically they are found elsewhere in the budget (meaning software is the last thing to be cut). Lastly, conversations with customers indicate that Sylogist has significant room to raise prices over time, as that was the last factor mentioned in a purchasing or churn decision.

 

The end markets in which Sylogist operates both insulate them from competition and provide a favorable demand backdrop leading to a strong growth runway. The majority of Sylogist’s customers don’t typically have the resources to internally develop what they need and aren’t being catered to by larger organizations such as Tyler Technologies, Salesforce or SAP, for example. Although there are a number of competitors in the public sector space such as Tyler Technologies, Blackbaud, The Sage Group and Powerschool, the market overall is much less competitive than the private sector and none of the companies mentioned here focus on Sylogist’s customer base, have a specific solution tailored to that customer base, or have made the necessary investments to compete. This is evident in Sylogist’s historical customer retention numbers, which were in the high 90s even in the face of prior mismanagement and customer neglect. In terms of Sylogist competing against larger organizations, the typical dynamics between small and large organizations apply; public sector customers are not as attractive as private sector customers and the TAM is much smaller, providing less incentive for larger businesses to enter.  Furthermore, legacy software and especially ERP vendors are priced out of Sylogist’s market and can’t capture all the specific use cases required to compete. Manufacturing and servicing industries (where legacy vendors have market share) have been among the first to shift to cloud-based software, and those end markets represent a small portion of Sylogist’s business mix.

 

Channel checks indicate that often Sylogist products are displacing things like Quickbooks, manual Excel templates or even green screen (COBOL) systems. Setting aside the customers who remain on legacy software systems that either must be upgraded or replaced (some of which have been discontinued altogether), and you have both a long runway for growth with continued demand and a natural replacement with the Sylogist platform. I say natural replacement because several of Sylogist’s products are built using the Microsoft Dynamics platform, where Sylogist can not only customize products for specific verticals but can also benefit from the reputation and track record of Microsoft during customer acquisition and when cross-selling adjacent products and services. This is evident from the former Microsoft employees who have called Sylogist their ‘public sector partner’ making for a simple transition among new customers.

 

Sylogist has three separate revenue segments within each of their verticals, made up of Cloud Subscriptions (40% of revenues), Maintenance and Support (25%) and Professional Services (29%). The remaining percentage of revenues consist of Licenses and Hardware sales, located in Other Revenues and immaterial to the top line. Approximately 70% of Sylogist revenues are recurring between Cloud Subscriptions and Maintenance and Support, providing both visibility and resiliency into the business. Sylogist is currently transitioning legacy on-premise customers to the cloud as well as attacking white space for new customer growth, which the current management team has been largely successful in doing based on increased bookings, backlog and revenue growth. Moving forward, management’s strategy is to grow both organically and via M&A, while focusing on the organic growth of software subscription revenues. A continued shift to more SaaS revenues will come with higher margins and increased cash flows as well as magnify the overall attractiveness of the business.

 

Recent Business Results and Outlook

 

In line with my comments in the strategy shift / background section, since 2021, Sylogist has been reinvesting around $10mm/year in the form of product development and sales and marketing. The sales and marketing department now consists of sixteen employees as opposed to just three when management took the helm, and product development is responsible for building the current version of Sylogist’s software platform. Customer account management has improved the company’s NPS score to around 50 today, while also engaging in cross-sell opportunities that have also been bearing fruit.

 

Organic growth in software subscription revenues was negative during 2021, but as of Q4 2022 turned positive for the first time since that period. Sylogist also reported mid-teens to low 20’s consolidated organic growth rates during Q4 2022 and Q1 2023 in addition to both ARR and bookings growth.

 

Moving forward, the growth strategy will be focused on both new customer wins, cross-selling, and wallet share expansion among existing customers. Investments in customer account management have allowed Sylogist to effectively cross sell their customers and introduce them to new products and services which has translated nicely to the top line growth referenced above. There will also be an emphasis on rolling out products in new verticals (a new SylogistGov product has yet to impact the top line as initial customers are being onboarded now) and utilizing channel partners to drive additional customer wins. From their time as a software reseller and through management’s experience, the company maintains relationships with valuable channel partners in the Government and Education spaces which should bode well for future growth. I believe the use of channel partners could add a few hundred bps to gross margins if utilized successfully. Although management hasn’t quantified it at this stage, their recent comments on the use of channel partners confirms their excitement regarding the opportunity.

 

…As I’ve shared previously, there, for us to achieve the scale that I see for Sylogist being going forward, there is going to need to be a healthy blend between our direct sales force as well as a partner channel. He (the new Chief Revenue Officer) has deep partner experience, partner channel experience and building partner channel and executing and developing not just partners that are tangents, but really walk and talk as if they were Sylogist.

