During our second quarter 2024 portfolio update, Ensemble Capital’s Chief Investment Officer Sean Stannard-Stockton, and Senior Investment Analysts Arif Karim and Eileen Segall discuss current market and economic conditions, a few short updates on Analog Digital Devices (ADI), Illumina (ILMN) and Chipotle (CMG) as well as an introduction of Veeva Systems (VEEV). There’s a Q&A with the team at the end of the presentation.

Below is a replay of the full webinar as well as a link to Ensemble Capital’s QUARTERLY LETTER.

Each quarter, Ensemble Capital hosts a webinar to discuss the current market, economic conditions, and a few of our portfolio holdings. This quarter, we’ll be talking about some unusual dynamics driving the S&P500, some important factors affecting a handful of our positions, and providing an overview of Veeva Systems Inc. (VEEV).

The event will use a webinar format. Participants will have a chance to ask live questions of the research team during the Q&A portion of the event.

This quarter’s webinar will be held on Tuesday, July 9 at 1:30 pm (PST)

We’d love for you to join us, which you can do by REGISTERING HERE.

If you’d like to listen to our previously-held quarterly updates, an archive can be FOUND HERE.

We hope to see you there!

During our first quarter portfolio update, we profiled portfolio holding, Perimeter Solutions. (PRM). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

Perimeter Solutions: Perimeter Solutions is the sole company that sells fire retardant to the US Forest Service. This mission critical component, the red stuff you see dropped out of planes during major fires, is needed to protect people, property and forests from out of control wildfires. Around the country, and even outside the US, government agencies that are tasked with protecting society from wildfires often look to the US Forest Service’s list of approved products and only buy items from this list. The general idea is that if it is good enough to pass the Forest Service’s extensive testing requirements, it is good enough for any agency to use.

But the Perimeter Solutions story is bigger than just wildfires. The company was founded by a group of investors led by Nick Howley, the founder of a very successful airplane parts maker called Transdigm. We owned Transdigm for many years until we sold it just before the COVID pandemic hit and over those years we came to appreciate Howley’s highly successful approach to M&A, running businesses in a profit maximizing way, and aggressively managing the capital structure to the benefit of equity owners.

So while we believe the Perimeter Solutions business by itself justifies a much higher share price, we also think that in the years ahead Perimeter will engage in a number of acquisitions that will drive significant increases in the intrinsic value of the business.

But the path to realizing these anticipated gains has not come easy so far. Last year ended up being the mildest fire season of the last three decades in the critical western region of the US. It seems to us that the stock ended up trading almost like a futures contract on estimated 2023 acres burned. Of course, the value of Perimeter is related to the long term cash flows it will generate over the next couple of decades of wildfire fighting. But even one Wall Street analyst came out with a report suggesting that the mild fire season may mean that the long term risk of wildfires was not as dire as previously thought.

But the evidence is clear that wildfires are a significant and growing risk in the US and around the world. This outlook is not conditioned on climate change triggering ever more risky weather, although we do believe that the science on this risk is very clear. Rather much of the risk comes from many decades of excessive fire suppression that allowed dry fuel to accumulate paired with the climate conditions that are already here.

Importantly, the validity of this risk is something that apolitical, profit seeking insurance companies have been warning everyone about. In California, where insurance regulators require insurers to assume that wildfire risk in the years ahead will be no higher than the average risk of the past 20 years, most home insurance companies have simply refused to write new policies in large part because they know that wildfire risk is in fact much higher.

And after the energy utility PG&E was bankrupted and convicted of manslaughter for their role in triggering massive wildfires, utility companies around the world have been sounding the alarm about wildfire risk as well. In his annual letter this year, Berkshire Hathaway’s Warren Buffett warn about the risk of wildfires saying that the big increase in wildfire activity, which he expects to continue to increase, risks the financial success of utilities to the extent they may need to become partially publicly funded entities.

Given Perimeter’s long term working partnership with so many government agencies, most importantly the US Fire Service and California’s Department of Forestry and Fire Protection, and their role as the only provider of fire retardant, the real risk to long term shareholders is not a mild fire season, but a breakdown in the natural monopoly position that Perimeter finds themselves in.

When we first initiated our position in Perimeter, a startup called Fortress had already become the first competitor to have its retardant product added to the Forest Service’s Qualified Product List. But the key to understanding Perimeter’s competitively advantaged business model is in understanding how challenging it actually is to supply retardant under life or death situations.
Rather than the company selling fire retardant as a product, Perimeter often fully staffs and maintains service operations on aerial firefighting bases. Inventory management of fire retardant is challenging because you need every base to be prepared to start fighting a fire at a moment notice, while also recognizing that many bases may not even have a fire each year.

