Keith Smith of Bonhoeffer Fund discussed the theme of serial growth and operating leverage in consolidating fragmented industries at Best Ideas 2022. Keith also presented his investment theses on Asbury Automotive (US: ABG), Consolidated Communications (US: CNSL), and Millicom (US: TIGO).

Theme overview:

Serial growth in revenues and cash flows are important in identifying promising investment opportunities. In most circumstances growth comes from underlying market growth, increases in market share, or velocity (quicker turns of product/service). Another source of growth is the consolidation of firms in either the same (rollup), related (platform), or various niche industries (accumulators). Consolidation creates earnings growth through operational leverage from economies of scale and scope if firms are purchased in close geographic or functional proximity. The industry structure is important in estimating the amount of growth one can expect from consolidation. In markets with little consolidation, the growth runway can last for decades. Innovation can also create market fragmentation which can be subsequently consolidated. The internet and e-commerce firms are examples of innovation fragmentation.

Another important KPI for growth is high returns on capital and incremental capital. High returns on capital are typically from a combination of margins, velocity (turns per years), and modest tangible capital required to generate the margins and velocity. Tangible assets can also be leveraged from other firms (Coca-Cola and Coca-Cola bottling firms are a good example of this). In this session, Keith investigates consolidation in fragmented markets with a focus on firms involved in consolidation through mergers and acquisitions and growth achieved by deploying new innovations to provide essential services. He discusses KPIs, benchmarks, and methodologies in assessing opportunities associated with consolidating markets.

Asbury Automotive is rolling up car dealerships in a fragmented US market. The US auto dealership market is fragmented with the top five firms only holding 8% of the total US market. Auto dealers can achieve local economies of scale (clustering) through shared advertising, auto selection, and service opportunities. The internet has also fragmented the customer base — most notably through age demographics — and provides high incremental sales and service opportunities for firms such as Asbury. In addition, Asbury’s management team has used traditional earnings growth techniques such as leverage and share buybacks when Asbury’s stock price is low and there are no immediate consolidation opportunities available in the market.

Consolidated Communications has historically rolled up local wireline telecommunications firms. The US telecommunication industry is a fragmented group of local markets that is being further fragmented with broadband fiberoptic technology. Consolidated recently obtained financing to complete a fiber rollout to more than one million customers. Offering fiberoptic broadband, Consolidated can compete with local cable firms in its coverage footprint for both consumer and business customers. As with Asbury, Consolidated uses leverage to increase shareholder returns and the amount of leverage can be easily serviced and paid down with current and projected cash flows.

Millicom has historically rolled up local wireline and wireless telecommunications firms in Latin America. The Latin American telecom industry is a fragmented group of local markets that is being further fragmented with broadband fiberoptic technology. Millicom, by having both wireless and wireline assets in each market, has two network effects associated with wireline and wireless assets. Millicom competes in smaller Central American and South American markets that have fewer competitors and relatively stable currency versus the large markets such as Brazil, Mexico, and Argentina. As with Asbury, Millicom uses both leverage and share buybacks to increase shareholder returns. In addition, Millicom has valuable tower, data center, and fintech assets that can be separated and monetized from its core assets.

Thesis summaries:

Asbury Automotive is an automotive dealership group located in the US, with 155 dealerships. 60 of the dealerships are considered premium or luxury brands, 47 are import brands, and 48 are mass market brands. Recently, Asbury has added an online sales channel through Clicklane. Asbury is in a fragmented industry that is consolidating with the top five competitors holding 8% market share. Asbury has four levers for cash flow growth: (1) buy new dealerships, (2) pay down debt, (3) internet distribution and (4) buy back shares. Asbury’s management has a returns-oriented framework, having delivered an average return on equity of 32% over the past ten years, the highest in the US automobile dealership market. This has led to 6% revenue and a 25% annual earnings growth over the past ten years. Over the next five years, Asbury is expected to increase its revenue by 20% per year primarily through M&A and internet sales. Given this profile, Asbury is an interesting opportunity selling for 7.9x 2021 earnings and 3.4x 2026 earnings. Using a DCF model and reasonable terminal assumptions (15x PE), Keith arrives at a long-term target (2026) of $782 per share.

Consolidated Communications provides local telecommunications services to consumers, businesses, and other telecommunications firms in the US via legacy voice and data services and some fiber-based services to firms and individuals. CNSL has 780,000 voice subscribers, 76,000 video cable subscribers, and 792,000 data subscribers. CNSL’s network includes 46,000 fiber miles and has 20,900 on-net buildings. The value-add going forward is CNSL’s plan to lay a fiber-optic network which will cover 1.9 million homes upon completion in 2026. The new network is fully financed. In 80% of CNSL’s markets, the compnay has one competitor and in 11% of its markets, no competitors. This should lead to high and stable pricing for its broadband services. Over the next five years, CNSL is expected to increase revenue by 5% per year and EBITDA by 9% per year by primarily through new sales over its fiber-optic network. CNSL is an interesting opportunity selling for 6.0x 2021 EBITDA and 3.9x 2026 EBITDA. Using a DCF model and reasonable terminal assumptions (9x EBITDA), Keith arrives at a long-term target (2026) of $49 per share.

Millicom provides mobile and broadband telecommunications services to consumers and businesses in Central America (Guatemala, Honduras, El Salvador, Nicaragua, Costa Rica, and Panama) and South America (Columbia, Bolivia, and Paraguay). TIGO provides legacy voice, wireless and data services, and fiber-based services to firms and individuals. Currently, TIGO has 43.1 million wireless subscribers, including 20.3 million 4G subscribers and 4.9 million home customers, including 8.4 million revenue generating units (RGUs) and 4.1 million broadband subscribers. TIGO provides mobile banking services for five million customers in six countries. TIGO also has 10,000 towers and 13 data centers which can be sold and leased backed. TIGO is in the process of separating its towers and data centers (i.e., Telefónica and América Móvil) and its mobile banking service to facilitate sales or investments by third parties. The growth story of Millicom includes the COVID recovery of Millicom’s Latin American customers, the consolidation of its joint ventures (“JVs”) (such as the Guatemala JV), investment into the fiber network or buying back stock. Over the next five years, Millicom is expected to increase revenue by 4% per year and NI/FCF by 12% per year primarily through new sales over its fiber-optic network. Millicom is an interesting opportunity, selling for 6.8x 2021 FCF and 3.9x 2026 FCF. Using a DCF model and reasonable terminal assumptions (15x FCF for the core business plus value of towers, data centers and mobile banking division), Keith arrives at a long-term target (2026) of $170 per share.

Listen to this session:

slide presentation audio recording

About the instructor:

Keith Smith, the fund manager, brings over 20 years of valuation experience to the Bonhoeffer Fund. He is a CFA charterholder and received his MBA from UCLA. Keith currently serves as a Portfolio Manager at Bonhoeffer Capital and was previously a Managing Director of a valuation firm and his expertise includes corporate transactions, distressed loans, derivatives, and intangible assets. Warren Buffett and Benjamin Graham’s value-oriented approach of pursuing the “fifty-cents on the dollar” opportunities, underpins Keith’s investment strategy. The combination of his experience and track record led Keith to commit most of his investable net worth to the Bonhoeffer Fund model.