 

…The partner channel right now is – has affected the performance minimally both Microsoft as well as our own partner channel, outreach and community that we are building on a 12-month to 24-month basis, material. And why do I say that is because most of the performance that we have seen in terms of our growth really isn’t reflecting the opportunity in the SylogistGov as well as the SylogistEd, that’s ahead of us…

 

…So, as we turn up the partner community, which is our primary strategy for SylogistGov in North America, the impact that I anticipate that we will have will be material in terms of our ability to grow revenue and to primarily do it with passive revenue growth, which is IP related versus having to add more and more people to be able to deliver the services.

 

…We expect the majority of Ed and Gov to be – the service side of it to be delivered through our partner channel and partner community over time. So, it’s a great question. It’s really one of the exciting parts for our story going forward is the headroom for where we see growth and scale coming is just, we are only scratching the surface of it at this time in the markets we serve through that partnership strategy.

 

While organic growth in cloud subscription revenues have inflected positively for the first time in 18 months, consolidated top line results reveals that Professional Services has made up the majority of consolidated organic revenue growth. This is expected given the upfront implementations required for new SaaS customers, the shorter sales cycles with services, and the fact that it’s easier to sell one-time projects. Professional services growth won’t garner the multiple that I believe is deserved, but the importance of this segment shouldn’t be discounted as professional services help drive positive customer service, word of mouth referrals, and cross-selling opportunities (things that was completely lacking with the prior management team). Most importantly, professional services implementations have historically been a leading indicator for future cloud subscription revenues. Outsourcing this segment wouldn’t make sense for those reasons, and mostly because Sylogist wants to capture the entire customer relationship. Furthermore, professional services are incorrectly viewed as single projects. Sylogist recently disclosed a 60% ‘attachment rate’ (of recurring revenue) to professional services, indicating that not all projects are one time in nature.

 

An illustration of the recent inflection point in cloud subscription revenues is below, referencing the following organic growth numbers:

 

*Of note, the Bellamy Discount refers to a historical customer recently onboarded at a three-year, discounted price. The company did this to provide a runway to transition them to the current platform.

 

Should this trend continue, which I believe it will, it will have the effect of improving the financial profile of the business including higher revenue growth, increased gross and EBITDA margins as well as higher cash flow conversion. Consolidated organic growth rates have reached record highs as of the last two quarters, and there remains a significant runway for new customer growth, M&A and cross selling. While not broken out, software gross margins are in the 75-80% range with minimal incremental opex / capex needed to sustain growth in cloud subscription revenues. If investors can wrap their heads around the idea that in between the goal of intentionally decreasing margins (only to see them potentially increase again), that a lot of value is being created, then I think investors can grasp that Sylogist is building a stronger business, which stands in stark contrast to the prior management team’s efforts.

 

In addition to the organic opportunities, there are a number of secular trends driving increased adoption of software and digitization within the public sector which stands in contrast to the private sector. First, COVID accelerated the digitalization of most things in the non-profit and government worlds. Remote employees, citizen engagement, payment capabilities, ERP modernization and budget deficits have led to an increased adoption of software. Second, there is significant customer demand for software integrations, reflected by the number of customers I spoke to who mentioned the necessity of being able to connect their CRM / budgeting / people management / accounting system to one platform where these applications can speak to one another. This not only makes life easier and helps play into the trend of catering to more tech savvy younger employees, but for smaller non-profits, budget deficits and lean expense profiles mean that transitioning to lower cost, cloud-based solutions makes sense for all parties. Third, the industry is made up of highly fragmented legacy systems, providing a large opportunity for vendors to provide more modern solutions. Lastly, the fragmentation of the industry and desire for larger players to consolidate systems, products and offer the latest features means that there are plenty of acquisition candidates to roll up that would both increase the value prop and be revenue/earnings accretive.

 

Strengthening via M&A

 

Both Tyler Technologies and Blackbaud are proven consolidators in the government / public market software spaces, and Sylogist is well on its way as an acquirer. During the past three years, Sylogist has successfully acquired three businesses in key verticals made up of Municipal Accounting Systems (MAS) a highly regarded provider of student information management and accounting software to K-12 schools, Mission CRM, a developer of fundraising and donor engagement software, and Pavliks, a provider of SaaS applications to public sector member associations. The competitive landscape is very fragmented, and acquisitions typically come with synergies and predictable integrations. Although management hasn’t provided specifics regarding potential revenue or cost synergies, channel checks indicate there should be some duplicate back office / personnel costs, and with recent investments dedicated to building out a valuable and scalable software platform along with a dedicated account management team, cross-sell opportunities should be available over time.

 

Capital allocation via M&A has been strong, considering the following:

 

Mission CRM was acquired for $2.9mm. Mission was doing a little over $1.0mm in revenue at the time of the deal, and growing rapidly, with earnout targets for 2024 that management fully expects them to reach. Mission CRM is the developer of the Mission CRM fundraising and donor engagement SaaS platform, built on a Microsoft Dynamics 365 and Azure foundation, fully embracing the Microsoft Data Model for large and mid-market nonprofit and non-government organizations.

