Kerrisdale Partners letter to investors for the third quarter ended September 30, 2015.
This is the quarterly letter for Kerrisdale Partners for the quarter ended September 30, 2015.
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The Kerrisdale Partners Fund was down -1.5% for the quarter ended September 30, 2015 net of fees, comprised of monthly returns of 2.4%, -3.8% and -0.1% for July, August, and September, respectively. In comparison, the S&P 500 was down -6.4% for the quarter, comprised of monthly returns of 2.1%, -6.0% and -2.5%. The Barclay Hedge Fund Index was down -4.6% for the quarter, comprised of monthly returns of -0.6%, -2.5% and -1.6%.
Since inception, the Fund is up 1,101.8%, net of fees and expenses. In comparison, the S&P 500 is up 138.2% and the Barclay Hedge Fund Index is up 42.7% during that time.
Our top five positive contributors during the third quarter were short BAVA (Bavarian Nordic A/S), long UHAL (AMERCO), short Undisclosed, long LXFT (Luxoft Holding Inc), and long MRKT (Markit Ltd). Our top five negative contributors were long JLL (Jones Lang LaSalle Inc), long BID (Sotheby’s), long TNET (TriNet Group Inc), long LOCK (LifeLock Inc), and long MHFI (McGraw Hill Financial Inc).
Kerrisdale Partners – Markit Ltd.
We are long shares of Markit (MRKT), a leading financial services information provider trading at 20x LTM FCF. Markit provides critical infrastructure for the credit markets. When Markit was founded in 2003, its key function was helping banks accurately price credit default swaps and other complex financial securities that lacked transparent prices and did not trade on traditional exchanges. Markit developed a unique give-and-get model, a system in which banks feed their pricing data to Markit in return for access to aggregated data. With this platform as a foundation, Markit methodically expanded in adjacent tools.
Ten years later, Markit generates over $1 billion of revenue and has a broad portfolio of mission-critical products serving asset managers, hedge funds, banks and other large financial institutions. Today, the company operates a suite of products that benefit from high barriers to entry, a highly recurring revenue base, 30% operating margins and 100% FCF conversion. The company’s valuation has been hampered by pessimism towards Markit’s processing segment: as certain, high-volume derivatives trading becomes more transparent and transitions towards swap execution facilities (as opposed to traditional bilateral arrangements), Markit is expected to lose some business in the near-term. We are confident that management will successfully navigate around this issue and that the company’s valuation will ultimately re-rate to be more in line with peers as concerns subside.
In 2014, 95% of Markit’s revenue base was recurring. Discussions with Markit’s customers explain why: the portfolio of products is strong, switching costs are high, and over time customers subscribe to more products (not fewer), making it extraordinarily difficult to replace Markit with a competing vendor. Many customers claimed that even if prices increased significantly, they would find it difficult to replace Markit’s products, including its CDS/Loan pricing, WSO, and (for equity investors) the daily short interest tool product.
One of Markit’s leading offerings (~14% of total revenue) is the WSO platform. WSO software provides a comprehensive loan portfolio platform for reporting, accounting, compliance and performance analytics for customers in the syndicated bank loan market. Credit investors are typically invested in hundreds of loan tranches across numerous issuers, creating a sea of idiosyncratic data to maintain – each loan has hundreds of terms that can vary widely across securities. Interest payments and calculations are calculated on a quarterly basis while CLO testing is done monthly, and sometimes the documentation between the issuer’s agent and the investor is still delivered via fax.
Markit adds value to this process by acting as the intermediary between the investor (client) and all the issuers’ agents. WSO collects all the data inputs and centralizes it in one database that is easily accessible by the investor. This platform saves the investor significant time and resources as less time and people are needed for this manual data entry process. We spoke to some customers who
told us that, prior to WSO, they would have employees sitting by the fax machines and manually inputting this data, resulting in an extremely inefficient data input process. Further, WSO’s close integration with middle/back office operations makes it cumbersome to replace, though few customers ever wish to.
Markit is also widely regarded as the best source for loan, CDS pricing, and reference data. Under a give-and-get model, Markit receives proprietary loan and CDS valuation data from the partner banks. Markit aggregates this data and returns the valuations to all of its customers. Access to this proprietary information flow allows Markit to provide the highest quality data to its customers. The Totem product showcases Markit’s ability to retrieve pricing data for illiquid and OTC securities. Totem provides market prices for a broad range of derivatives (including CDS, interest rate swaps, commodity swaps) to OTC derivative market-makers (mostly sellside banks). As shown below, Totem’s coverage goes well beyond the prices available from brokers, making it indispensable for regulatory reporting and daily VaR calculations.