The pilots of these firefighting planes take massive risks to protect the rest of us. A misloaded plane, or the slow loading of a plane, risks lives and properties. Going so far as running out of retardant during an active fire is unacceptable.

The best analogy we’ve come up with is the difference between selling tires and running a pit crew at a NASCAR race. The limiting factor to being a successful pit crew is not just obtaining qualified tires. Rather, running a pit crew is about operating flawlessly under mission critical circumstances. And operating flawlessly for decades is exactly what Perimeter has done.

But last year, as pessimism over the mild fire seasons pressured Perimeter’s stock price, it also became apparent that the federal government was going to give Fortress every possible opportunity to win part of the Forest Service’s annual fire retardant contract. While no one doubts how well Perimeter’s product works, and Fortress has been clear that their service wouldn’t be any cheaper than Perimeter, the federal government has a mandate to minimize sole source vendor relationships. Sole source means there is only one provider. And it appeared clear that despite concerns from firefighters about experimenting with an unproven product, Fortress was going to win at least some of the Forest Service contract.

We had bought Perimeter with this risk in mind because we believed that simply getting on the qualified products list was not winning, but rather Fortress still had a lot to prove in terms of their ability to actually deliver.

Last month, the challenges of this industry because clear when the Forest Service announced that they would not be signing a contract with Fortress because further testing had shown that their product corroded the airtanker planes it was used in.

In a press release, Fortress stated, “we have to assume based on this new information that Fortress’ proprietary, magnesium chloride-based aerial fire-retardant formulation will not be utilized for the foreseeable future in the fight against wildfires.”

There are many different kinds of competitive moats that give rise to lucrative businesses. But one of the least discussed is simply “doing truly difficult and important things really well.” We think Perimeter Solutions is a great example of just this sort of moat.

During our first quarter portfolio update, we profiled portfolio holding, IDEX Corp. (IEX). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

IDEX Corp: One of Ensemble’s newer positions is IDEX Corporation. IDEX is not a well-known company, and we believe it has the chance to be recognized as one of the next great serial acquirers like past Ensemble holdings TransDigm Group (TDG) and Heico (HEI).

One of the reasons IDEX is not well-known is because it sells decidedly mundane products, under many different brand names – mostly to distributors and other product manufacturers. It is highly diversified and owns over 50 subsidiary companies; these businesses typically sell niche parts and technology that help larger systems run smoothly in industrial and healthcare end-markets.

One of IDEX’s products is its Systec OEM MINI Degassing module. This module removes gases from fluids and can improve the accuracy of liquid chromatography equipment used to analyze the chemical composition of drugs in the pharma industry, for example. It is sold within IDEX’s Health and Science Technologies (HST) segment, 40% of revenue. Another is its Sandpiper Heavy Duty Flap Valve Pump sold by its Warren Rupp business, counted within its Fluid and Metering Technologies (FMT) segment, 38% of revenue. The pump can be used in a larger Dissolved Air Floatation system that factories use to treat industrial wastewater. Its StreamMaster Fire Monitor is installed on fire trucks and used as a water cannon to extinguish fires. It is sold by the Akron Brass business within IDEX’s Fire and Safety / Diversified Products (FSDP) segment that is 22% of revenue. Flashy Ferraris these are not.

IDEX has been acquiring businesses that sell niche products like these for over three decades. In the last two calendar years, five acquisitions totaled over $1.2 billion. But why would we want to own a company that does so many acquisitions, when acquisitions so often fail, and for so many reasons? Roger L. Martin estimated in his 2016 Harvard Business Review article that “M&A is a mug’s game, in which typically 70-90% of acquisitions are abysmal failures.” Some famous M&A failures include AOL’s $165 billion combination with Time Warner, Daimler-Benz’s $37 billion deal with Chrysler, and Sprint’s doomed $35 billion merger with Nextel.

There are many ways for an acquisition to fail, among them for an acquirer to overestimate strategic fit, to overpay, and to not recognize conflicts in business cultures or technologies. We believe, however, that IDEX is among a class of companies that can outperform via acquisitions, because acquisitions are its bread-and-butter. As opposed to an online service provider like AOL or a car company like Daimler-Benz overestimating the synergies of one big tie-up, acquisitions are what IDEX specializes in. Serial acquirers can be similar to great equity investors who have a disciplined process of buying good businesses at reasonable prices and do so repeatedly and at growing scale over time, much like Ensemble aims to do.