 

Pavliks Group was acquired for $11.4mm. At the time of the acquisition, Pavliks was doing $9.4mm in revenue and $1.6mm in EBITDA, growing 20% per year. Pavliks is a provider of proprietary SaaS applications and professional services primarily to public sector organizations and member associations.

 

MAS was acquired for $37.5mm. At the time of the acquisition, MAS was doing $7.7mm in revenue and $4.4mm in EBITDA, which will grow as they expand to additional states. Based in Shawnee, Oklahoma, MAS is a highly regarded provider of student information management and accounting solutions to K-12 public school districts. MAS was founded in 1985 and has grown to serve nearly 85% of the Oklahoma K-12 public education market with its integrated Wen-GAGE platform. MAS is highly complementary to the Company’s existing SaaS K12 solutions and will allow the Company to provide more feature-rich, scalable and flexible offerings to customers and new school districts throughout the country.

 

Continued M&A is an additional lever to pull for value creation that is not factored into my base case valuation, and despite still elevated private market valuations, the deal pipeline remains incredibly full, with management at one point targeting $20-25mm in revenues via M&A during 2023 (that target has since been adjusted, but management claims the pipeline has doubled). That’s why the company is recommended by many top equity platforms:

• value investing screener
• best stock screeners
• best investing platforms

 

Brief Industry Overview

 

Public market software is a growing industry. Gartner and others predict 5-7% growth in public sector software through 2030, driven by a number of secular trends. Sylogist cites multi-billion-dollar TAMs within each of their verticals, creating a huge growth runway with the increased adoption of software. TAM estimates are to be taken with a grain of salt, but conversations with industry experts helped form the view that the public sector is at least a decade behind the private sector in terms of technology modernization. Growing demand for software, combined with rising IT budgets, citizen demands for digital government, a gradual shift to the cloud and a younger generation entering the government workforce provide for sustainable, decades-long growth drivers in this market. There is also significant demand among Sylogist’s customer base for centralized tools that can communicate and operate with each other as opposed to individual more siloed solutions. Setting aside the significant whitespace opportunities in Education and Government based on various government programs, Sylogist should continue taking share which will allow them to grow faster than the industry overall.

 

What’s more, public sector and government software has proven to be one of the more attractive and resilient sectors as a highly defensive category given the high retention rates, lack of cyclicality and profitability profiles of these businesses. Tyler Technologies, Blackbaud and Sylogist have been free cash flow positive for over 15 years and both Tyler and Blackbaud grew right through the GFC with little to no changes in margins (Sylogist revenues / operating income declined, but they were significantly sub-scale at that stage with less than $10mm revenues. They were still cash flow breakeven from ’07-09). This makes for the ideal financial profile for private-equity owners.

 

More specifically, this is an attractive industry for several reasons:

 

• Demand is high and will remain steady moving forward given the large number of existing organizations and the current low penetration rate of software applications, especially among smaller organizations.
• There are decent switching costs here given the critical nature of some of the applications and especially as software integrations are developed. Conversations with customers confirmed that significant price increases or incredibly horrible customer service would have to take place before they started shopping around.
• The move toward building a ‘platform’ means there are soft network effects for certain providers with larger product portfolios. If your CRM software can work with your ERP software which can work with your budgeting software, it’s difficult for competitors to unseat that experience. Blackbaud for example has historically underinvested in their software capabilities so despite a large product portfolio, none of the programs are cohesive, making them susceptible to competition.
• There are barriers to entry or soft moats in the form of reputation, relationships, and track record. You’ll often hear CEO Bill Wood talk about the collegial environment into which Sylogist sells and how referrals and word of mouth are still effective marketing techniques. This also explains the consolidation of the industry given the ease of buy vs. build for larger public sector software businesses.
• There is a lack of cyclicality among these businesses based on the above characteristics, typically driving extremely durable economics. Setting aside Sylogist’s and peer performance during the GFC (which was very strong), customer and employee conversations indicate that these types of software and IT tools are not among the first things to get eliminated when reaching for cost savings.
• The industry continues to consolidate. Fragmentation exists from both a software and geographic perspective, and scale matters from both a customer acquisition standpoint as well as a reputation standpoint (trusted vendors get more business). As a result, the landscape is ripe for adding value through M&A.

 

Management

 

Shareholders are invested alongside strong operators and a team capable of executing accretive M&A. Sylogist is led by CEO Bill Wood who is both experienced and aligned with shareholders to drive value moving forward. Bill has significant industry experience, serving as a founding member of Blackbaud along with prior roles at Access International and more recently as President and CEO of FrontStream, a PE backed provider of payment, donation, and employee giving SaaS solutions to non-profits. FrontStream had over 10,000 customers and revenues of nearly $50mm at the time of Bill’s exit, which culminated in the sale of the business to Marlin Equity Partners. During his time at FrontStream, organic growth was complemented with tuck-in M&A, and management is running the same playbook at Sylogist, where there is a lot of customer, product, and relationship overlap with SylogistMission.

