An Interview with David Barr of PenderFund Capital Management

An Interview with David Barr of PenderFund Capital Management

Seeking Alpha recently conducted an interview with David Barr of PenderFund Capital Management, an investment institution I have followed for a few years now. I thought I would pass along this interview as it sheds light into his investing approach to the stock market...

David Barr, CFA, is the President and CEO of PenderFund Capital Management. He is also the Portfolio Manager of several of Pender’s funds. David began investing in 2000, initially working in private equity, which gives him a unique background to investing capital in public markets. He is an advocate of value investing and believes that investing in a company well below intrinsic value decreases the risk and sets it up for generating long-term performance.

He looks for value in unpopular places with a view to finding “quality at a discount.” David has been interviewed for his opinions on small cap, the technology sector and value investing by Bloomberg, Financial Post, The Globe & Mail, BNN and other media. We emailed with David Barr about major catalysts for a thesis, how to determine the private market value of a company and how he takes a private equity style approach to public markets.

Seeking Alpha: For two years in a row, your fund (Pender Small Cap Opportunities Fund) won a Lipper Fund Award for Best Canadian Small/Mid Cap Equity Fund – what are the key drivers for this performance? How does this apply on a go-forward basis?

David Barr: The fund’s performance since inception has been driven by two factors. First, our investment process and secondly, the sector of the market we invest in.

Our investment process is a private equity style approach to public markets. We like to dig deep on the companies we invest in and the industries they operate in. This gives us an in-depth knowledge of various aspects of the company which helps us to evaluate the opportunity.

We look at competitive advantage, what does the company do to differentiate itself and how sustainable is it? What is the operating landscape and what are the associated dynamics?

How big is the market being addressed, and how fast is it growing? What stage is the company at?

We assess the management team, asking ourselves how competent are they, can they execute on an operational and strategic level? What is their ability to allocate capital? We also like to assess the incentive system for management and the cultural integrity of the firm.

And of course, we look at fundamentals; what are the underlying economics of the business? What is the true, long-term earnings power of the business in terms of free cash flow?

Once we understand the business, we can make a better estimate of what we believe the intrinsic value of the company is and answer the question “what would an independent third party come and buy this whole company for?”

The second factor is the part of the market we operate in. Many traditional Canadian investors have a significant portion of their portfolios allocated to resource-based stocks. We have always gravitated towards non-resource stocks and more into technology, and technology has outperformed resources over the past five years.

On a go-forward basis, we don’t know which part of the market is going to perform well, particularly in the short term. What we do know is that we will continue to execute the same disciplined process that has underpinned our performance record to date.

SA: As a follow up, can you explain the reasoning behind the decision to cap the fund and the benefits of this? How much capacity is available in the Canadian micro/small cap space? How does this compare to the U.S. markets?

DB: We capped the small cap fund a couple of years ago to allow the fund to maintain the same investment strategy it had employed since inception. As funds grow, they become restricted from investing in small and microcap companies and we believe this part of the market contains some of the most compelling investment opportunities. Our view on capacity is that you can continue to operate effectively at $200 Million, but it becomes more challenging when you get to $500 Million.

We are spending a lot of time looking for US-listed opportunities now. The reality is that US markets have more companies to invest in, and in particular, non-resource ideas. Our view on capacity is the same for the US as for Canada. As long as you are running a fairly concentrated portfolio, the limiting factor is the size of positions in microcap opportunities.

SA: What are some of the most out of favor industries or stocks right now? How do you make the key determination between a security that is out of favor for a good reason compared to one that is merely oversold or misunderstood by the market?

DB: To determine the merits of a security that is out of favour for good reason, compared to just being oversold, you need to distinguish between secular and cyclical forces. Wynn Resorts’ (NASDAQ:WYNN) problems a few years ago seemed cyclical. Sears Holdings’ (NASDAQ:SHLD) on the other hand are secular.

