Fishing for Value in the U.S. Market: three small-mid cap companies to consider

Today we begin a series of analyses of some of the stocks included in the portfolio of the MAPFRE Forgotten Value Fund, a MAPFRE AM fund that, thanks to its partnership with The Boyar Value Group, focuses on US small and mid-cap companies. In this first installment, Jonathan Boyar, Director of The Boyar Value Group and Advisor to the fund, analyzes three companies that recently appeared in the following Barron’s article (https://www.marketwatch.com/articles/disney-uber-watsco-value-stocks-51672360586?mod=search_headline):

1) Laboratory Corporation of America Holdings (3.53% holding of the Mapfre Forgotten Value Fund)

The Traditional Business

Laboratory Corporation of America Holdings (“Labcorp,” “LH,”) is a leading global life sciences company that operates in two business segments: Labcorp Diagnostics (Dx) and Labcorp Drug Development (DD). Aided by COVID-19 testing revenues ($2.7 billion), LH generated ~$16.1 billion in revenue in 2021 ($11.6 billion in 2019), adjusted operating income of $3.8 billion (versus $1.7 billion in 2019) The Diagnostics segment is an independent clinical laboratory business that offers frequently requested tests (such as blood chemistry analysis) and specialty testing (such as gene-based testing) through its network of ~2,000 patient service centers and more than 6,000 in-office phlebotomists located in customer offices and facilities. The Company typically processes tests for more than 3 million patients each week, and nearly all the segment’s revenues are generated in the U.S. The independent clinical lab industry is a duopoly, as Quest Diagnostics (DGX) and LH combined have over a 50% market share (and approximately equal market shares). Tailwinds for industry growth include, among other things, an increasing number of gene‑based diagnostic tests due to the expanding knowledge of the human genome and the general aging of the U.S. population.

Faster Growing Contract Research Organization

The DD segment, also known as a CRO (contract research organization), provides end-to-end drug development, medical device, and diagnostic development solutions from early-stage research to clinical development. Importantly, DD supports clinical trial activity in over 100 countries. The global CRO market was estimated to be over $60 billion in 2021 and is expected to have a mid- to high-single-digit CAGR (approximately 2x-3x the expected base business growth rate of the drug diagnostic industry).

With a stronger growth profile, CRO valuations have averaged ~18x EV/EBITDA over the past 5 years, and as the industry consolidates, several large acquisitions in the past couple years have taken place at levels exceeding 20x. Comparatively, the slower-growing diagnostic testing industry (Quest grew at low single digits for years prior to the arrival of COVID testing), using Quest as a proxy for the industry, had an ~11x EV/EBITDA average for the (pre-COVID) 5 years ended 2019. Remarkably, Quest’s valuation has remained higher than LabCorp’s since mid-2019 despite not having a faster-growing segment.

Activist Involvement

This valuation disparity did not go unnoticed: With a push from activist Jana Partners, in March 2021 LH began a strategic review to unlock shareholder value (including a possible spin of DD). At its conclusion, LH announced at the end of 2021 that it would keep DD, initiate a dividend ($2.88 annual rate: 1.3% yield), repurchase $2.5 billion in shares, and launch a $350 million cost savings initiative. Surprisingly, in July 2022, LH announced that it would spin off the clinical trial business of DD (LH is retaining DD’s central lab testing and early drug development businesses), which represents ~50% ($3 billion) of the segment’s revenue and has had a revenue CAGR of ~7% since the end of 1Q 2019. (Margins for this business unit are not disclosed.) Notably, the two businesses LH is retaining also have mid- to high-single-digit growth rates. Management described the transaction as being “designed to create value through enhanced strategic and operational focus” and noted that the planned spinoff will be a tax-free transaction, expected to close in mid-2023. Importantly, the new company will retain access to Labcorp’s health and clinical data, enabling it to provide enhanced trial execution. We believed this to be a significant synergy between the two segments and welcome its retention.