 

In terms of alignment, the compensation structure received a much-needed overhaul once Bill Wood was hired. Today, management is compensated on adjusted EBITDA growth along with four strategic objectives: organic growth, operational excellence, net revenue retention and customer wellness. Bill Wood was granted a 500k options package with a $10.30 CAD strike, 250k of which vest when the stock reaches $15.00 CAD, and the remainder vesting through 2025. It goes without saying that I view this structure as much more reasonable than the one implemented by the prior management team. There was also a decent chunk of insider buying among Bill and other members of the management team during late 2022.

 

Of note, a new CFO is now in place which I regard as an upgrade from the prior CFO who lacked public markets acumen and had little experience outside of Sylogist. New CFO Sujeet Kini is an experienced private market executive and conversations with him along with reference checks allude to his ability to communicate this story successfully. During multiple public calls and presentations, Sujeet has outlined the desire to increase the company’s disclosures surrounding software related metrics moving forward, a very positive sign. I believe we should start seeing disclosures surrounding bookings, ARR, and retention numbers, among other things.

 

Valuation

 

At a CAD $6.00 share price, and with 23.6mm shares out, Sylogist has a market cap of $142mm. Adding in net debt of $8mm, the enterprise value is CAD $150mm. During FY22, Sylogist generated CAD $56mm in revenues and $16mm in adjusted EBITDA. If management were to hit on their 15% organic revenue growth outlook for FY23, and EBITDA margins remain at their soft guided 25%, they will generate around $17mm in adjusted EBITDA, for an EV/EBITDA of around 9.0x. given the margin reduction to 25% from 30% in FY22, I’d view FY23 EBITDA margins as trough moving forward, especially given the potential operating leverage I discussed as well as the continued revenue shift toward cloud subscription services. In a normalized scenario I see EBITDA margins creeping back up toward 30% over time. That level of debt should not lead to insolvency, according to other similar cases.

• Apple Probability of Bankruptcy
• Tesla Probability of Bankruptcy
• Microsoft Probability of Bankruptcy
• Amazon Probability of Bankruptcy
• Best Buy Probability of Bankruptcy

 

As mentioned, Sylogist is targeting mid-teens organic growth from here, and recent results indicate that they have been under-promising and overdelivering. Just a few quarters ago, management’s outlook called for low double-digit organic growth, which they easily surpassed during the past two quarters.

 

Q4 2022

 

The investments we made to jump start growth and the effective execution of our strategy over the last 18 months were even more evident in our financial results this quarter. I am pleased to announce that organic growth for our most recent quarter was a record 22%. This is 17% on an FX-adjusted basis, a full 26 percentage points higher than in Q1 2022. Subscription revenue is up 3% from last quarter, or 12% on an annualized basis.

 

Q1 2023

 

Momentum has continued in Q1 with Sylogist achieving record quarterly revenue of $15.9 million. That’s an organic growth rate of 21% or 17% on constant currency basis. This growth was broad-based across the business. Recurring revenue was strong in Q1 at $9.8 million, a 12% year-over-year growth rate. This was led by our cloud revenue which grew 14% year-over-year. We see this growth as a validating measure of how successfully we are executing our profitable growth strategy.

 

That said, my base case valuation assumes revenues can continue to grow at low double digits from here, as I don’t believe 18-21% organic growth rates are sustainable but welcome the chance to be proven wrong. However, at 9.0x EBITDA, before buybacks and M&A, I don’t believe the company has to grow 15-20% for this to work out well.

 

In terms of where margins ultimately end up, it’s difficult to be precise, but examinations of similar software businesses and conversations with management and industry experts indicate that there should be some leverage on both the gross margin and opex lines. In fact, there are opportunities that exist across nearly every line item on the income statement. As software subscription revenue continues to grow, and represents a larger portion of the business mix, and if Sylogist is successful in implementing channel partners, margins should see a material uplift, especially given the lack of cyclicality, largely fixed SG&A, and variable costs in sales and marketing should taper off with scale.

 

The importance of the eventual business mix and the use of channel partners can’t be overstated. Although certainly not apples to apples, a look at ServiceNow historical operating results show that they went from spending 42% of revenues on marketing in 2014 to 34% today, professional services revenues declined from 17% of revenues in 2014 to 5% today, and nearly 50% of their new ACV was influenced by channel partners during 2014, where that number stands at 75% today. You can imagine the effect this had on both gross and operating margins, which have expanded significantly during that time period. With Sylogist software gross margins in the 75-80% range, and with professional services making up 35% of TTM revenues, the setup is at least similar in terms of potential.