A strategy of serial acquisitions can compound above-average returns for decades if done right. Examples of successful serial acquirers include Constellation Software (CSU), TransDigm (TDG), Heico (HEI), Danaher (DHR) and Illinois Tool Works (ITW), all of which have outperformed the S&P 500 over the last 15 years.

IDEX’s stock has outperformed as well, with a 15% annualized total return since its IPO in 1989, about 4.5% above the S&P 500’s return over the same period.

IDEX’s path to its IPO started 10 years prior in 1979 as the first major leveraged buyout (LBO) by famed private equity firm KKR. At the time it was a 50-year-old auto parts company called Houdaille Industries. Houdaille was taken over by the British-based TI Group PLC, which spun off several businesses it didn’t want into an entity that was again LBO’d by KKR in 1988. The resulting company was named IDEX – an acronym for Innovation, Diversity and Excellence, headquartered in the Chicago area. The LBO left IDEX with a pile of debt to pay off; according to Donald Boyce, the first CEO of IDEX, “It made us focus on cashflow.” Since 1990, IDEX’s operating cash flow has grown at a double-digit pace of 11% annualized, according to data from Bloomberg.

We attribute IDEX’s success to three things: Its 1. Discipline 2. De-centralization and 3. Scale.

IDEX is disciplined in the types of investments it targets and in its financial management. IDEX generally acquires businesses that have #1 or #2 share in small, fragmented markets uninteresting to larger competitors. The businesses IDEX acquires typically sell components or technology that are small portions of the overall cost of their customers’ systems, but that also must be counted on to work. For example, its BAND-IT fasteners, such as steel bands and clamps, are used to hold together objects on everything from ships to aircraft where the cost of failure could be disastrous. These types of parts, once trusted to work and to be supplied quickly and reliably, create a switching cost for customers who don’t want the risk or inconvenience of designing such a part out. This gives IDEX pricing power with its customers.

Management also has a minimum financial return it expects to achieve on its capital invested by year five after an acquisition, and regularly passes on deals that are too expensive. There is a minimum incremental EBITDA margin target of 25% for IDEX that discourages a lot of dilutive acquisitions, and it aims to consistently pay out 30-35% of its net income in dividends.

A second key aspect to IDEX’s success is its decentralization. Unlike the rationale for most acquisitions talked about in the press, IDEX does not expect much synergy between its businesses. While IDEX does buy businesses in certain areas it calls its “business platforms” — such as pumps, valves, water, scientific fluidics & optics, and fire & safety, these businesses are not usually integrated with each other. IDEX gives its general managers performance targets specific to their business and enough leeway to empower them to achieve its goals. It is the antidote to micromanagement.

Lastly, we believe IDEX is successful because it operates at a scale that’s differentiated. It has gained talent, experience, and capital the last 35 years. Acquisitions have been part of IDEX’s DNA from the beginning, having got its start as a collection of businesses spun off from private equity firm KKR; KKR’s co-founder Henry Kravis served on IDEX’s board for the first 14 years (1988-2002.) In the last several years, IDEX has built up a team that specializes in sourcing deals for each of its segments, and in greenfield areas.

The company has also been influenced by the culture of Danaher, another successful serial acquirer whose stock price has returned almost 20% annualized the past 15 years. The past three CEOs of IDEX have been Danaher alums, including current CEO Eric Ashleman and the previous CEO Andrew Silvernail who adopted the “IDEX Difference” that is similar in concept to the Danaher Business System (DBS.) Danaher calls DBS a process for continuous improvement, lean manufacturing, and innovation. The IDEX Difference[…]

During our first quarter portfolio update, we profiled portfolio holding, Ferrari (RACE). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

Ferrari N.V.: Ferrari has had a very successful run since we first bought shares in the company in 2017. It has been one of our most successful investments since, with shares rising over five times, and understandably so given how phenomenal this business is and how well it has been managed.

Initially spun out of Fiat (now Stellantis) in 2015, it was a rare jewel within the parent company, where its value was hidden among more standard and premium cars sold under brands such as Fiat, Alpha Romeo, Maserati, Chrysler, Jeep, and others. Under the leadership of the astute business manager Sergio Marchionne, who had run Fiat since 2004, Ferrari came to be recognized as the undervalued and unique asset that it was within its parent.

It was being run below its potential, perhaps because of over-conservatism in reverence to its legacy – a legacy of offering products that were highly desired by many and undersupplied to only a limited set of privileged customers, who built up their relationship with Ferrari buying nearly two-thirds of its annual output. This allowed them to continue getting access to the most desirable, collectible models Ferrari built in the future.