Valuation

We value LH on a sum-of-the-parts basis and apply an 11x EV/EBITDA multiple for and a conservative (vs. the 18x industry average and 20x acquisition multiples) 16x for DD to our 2023 (the spin being expected in mid-2023) estimates of EBITDA to derive an intrinsic value per share of $349, representing 52% upside from current levels. (Not enough information is available to value just the clinical trial business being spun, and we believe that a valuation increase should accrue to Dx once the other faster-growing businesses of DD are part of Dx.) Additionally, while some higher-margin COVID revenue is expected in 2023, we have conservatively applied LH’s lower historical operating margin to the COVID revenue in our valuation model

2) Watsco Inc. (2.07% holding of the Mapfre Forgotten Value Fund)

Watsco has been under the stewardship of the Nahmad family for about five decades. Albert Nahmad (the current chairman and CEO, age 81) purchased a controlling stake in the Company in 1973. The Company has excelled under his leadership through multiple strategic acquisitions and a shareholder-oriented culture.  Watsco is the only publicly traded pure-play HVAC/R (heating, ventilation, air conditioning, and refrigerant) distributor in the U.S. With ~90% of sales derived domestically—limiting FX and trade exposure—Florida-based Watsco has a major foothold in the Sun Belt, where a hotter climate (equipment is used more frequently) and proximity to water (salty air has corrosive properties) ensure that its distribution centers benefit from favorable replacement dynamics. The useful life of a central AC unit is ~10-20 years, a figure that declines by as much as ~5-7 years in high-use geographies near salt water. The business model skews heavily toward residential replacement services (~65%-70% of sales), making Watsco less cyclically sensitive than many housing-related businesses (especially since ~80% of units are replaced under emergency conditions).

Watsco’s Attractive Business Model and Competitive Advantages

By the nature of the HVAC/R market, customers often need timely or even immediate service. Being prepared to respond accordingly means staying well stocked with supplies and being adept at inventory management. For a company to operate at scale in the industry, it also needs sufficient warehouse location density within its markets. All these things add to overhead and require significant working capital. But the scale advantages are significant. Watsco can better compete with smaller players that may not offer such a wide range of products or that may be more likely to suffer inventory shortfalls in high-demand/low-supply periods. WSO also claims an advantage in the higher-margin replacement parts and supplies arena (~28% of company sales), as its inventory diversity is typically superior to OEM factory-operated distribution networks’ and other family-owned distributors’.

Recessions take a toll on construction activity, and Watsco is not immune to that concern. However, the biggest piece of its business (~65%-70% of companywide sales) is residential replacement. In that segment, consumers are not likely to ignore malfunctioning HVAC equipment but have historically opted for short-term repairs more frequently. Since heating and cooling are necessities, customers are unlikely to delay purchases and may instead select a cheaper, lower-efficiency unit for a more affordable initial outlay.

Exposure to Attractive Geographies

The U.S. market is the central focus, at 90% of annual sales. Meanwhile, Canada is 6% and Latin America and the Caribbean are 4%. Properly functioning HVAC equipment is of high importance in most regions, but especially in areas like the Sun Belt (the southern half of the continental U.S.), where the absence of air conditioning can be particularly burdensome in hot weather, making repairs/replacements urgent. Within the U.S., the Company’s presence is mostly concentrated in the Sun Belt states, especially Florida and Texas. Given that maintaining a comfortable indoor environment in hotter regions can require significant hours of operation, the useful life of central air conditioning equipment tends to be shorter. In these hotter and/or more humid climates, it is estimated that the useful life of central air conditioning units drops by as much as 7 years. This is a plus for the Company, as more frequent replacement creates greater distribution need.

Unrivaled Scale

Watsco is by far the largest distributor of HVAC equipment and parts in the country, well exceeding its largest competitor, independently owned cooperative Johnstone Supply ($6.3 billion in 2021 vs. ~$3 billion in annual sales). Despite its unparalleled scale, Watsco commands just ~12% of the North America HVAC distribution market share, by its own estimate. Over the past decade or so, Watsco has also built up a strong presence along the densely populated east coast of the U.S. (~$70 million in sales in 2010 vs. over a $700 million run rate this year). With 671 total locations as of March 13, 2022, its scale provides purchasing power superior to other suppliers’.

Limited Customer Concentration

In contrast to the limited number of suppliers for its cornerstone products (~20 vendors for HVAC equipment), there is minimal customer concentration risk for Watsco. It sells to an active base of 120,000 contractors and dealers, none of which makes up more than 2% of the top line in a typical year. HVAC system installation is not DIY work: expertise is required, with end users relying on the technician to order and install equipment. Contractors tend to select a distributor based on existing relationships with its people and processes. That familiarity may even supersede other conveniences like location, payment terms, and order fulfillment speeds. What’s more, price is a lesser concern for the contractor, as that cost is passed along to the end user. We believe that Watsco offers a superior value proposition to contractors, based in large part on its robust technology platforms, discussed hereafter.