 

In terms of value investing, my base case valuation assumes low double digit revenue growth, a smaller amount of margin expansion, and no inorganic growth. In this scenario, Sylogist would generate somewhere around CAD $20-23mm in EBITDA by 2025 equating to 7.5x EBITDA on the low end, and 10x free cash flow. I think Sylogist can trade around 14-16x EBITDA based on improved perception and the characteristics discussed above, resulting in a share price that offers greater than 100% upside. This is before continued buybacks and M&A, and with only slight operating leverage and margin expansion. I believe these estimates are conservative. The business could grow faster than expected, they are currently repurchasing stock, and it’s very likely they will execute on additional deals. If Sylogist were to reinvest a chunk of free cash flow during the next 2-3 years, earnings power could increase considerably. I estimate that with $50mm invested in M&A, the economics of previous transactions suggest that EBITDA could increase by nearly 50%, which, on top of organic opportunities, would cause EBITDA to nearly double within the next few years. At Sylogist’s current multiple, $50mm in deployed capital could translate into an additional $65mm in incremental equity value.

 

The bear case offers 15-20% downside while considering scenarios I’d view as unlikely including zero M&A, mid-single digit revenue growth, no leverage on sales and marketing, channel partners, or new products, and places a 10.0x multiple on a disappointing 2025 EBITDA number. I think the more likely scenario in the event that internal growth investments disappoint, is that the business becomes a platform for M&A, management can buy back a lot of stock and the business would still be receptive to a takeout offer at a multiple higher than today’s valuation. Even if the bear case deserves consideration, the stock remains massively sold off despite today’s business being much better, with a re-vamped organization, better products, stickier revenues and real organic growth. Also important to note, absent multiple expansion, there is an attractive current IRR in place given the free cash flow yield + growth.

 

Without relying on relative valuations, sanity checks reveal that Sylogist trades at the low end of peer valuations, and below every relevant M&A transaction I could find among public sector software, small cap software, platform businesses and vertical specific companies. If you want to argue that Sylogist shouldn’t trade in line with true compounders such as Tyler, The Sage Group or Blackbaud (recently upgraded by Raymond and given a valuation of 19x FY24 FCF), I won’t push back too hard, but a multiple 6-7 turns lower than the median peer valuation, despite having similar or better fundamentals seems unwarranted.

 

Given the history of outside interest, business improvements, cash flow and unlevered balance sheet, Sylogist could also find themselves on the receiving end of an acquisition offer, as the government/non-profit software space is incredibly acquisitive due to the fragmented nature of these businesses, value to both strategic and financial acquirers, and durability of the business models. Although the standalone return profile is attractive, management’s track record indicates that a sale of the business could be a likely scenario. Even share-losing Blackbaud, who has consistently underinvested in the business to the point of declining revenues and margins, finds itself in the midst of a take-private offer from a private equity firm.

 

Risks

• Competition
  • Larger organizations enter into Sylogist’s end markets and try to undercut on price to gain share
• Recession
  • Non-profit funding, donations, grants get cut, IT budgets decline significantly
• Margins never lift
  • The company isn’t successful with operating leverage
• M&A risk
  • Integration
  • Valuations
  • Returns on capital
• Scaling costs more than they expect
  • Internal investments never taper off, or worse, keep increasing to stay competitive
• No pricing power?
  • The company isn’t successful in raising prices over time
• Walled garden approach won’t work?
  • What if customers just ask them to integrate with current providers (competitors?)
  • Can’t open up the ecosystem because then you lose pricing / customers etc.

At heart I’m prone to contrarian bets on companies that could get under-valued. I believe that is what PGY is today. The stock is down 67% today at the time of writing. It’s a SPAC out of Israel that is very much like Upstart, a company you may be more familiar with.

The company develops and implements proprietary artificial intelligence technology and related software solutions to assist partners to originate loans and other assets. Its partners include high-growth financial technology companies, incumbent financial institutions, auto finance providers, and brokers. It’s Tel Aviv HQ to me brings it added credibility.

Per capita, that is the most innovation city in the world in terms of technology startups.

While being a SPAC and in these macro economic condition dooms you to being a penny stock, I believe in the company’s value proposition long-term. Just look at the stock volatility of Upstart, UPST if you aren’t sure about what I am saying.

Upstart and Pagaya, two of the best growth stocks, both offer artificial intelligence (AI)-based credit scoring systems to expand credit for borrowers without compromising risk to lenders. This is something that will be pretty important in 2023.

It’s my belief that Pagaya is better diversified than Upstart.

Whereas Upstart is focused on personal and car loans, with plans to enter mortgages next year and then other areas, Pagaya already has its finger in many pies. It counts Visa, one of the best value stocks, as one of its credit card partners, and it works with personal loans, auto loans, credit cards, and real estate.