“Build one less car than the market demand” is a quote attributed to founder Enzo Ferrari, yet where that line stands is more art than science. Conservatism on the supply/demand balance is generally a healthy strategy in protecting the value and exclusivity of the brand. But being too conservative results in too much unrealized value left on the table.

After the company went public in 2015, it reported revenue of just under €3 billion for the year while shipping less than 8,000 cars at an average selling price (ASP) of €270,000 per car. EBITDA margins were 25%. Importantly, by our calculation, its return on invested capital (ROIC) was over 100%.

Ferrari was demonstrating economics more in line with digital and luxury businesses and deserving of a much higher valuation, more like a Hermes or Apple, rather than a typical auto company.

In 2024, the company expects to generate over €6.7 billion in revenue in 2024 with EBITDA margins exceeding 38%. We expect over 14,000 cars to be shipped with an ASP over €400,000 – that is an ASP increase of €100,000 over the past 5 years!
There were two important things we recognized that the market did not appear to fully back in 2017 that made this an attractive investment for us.

When we did our first deep dive into the business in 2016, we estimated there were 2-3 million potential high net worth customers who could afford to buy a Ferrari. Consequently, selling less than 8,000 cars meant a customer capture percentage of less than 0.1% in any given year. Even this year, when the company will likely sell 14,000 cars, we believe it is still selling to less than 0.1% of its potential market. That seemed a very conservative ratio, albeit limited by the appeal of its 2-door, 2-seat ultra-high performance sports car form factor. But we came to believe that Ferrari could increase its appeal to a broader set of customers (increase demand) by widening its form factors to 4-door cars and SUVs.

In addition, its ASP had only risen at a slightly higher than inflation rate of 4% per year over the prior decade. And the company had long wait lists at those prices that sometimes surpassed 18 months. Meanwhile, the wealth of customers in this segment grows at something like 5-10% per year from returns on their assets and businesses.

We realized there was a growing gap between the wealth of their customer base and the pricing that Ferrari captured. For a material proportion of the customer base, Ferrari’s appeal as a Veblen good, means that the more people who could afford one, the less desirable the product because its value comes from its differentiation from the ordinary. A Veblen good is one where demand increases with price precisely because they are so hard or expensive to attain.

Ferrari’s current CEO Benedetto Vigna has succinctly described Veblen good’s relevance to Ferrari saying:
“The client is giving a value to our cars because they are unique, because they are limited, because they are exclusive. We could make more, but that does not make sense. We will offend our clients.”

Our view was that Ferrari would be required to raise prices at a rate that kept pace with their customers’ wealth to continue delivering to customers the Veblen expectations of the product, with shareholders disproportionately benefiting from the increased pricing growth.

It was clear to us that there was a large gap between market expectations priced into Ferrari’s stock and the higher fair value implied by our analysis. Interestingly the large gap persisted for years even after Ferrari began to confirm our thesis when it revealed its 2022 financial targets at the 2018 Investor meeting.

Under Sergio Marchionne, Ferrari began to push the envelope on volumes but in an intelligent manner that included leveraging its core assets to build new form factors that would expand the appeal of its cars to new customers. For example, the Ferrari Roma has been a much bigger hit with women than the traditional style of the 488, F8, or 812. The recently launched Purosangue appears to have every sign of success with those that might have the means to buy a Ferrari but would rather it come with the utility of four doors that can also bring three passengers and some gear along for a weekend.

Ferrari also rolled out the SF90 and 296 GTB/GTS plug-in hybrid models that appealed to a younger segment of its market while making strides towards the global trend of cleaner emissions, but without sacrificing the performance and driving dynamics of Ferrari. These hybrids are likely to also do well in the Chinese market over time, a large fast-growing market for high net worth (HNW) individuals.

These new form factors have increased the appeal of Ferrari across new HNW customer segments without necessarily oversupplying Ferraris within each model line thereby preserving its exclusivity. We see evidence of this from the fact that nearly all models are sold out through 2025 with average selling prices approaching a record €400,000.

This also confirms our initial thesis that Ferrari’s customers would accept higher prices while driving margins and profits benefiting shareholders.

With the launch of the Icona design-oriented collector cars such as the SP1, SP2 and SP3, Ferrari was able to effectively sell high value limited cars more often per decade than when it was strictly reserved for hypercars like the LaFerrari, the Enzo, or the F40. These cars sold for more than €1MM, while the SP3 now surpasses €2MM.

Ferrari also opened up the €500,000+ pricing tier with its higher priced SF90 and Purosangue for the normal production, non-collector cars, which sell in higher volumes further supporting the brand’s higher[…]