ESG

Consumers increasingly want to use products that are less harmful to the environment, and regulations are increasingly mandating their use. Watsco, whose motto is The Coolest Green Company, boasts a committed ESG (environmental, social, and governance) focus. The U.S. Department of Energy puts heating and air conditioning at about half the U.S. household energy consumption, leaving plenty of room for households to cut CO₂ equivalent emissions over time—a strong selling point for consumers. Reduced household power consumption means eliminating some CO₂ emissions from power companies. The Company claims (validated by independent sources) that through sale of high-efficiency replacement residential HVAC systems it helped eliminate 10.1 million metric tons of CO₂ equivalent emissions during 2020 and 2021, equivalent to about 2.2 million passenger vehicle miles driven. Indeed, replacement HVAC equipment often takes the spot of outdated units that would no longer comply with prevailing minimum efficiency requirements. New refrigerants are also replacing old standards that were more harmful to the environment, and additional lower-CO₂ refrigerants are coming in a couple years.

Balance Sheet, Free Cash Flow, and Capital Allocation

The Company prefers to maintain a healthy balance sheet so that it has the capacity to jump on attractive opportunities, whether large or small. Long-term borrowings under its revolving line of credit declined to just $8 million at the end of 3Q, reduced from $89 million entering the year. The Company consistently employs modest financial leverage and currently sports a net cash position, while gross debt to trailing 12-month EBITDA was also extremely conservative, at just 0.1x.  The capital will be used to support working capital and inventory growth. Inventory levels have risen quickly but roughly in line with revenues.

The Company has deep ties with HVAC equipment OEM Carrier. The two have four JVs that account for ~56% of Company sales. These JVs have been quite fruitful, giving Watsco access to exclusive distribution in several markets across the Sun Belt, the Northeast, Canada, and the Midwest while Carrier benefits from superior distribution efficiencies. Notably, Watsco maintains a controlling stake in all four JVs. The exclusive distribution rights do not expire, and WSO has additional perpetual distribution rights with Rheem and Mitsubishi, though on a smaller scale, which benefit the Company through a lack of competition (volume and price advantages) and via supply priority/favorable credit terms with the supplier. The Company lacks a foothold in the Pacific Northwest but could quickly tap into that market with another JV or acquisition, enhancing its leading ~15% nationwide market share. Its use of debt has remained conservative through business cycles, typically under 1.0x net debt/EBITDA. Most recently, WSO sported a net cash position. The underleveraged balance sheet seems primed to be tapped for accretive M&A. Watsco has not been repurchasing shares, but it does offer a dividend yield of 3.8% (recently increased 11% for the January 2023 distribution).

Valuation

A premium valuation seems warranted considering the strength of the replacement HVAC distribution model and WSO’s lack of peers with equal standing. A reversion to the norm for the gross margin (as inflation cools) should go only partway as rising digital sales and environmental tailwinds boost profitability. Applying a 17x 2024E EBITDA (on par with its 10-year trading average), we derive an intrinsic value estimate of $340/share, 32% above the current price, plus a meaningful dividend (currently $9.80/year; yield: 3.61%).

3)Liberty Braves Group (2.98% of the Mapfre Forgotten Value Fund)

Liberty Braves Group is a tracking stock of Liberty Media that represents their ownership of the Atlanta Braves MLB franchise and a related mixed-use real estate development project (The Battery Atlanta) that surrounds the team’s ballpark (Truist Park). The Atlanta Braves have the third-largest marketing territory in MLB, reaching over 31 million people. Meanwhile, Atlanta is an enviable market for professional sports franchises, as Metro-Atlanta is the sixth-largest market in the U.S. and ranks fourth in the U.S. among the Fortune 500 (includes Coca-Cola, Delta, and Home Depot), offering significant sponsorship opportunities.