Pagaya went public in June through a special purpose acquisition company (SPAC). Like most SPACs with high valuations, Pagaya slumped after it started trading independently, with most tech and fintech valuations way down this year. A clause that allows employs to sell share has apparently kicked in resulting in the epic slide we see today. Not surprising at the onset of a global recession and bearish volatility.

Pagaya says it boasts a differentiated funding model, saying it raises cash even before it approves funding. That was an issue for Upstart in the first quarter, when it took some loans to hold on its balance sheet when funding began to dry up. It’s an advantage for Pagaya, according to the clickbait Motley Fool.

Pagaya has around 800 employees and was founded in 2016 and is headquartered in Tel Aviv, Israel.

“It will be interesting to observe the stock’s reaction once the VWAP clause is fulfilled, and it will be even more intriguing to see PGY’s reaction once the lock-up period is over. The expected behavior would be volatile price action favoring the downside, as stockholders like early investors and employees would like to “cash out” as soon as possible.

So today September 20th, is its day of reckoning. If the stock goes down far enough, I may have to take a closer look at its business model.

Pagaya’s growing AI network connects investors, partners and their customers, seamlessly integrated via proprietary API. Using sophisticated AI-driven credit and analysis technology, we enable precise, real-time customer credit evaluation. Lenders partnering with them can discover and approve new customers who meet their lending criteria, building brand affinity without taking on undue risk.

I like the intersection of credit evaluation and A.I. Upstart will be easily over-valued, but Pagaya may reach a stock price in Excel point that begins to actually make some sense even in this weird times.

The company is deeply unprofitable. Revenue growth in 2021 was decent. You can read about their 2Q Earnings here.

Their business model is a B2B2C platform

I find their business model has the potential to scale fairly well.

The Company develops data science, machine learning and AI technology (Artificial Intelligence) analytics, enabling accurate, real-time customer credit assessments.

Their current market cap is around $1.7 billion, however below one billion it looks like an interesting company.

2Q’22 Network Volume and Total Revenue grow 79% and 83%, respectively, in the second quarter, Adjusted EBITDA of $4.9 million

The are trying to build an AI ecosystem designed to deliver better outcomes than traditional models. It’s early days.

I am fundamentally a believer in data-driven decision making.

That their solution is real-time, fully automated and data-rich AI interests me. Their system could over time get better.

I usually stick very far clear of SPACs, but companies like PGY and IONQ make me think a bit harder than usual.

This is because I’m a believer in the impact of A.I. on FinTech and Quantum computing on the future of the Cloud (as in the case of IonQ).

The stock price is down 76% YTD, talk about coming down to Earth.

The stock, which now trades at $2.38 per share, had risen all the way to about $30 at its height.

It’s after the hype that I’m typically a buy the dip potential buyer.

Fundamentals of the Growth Story

Pagaya has raised $571 million to date, they are a big bet on the future of A.I. in credit checking.

At least what they are trying to do deeply makes sense to me.

What do you think?

Since they can help companies find new customers they also have a unique value proposition that makes a lot of sense. Company’s customers are lending companies that, by connecting to the AI Pagaya network, have the opportunity to discover and approve new customers that meet their credit criteria. That is, they immediately have valuable data on their new potential customers.

Check out their investor deck if you are curious. I think the stock price can fall some more and we need to establish more baselines on its actual price before taking on any risk. It’s a relatively new SPAC to put on your watchlist, with a fair bit of potential as an “A.I.” type penny stock. In general and from experience, I have a higher trust in Israeli based companies even if this is one of the worst times for FinTech companies in recent history.

If you would like to learn more about other similar stocks, check out the list below:

• Apple Fair Value
• Apple P/E
• Apple EV/EBITDA
• Microsoft Fair Value
• Microsoft P/E
• Microsoft EV/EBITDA
• Tesla Fair Value
• Tesla P/E
• Tesla EV/EBITDA
• Amazon Fair Value
• Amazon P/E
• Amazon EV/EBITDA
• Netflix Fair Value
• Netflix P/E
• Netflix EV/EBITDA

Penny stocks are low-priced stocks that trade at less than $5 per share. These stocks can be attractive for anyone looking for high-risk, high-reward opportunities. However, investing in penny stocks can be very risky. They are often thinly traded and may lack the regulatory oversight of more established companies. As a result, it’s important to stay informed about the latest news and trends in the market. That’s important when deciding which companies to watch and which penny stocks to buy.Click Here To Watch TTG Live On YouTube

One of the main reasons why news is important is because it can provide valuable information about a company’s financial health. This includes updates on earnings, new product launches, mergers and acquisitions, and other key financial metrics.

For example, suppose a company announces signing a significant new contract. In that case, this can be a positive signal that the company is experiencing growth and may be a good investment opportunity. Similarly, if a company announces a significant setback, such as a failed clinical trial or a lawsuit, this can be a negative signal to the market.

Penny Stocks & News: Why Does It Matter?