As for what’s out of favour? We ask ourselves what’s currently most popular and invert. The case right now is that ETFs and passive investing are in vogue, therefore we look for non-index names that appear either attractively valued or cheap. And small cap companies seem to be more chronically undervalued because they don't get an automatic bid from the inflows of index investors. Eventually, math matters. In the meantime, it's a great time to pick up undervalued securities in these ignored areas.

SA: What catalysts do you look for in value investments? How often are the projected catalysts realized? How do you determine when to sell if a catalyst is realized (or not)?

DB: As is our answer to so many questions, it depends. Let’s define a catalyst as an event that makes the share price go up. The most logical event is the sale of a company. For our part, we try to determine private market value or the price another company will pay. This process also helps us to assess the likelihood that company will be acquired and to do this you need to understand the shareholder base and management incentives.

Having a large assertive shareholder will increase the probability of acquisition, as will having a management team that is incented to create an exit for shareholders. These include companies that are increasing their market share and addressing new and large markets, or companies that have a wonderful product that fits into the product roadmap of a competitor. Not only do we think these types of companies are worthwhile to own over the long term, other companies tend to share our view.

The other major catalyst we see is when uncertainty becomes certainty. For example, when a company hits a significant inflection point such as going cash flow positive. In this situation, the uncertainty as a going concern is removed. Another example is an established company with a declining legacy business that develops a next generation product, and growth in sales of the new product eclipse those of the legacy product, making the business attractive again.

SA: How do you determine the private market value of a company, especially from an M&A standpoint? What metrics do you use to arrive at this value?

DB: Having been involved in the sales process of several companies, it gives you a lot of insight into what buyers are looking for when they buy a company. In determining private market value and the metrics used, again, it depends. So many variables come into play that every situation is unique. The bottom line is that you need to determine what the earnings power of the acquired entity will be within the acquiring entity. To assess this, you need to understand what drives the gross margin.

You need to understand the degree of general and administrative expenses that can be eliminated, similarly with sales and marketing overlap or R&D overlap. That drives the base earnings power and value. You can then layer in some additional assumptions, like whether the larger company will get an immediate revenue bump through increased distribution, or sometimes companies only want to buy from a larger, very well capitalized company so this will drive an increase in sales. When calculating our margin of safety, we use the base case, but we are always looking for additional optionality.

SA: Can you walk us through your thesis on GreenSpace Brands?

DB: GreenSpace Brands (TSXV: "JTR") is a Canadian organic food, consumer product company. Their brand development is done in-house or through acquisition, and their current brands include: Love Child, Rolling Meadows, Central Roast and Kiju amongst others. The company has recently traded with a market cap of around $85 Million.

We believe GreenSpace Brands has the potential to grow significantly as they consolidate the highly fragmented natural and near-organic food market in Canada. Smaller mom and pop brands naturally hit a growth plateau as it is very challenging to secure large distribution arrangements.

Large retailers dominate the Canadian grocery market and these companies prefer to deal with suppliers that have several brands. GreenSpace Brands has developed strong relationships with these national retailers and can introduce acquired brands quickly into their distribution channel. M&A can be accretive as a result of increased revenue growth and cost savings from M&A, G&A and manufacturing.

Two recent transactions, Love Child and Central Roast are shining examples of possible M&A accretion. GreenSpace Brands was able to double Love Child revenues in five months and turn $600K losses into profitability. And with Central Roast, the company was able to close two distribution deals (Costco and Loblaws) within six months of acquisition for a nearly 50% lift in revenue.

Management has a proven ability to execute. The CEO has an extensive background in natural foods, having founded and operated multiple brands of his own. There is also significant experience at the managerial level in retail product placement and marketing at the national level. On the M&A side, the team has already completed several successful acquisitions, proving their discipline on buying brands at the right price and their ability to integrate them into their existing business.