Strong Performance

The Braves produced strong performance in 2022 on the field and in the equity markets, winning the NL East for the 5th consecutive year, while BATR posted a return of +13%  (S&P 500 -19%). The Braves’ on-field success has translated to healthy attendance gains at Truist Park, with a record 3.1 million fans attending games, 18% higher than 2019 levels. Notably, the Braves recorded 42 sellouts out of 81 home games in 2022, driving a number of key operating metrics higher, including average gate receipts (+48% vs. 2019), average paid attendance (+20%), and gross contracted sponsorship (+13%).

A Sale on the Horizon

In November 2022, Liberty Media announced that it will be splitting off the Liberty Braves Group into a standalone publicly traded company (no longer a tracking stock).  A Braves separation should pave the way for the sale of the team while helping narrow the discount between BATRK’s public- and private-market values. Liberty is likely to be amenable to a sale under the new structure, as an acquisition of the Braves would avoid corporate-level taxes—a home run for Liberty and BATR investors. Sports franchises continue to transact at record values (Denver Broncos sold for $4.7 billion in 2022, an all-time high price for a professional sports team), and we believe that the Braves would command robust interest if put up for sale. Interest in sports teams continues to be elevated, as private equity and other nontraditional investors have entered the fold.

An Increase in Forbes Value?

After only modest (single-digit %) increases during the preceding 4 years (2018-2021), the 2022 Forbes value for the Braves experienced a more meaningful (+12%) increase to $2.1 billion, reflecting a couple factors, such as the beginning of a more favorable MLB national media contract and the Braves’ 2021 World Series win, which has had favorable implications for key Braves revenue components. There are several items that could help the Braves garner another large valuation increase in 2023, including a step-up in the Braves’ local media rights payments (+$100 million in 2023 vs. ~$80 million in 2022) and meaningfully higher sponsorship revenue thanks to MLB’s recent decision to permit a jersey sponsor—a move that is expected to generate a “significant” amount of revenue for the Braves (perhaps double-digit millions annually). The current operator of the Braves’ RSNs is facing financial difficulty (could impact media rights payments), but we believe that there would be robust interest in these rights (tech companies, MLB, etc.) if they were to come up for sale.

Although legalization of online sports gambling continues to flounder in Georgia, there is reason to be hopeful that 2023 might bring progress, which would have a favorable impact on the Braves franchise value, as sports gambling tends to increase fan engagement and open up new revenue streams. According to a recent poll, 45.6% of Georgia voters favored making online betting on professional sports legal in the state, versus 42.5% opposing it. The success of online sports betting in surrounding states could provide the impetus for approval (Tennessee has generated $80 million in sports betting tax revenue since 2020), and revenue from sports gambling would go a long way toward helping Georgia (nearly 2x the population of Tennessee) close its budget gaps. (Georgia’s revenue shortfall reserve currently stands at ~$5.2 billion.)

Valuable Real Estate

Revenues from the Braves real estate business were up 18% during the 9 months ended 2022 (adjusted EBITDA: +13%). In our view, investors should be charged up about the Battery, which with its over 10 million visitors annually ranks #4 among U.S. attractions, even ahead of Disney’s Hollywood studios (10 million visitors). During 2H 2022, the Braves broke ground on a new office building (Five Ball Park Center) that will serve as the new national headquarters for Truist Securities. The new 250,000-square-foot building will be located about 300 feet behind home plate and will include a 42,000-square-foot trading floor. Truist has agreed to a 15-year lease and expects about 1,000 employees to be located in the building, providing a large group of potential visitors to the Battery and Truist Park. Another project dubbed The Henry (named after Braves legend Hank Aaron) is in the works and is expected to include an upscale apartment building and hotel, with the Braves contributing land for a minority stake, minimizing its cash outlay. The Braves are targeting ~$64 million in stabilized NOI (~$51 million attributed to the Braves after JVs vs. ~$40 million annually today) from its current and under-construction (not including the Henry) real estate projects.

Valuation

We value BATR by applying a discounted (vs. precedent transactions) 25% premium to the most recent Forbes value for the Braves. Factoring in our estimate for BATR’s mixed-use real estate, including the Truist Securities headquarters, we derive an intrinsic value of $49 a share, representing ~45% upside from current levels. We believe that our estimate of the real estate is conservative (having applied what we view as extremely conservative cap rates for hotels and nonhotel properties of 9% and 8%, respectively) and have not given the Company credit for real estate beyond that currently owned or under construction.