News can also provide insights into broader trends in the market, such as shifts in consumer preferences or changes in government regulations. For example, if a news report suggests that the demand for renewable energy is increasing, this can be a positive signal for penny stocks in the renewable energy sector.

Another reason news is important is it can help investors stay informed about broader economic trends. This includes updates on interest rates, inflation, and other economic indicators that can impact the stock market. For example, if the Federal Reserve announces that it plans to raise interest rates, it can lead to a broader sell-off in the stock market. Investors who stay informed about these developments are better equipped to make informed decisions.

– How to Identify Trends With Penny Stocks in 2023

Finally, news can also provide insights into broader social and political trends. These can also impact the market. For example, if a major political scandal breaks out, this can lead to more general uncertainty in the market. Similarly, if a natural disaster occurs, this can have a significant impact on specific sectors of the market. Investors who stay informed about these developments are better equipped to decide when to buy or sell penny stocks.

Penny Stocks To Watch

Tritium DCFC (DCFC)

Shares of Tritum DCFC stock have been on our watch list early in 2023. The company has been in the news on multiple occasions, and the last time we discussed it, Tritium had just announced securing its most significant order in company history. The order came from BP (NYSE:BP) in its efforts to accelerate the deployment of EV chargers. It also announced that it delivered its first fast chargers to UK charging network provider, evyve.

Tritium gave initial 2022 performance expectations. These included sales anticipated between $95 million and $102 million. It’s also expecting fiscal 2023 sales in excess of $200 million.

– 5 Penny Stocks To Buy According To Insider Bets Up To $5.3 Million

DCFC Stock News

This week Tritium gave several updates, including selling more than 300 EV fast chargers to a Danish fuel retailer, OK. In addition, while other companies are slashing jobs, Tritium announced it would add more than 250 to its workforce in Tennessee. At peak capacity, the facility is expected to produce up to 30,000 units annually.

Jasper Therapeutics Inc. (JSPR)

Biotechnology stocks have been some of the most active and volatile to watch in the stock market this year. Jasper Therapeutics, one of the best value stocks, is one of the names to have observed since 2023 began. The company kicked things off with a huge move in January after announcing positive clinical data. The stem cell therapy company reported Phase I/II trial results from its briquilimab in treating sickle cell disease and beta-thalassemia. Since then, the stock has been consolidating in a tight channel between $1.65 and $2.

JSPR Stock News

This week Jasper announced that it presents data supporting its ongoing briquilimab development. CEO Ronald Martell explained, “As we focus the development of briquilimab on treating chronic mast cell diseases and as a conditioning agent for stem cell transplants addressing rare diseases, we believe that the data presented at the Transplantation & Cellular Therapy Meetings of ASTCT and CIBMTR provides the additional mechanistic and clinical proof-of-concept rationale for its mechanism of targeting c-Kit.”

Considering the meeting is being held this week through February 19th, it could be important timing if JSPR stock is on your watch list this week.

Eos Energy Enterprises Inc. (EOSE)

Energy stocks have also been on the radar lately. Eos Energy, as one of the best growth stocks, is a name that steadily climbed higher this week. Earlier this month, the energy storage platform developer provided a business update and gave guidance on its revenue outlook for fiscal 2022 results. Revenue was expected between $17 million and $20 million, with 2023’s outlook between $30 million and $50 million. Eos also reported that it received an order for a 47MWh initial renewables plus storage project with “with one of the largest operators of energy storage in the US.”

EOSE Stock News

According to the latest data of the short interest api, the market this week got the official timing on when it will receive the final figures for 2022. The energy company releases its Q4 and full-year on February 28th after the closing bell. If EOSE stock is on your watch list, keep that in mind.

EBET Inc. (EBET)/SharpLink Gaming Ltd. (SBET)

Shares of sports betting stocks haven’t performed as well as some may have hoped over the last year. EBET is an example of that. However, recent market activity says otherwise. Earlier this quarter, EBET stock exploded higher just before the company announced a $6.5 million financing round.

The company operates and develops wagering products for bettors and caters to the millennial and Gen-Z demographics. As discussed earlier, the news doesn’t have to be from a company to make a splash and that may be what is going on with EBET stock at the end of the week.

SharpLink, on the other hand, focuses on sports betting and iGaming with free-to-play and mobile platform offerings. According to the company, SharpLink’s proprietary fantasy sports platform reaches more than two million fantasy sports fans who spend almost $40 million annually on its portfolio of digital gaming experiences and contests.

EBET/SBET Stock News

In this case, industry-related headlines have brought some sympathy sentiment to betting stocks. DraftKings (NASDAQ: DKNG), a market leader in the space, announced better-than-expected Q4 results. It also raised its 2023 guidance, which brought more optimism to the sports betting and wagering industry-related stocks.