As previous shareholders of Whole Foods Market, we have spent a lot of time looking into the organic and natural foods market. In Canada it is a $10 Billion market and growing in the low-double digits. We see a great runway ahead as Canada ranks in the middle of the pack in organic food sales per person. In addition, lots of big players are scrambling to compete and the traditional CPG companies have been highly active on the M&A front, something we look for when trying to identify potential catalysts.

The current run rate for the business is around $40 Million of revenue and $1 Million in EBITDA. We are comfortable with some analyst estimates of $55-60 Million in revenue, $2-3 Million in EBITDA (year end March 2018) before any further acquisitions, and ~$65-75 Million in revenue, $3-4 Million in EBITDA (year end March 2019).

The stock is currently trading ~1.4X 2017 revenue, a slight discount to larger food manufacturing brands, which trade around 1.5X revenue and organic/natural brands, which trade around 2X revenue. We believe the discount is unwarranted due to the significant growth runway ahead of company, the lack of competition in its niche and an accretive M&A roadmap.

We see several potential catalysts for increased financial performance of the company. Operational improvement through continued integration efforts and a new warehouse facility coming online (1-2bps improvement to EBITDA); internal development efforts, especially New Love Child products, are gaining momentum and should drive company SSSG; and lower margin products, such as dairy, are naturally becoming a smaller portion of overall revenue. In addition the company has around $5 Million of dry powder for future M&A.

SA: Can you walk us through your thesis on BSM Wireless?

DB: BSM (TSXV: "GPS") is a hardware and software provider for commercial fleet tracking and asset management focusing on key verticals including rail, construction, government and service (utility, security, trucking).

The company is an industry leader with an attractive valuation and the upside of potentially being acquired. It’s a global leader in its key verticals such as the rail industry and has all seven of the Class 1 railways as customers. Its merger with Webtech in late 2015 is a game changer. The merger expanded BSM’s vertical and geographic footprints and catapulted the company into the top 20 commercial fleet telematics providers globally. Post-merger, BSM effectively doubled revenue to $60 Million, reduced costs by $4-$5 Million through cost synergies and moved its EBITDA margin up to around 15% from the low single digits.

BSM has continued to strengthen its core business by consolidating into one software platform and one hardware platform. It is also working on becoming more software focused and hardware agnostic. The company acquired Mobi in October 2016, adding higher margin recurring revenue on analytics to its subscription revenue. At the end of Q3 (June 30, 2017), BSM had 161,000 subscribers and approximately 70% of its revenue was recurring.

As BSM consolidates, organic growth has been slower. However, the company is starting to gain traction in converting its sales pipeline into revenue, especially in the rail and government sectors. Notable recent successes include a government agency signing monthly subscriptions for a potential fleet size of 6,000 vehicles, a Tier 1 rail customer adding 1,500 subscribers, and ongoing orders from the Company’s largest construction customers.

While the sales pipeline is growing, the churn rate is stabilizing. BSM’s churn rate was abnormally high in Q2 due to the 2G/CDMA shutdown of AT&T (NYSE:T) in the US, but it returned to 9% in Q3, a more normal annualized rate. Another 8,000 subscribers are potentially at risk as a result of the 2G/CDMA turndown in Canada: roughly 4,000 will drop off in 2018 and the remaining 4,000 subscribers will go by 2020.

BSM is in the early stages of working through these subscribers and it is likely that some of them will return. In the US, around 1,000 customers returned out of the 10,000 estimated subscriber losses. Gross subscription “adds” from increasing new business will also offset some of these subscriber losses.

The stock is trading at 1.6X revenue and 12X 2018e EBITDA at consensus estimates, a discount to its peers. Recent telematics transactions point to higher valuation multiples - Verizon (NYSE:VZ) acquired Fleetmatics at 6X revenue and 18X EBITDA forward multiples. Given the involvement of activist investor Crescendo (with over 10% ownership) and BSM’s increased scale, it is more likely to become an acquisition target itself for financial and strategic buyers.