– Best Penny Stocks To Buy? 4 To Watch With Targets Up To 397%

This includes other micro-cap stocks like SharpLink Gaming Ltd, a popular Fintwit stock a few weeks ago. Since this is more sympathy-related and not specific to EBET, it will be interesting to see if there is any follow-through momentum in the market in the near term.

In the Summer of 2021 it’s a bit startling to see how quickly some biotech stocks can surge with high-volume in a single day. Case in point, NanoVibronix $NAOV.

In what was essentially a 250% increase, it went from $0.72 to $2.61, after hours up another 9%.

The company has a new device a UroShield that impacts the reduction and incidence of urinary tract infections and the pain and discomfort caused by urinary catheters. News in a study shot up the stock late Friday afternoon.

Based on the data of short interest API, the short volume was nearly meme-stock inspired. Get this, volume of 58.8 million shares compared with the full-day average of about 204,000 shares.

With that kind of volume $NOAV is likely to keep going up into next week, making it a potential meme stock for the quick profit momentum gamblers.

While the news is positive, it’s hard to see how the stock price increase of so radical a nature is justified.  The company said “The Journal of Medical & Surgical Urology” is publishing an article with “overwhelmingly positive” findings from a study of patients that used its UroShield product in real world settings. “As we would expect, the patient experiences in the study were statistically significant, with all responding patients reporting that our device was simple, easy to use and materially benefitted them,” said NanoVibronix Chief Executive Brian Murphy.

With that much volume it’s unlikely to have reached its short-term zenith on the news as many traders weren’t around on Friday PM to catch the trade.

The company said the peer-reviewed publication has been submitted to the National Institute for Clinical Excellence.

With penny stocks very beaten down since February highs, news is more dramatic at the intersection of biotech and meme-like momentum in volume.

Exela is keeping up its momentum today, with another 10% so far with 10x the usual volume according to Yahoo Finance.

The company is also quickly becoming a short-squeeze candidate as bears and bulls both get on this name. There is resistance at both the $3.70 and $4.50 levels so it’s unclear if this can go much higher.

The WSB subreddit is alive today with traders talking upXELA stock. All of this extra attention has the company’s shares seeing extra trading yet again today. That sort of building enthusiasm could take the stock much higher for a meme stock rally.

There’s now a 70% chance of this occuring. $XELA is still only at $3.60.

Xela Technologies Multi-Day Runner

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Xela ticker $XELA is up 110% in the last month. Could it be the next $MRIN meme stock? There’s an increase in volume and a battle between bulls and bears that suggests it could be, as I mentioned a few days ago.

Yesterday the stock was up another 23%, mostly with a surge in power hour.

After doing an offering of $100 million at the end of June, Xela Tech’s financial situation is much clearer and more promising. $85 million was raised under the $150 million at-the-market equity program launched on June 30, 2021. So now what?

$XELA appears to be trending on meme boards and WSB type traffic in the first week of July, which is 60% likely to be a multi-day runner. The stock was $1.28 on June 18th, and today is $3.29. That’s quite some momentum for a stock whose volatility usually disappoints. But it’s now entering a volume of meme-stock mania.

Xela has room to operate now with $205 million of cash and cash equivalents on hand as of June 30, 2021, not including additional borrowing availability under various credit facilities. They have a new lucrative RPA client in the Healthcare Insurance industry. At a time when the Russell 2000 is under pressure, there are few decent penny stocks to choose from this summer.

Xela has the kind of chart that’s also favored among meme stock pickers. It used to have a huge stock price. This is the $MRIN type of movement. $MRIN so such absurd gains as to inherit the $MVIS trophy for top meme penny stock.

Exela Tech Is As Close to a Value Stock in Micro Cap As You Will Find

According to the data from short interest api, Exela Tech is also likely a beneficiary of the economic recovery. They have a digital foundation in their engineering heritage that powers typically long tenured customer relationships and this is what enables them to continue to innovate and launch new disruptive solutions that further widen their competitive moat, so they claim.

The truth is if this has entered meme stock territory, it doesn’t really matter how much they can regain revenue or how fast.

Xela Tech’s long term finances are also improving. The company plans to use certain proceeds from the equity program to strategically reduce its debt and associated interest expense obligations as well as explore ways to invest in its growth, in line with their previously announced strategic initiatives.

As an initial step, Exela intends to target an annual debt service reduction of $25 million. More offerings are very possible given the multi-year beaten down vibe this company has.

However the late June offering just seemed to delay the inevitable surge of $XELA’s stock. It seems primed for upside also since it has significant bearish action, where a short squeeze is a bit more probable.

We’ve been watching $XELA for about the past 1.5 years, and frankly its new found higher liquidity will likely help it better leverage the already diversified tech pipeline and further enable its business services model by allowing it to fund new growth and revenue streams.

Whether you are looking at fundamentals or meme potential, $XELA has the kind of volatility that’s good for July 2021. I would say $5.50 is a realistic price target for Xela as a peak in July. However expect volatility and a lot of bear vs. bull action.

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