Management has successfully demonstrated its ability to grow the business both organically and via acquisitions. Since inception, management has made 26 acquisitions, with most achieving double-digit returns on capital. Taking a single product category, Markit’s loan franchise (includes loan pricing, WSO, Clearpar and loan indices) produced $4 million of revenue in 2004 and generated 58x more in 2014 reaching $215 million.
The lack of capital intensity and high incremental margins result in substantial free cash flow: Markit generated roughly $300m of cash over the past twelve months with $200m+ of FCF in every year since 2011. Finding itself with a completely unlevered balance sheet and shares at a nadir thanks to the sellside’s ambivalence, management recently initiated a $500 million buy-back program, representing about 10% of shares, which increases leverage to a still meager 1x EBITDA. An acquisition target itself – it draws envy from even the vaunted Bloomberg for reference data, OTC, and loan pricing – Markit can continue to bolt on software platforms to further entrench itself within the global credit infrastructure. At less than 20x earnings, sustained by hard-to-replace services and products, we anticipate a high return on our investment.
Kerrisdale Partners – Parexel International
We are long shares of Parexel International (PRXL), a leading contract research organization (“CRO”) with a multi-decade track record of double-digit growth. Founder/CEO Josef von Rickenbach launched the business in 1982 and took it public in 1995. Over the past decade, von Rickenbach grew Parexel’s revenue from $545m to $2bn, EPS expanded from $0.36 to $2.70, and Parexel solidified its position as a top three CRO, all while maintaining an unlevered balance sheet and generating consistent free cash flow. Short-term market gyrations, first caused by a guidance reduction of NTM EPS growth from 20% to 17%, then aggravated by a broad-based healthcare selloff, have left Parexel with the extremely undemanding valuation of 1.7x NTM EV/Revenue (peers are 2.5 – 3.5x) and 20x FCF. A recent hiring spree, in anticipation of a growth uptick and move towards later-stage trials, combined with a soon-to-be-remedied full tax rate (35% now; moving to 20-30% over time) result in PRXL’s below-industry margins. Management seeks to remedy this with organic growth and a cost-reduction plan to achieve $50-60m in annualized savings within the next few years. Management further believes margins can swell 150-200bps next year with 15-20% long-term EPS growth and sustained 20%+ ROICs. Looking at Parexel’s pristine long-term operating history, we’re apt to agree.
Parexel’s success springs from three primary growth drivers: i) global pharmaceutical R&D growth (c. 2-4%/year); ii) increased outsourced penetration (currently c. 50%); and iii) industry consolidation. Taken together, Parexel’s organic revenue growth can average 7-9% and total growth reaches 10-12% with reinvestment of FCF into bolt-on M&A. Both our primary research and a variety of public studies support these notions. Industry forecaster ISR predicts a 7.9% industry growth CAGR from 2014 to 2018; recent sellside surveys of pharma staff predict R&D growth of 4-7% in 2016 – a sentiment maintained through September; and both anecdotal and quantitative data from our own primary diligence speaks to the entrenchment of CROs in the global clinical research process. As one clinical director explained, CROs dampen the volatility of internal budgets by converting fixed R&D capital costs (overhead, clinical staff, reporting infrastructure) into a variable cash expense. This allows research organizations to focus on what they do best: drug discovery and/or selling and marketing. The top five CROs have about 50% share, trending towards 60% by 2017, with Parexel near 10% share. Industry leaders like PRXL can gain ~100bps of share per year from smaller firms as sub-scale organizations no longer possess the scale to satiate global research projects in a world of growing regulatory complexity.
Within this consolidating industry, Parexel stands out for the breadth and depth of its services. Parexel has worked with all of the top 50 companies in the biopharma space, with some form of involvement on 95% of the top 200 biopharmaceutical products on the market. Further, a recent analysis of clinicaltrials.gov cited Parexel’s involvement in more clinical trials than all but one of its peers, the larger but slower-growth Quintiles. Our diligence discussions buttress these assertions. Paraphrased from the head of clinical research at a major pharmaceutical company about his relationship with Parexel, ‘If someone sneezes in Korea, I’ll know…if a group of patients shows side-effects, I’ll know immediately instead of two weeks. That way I’m prepared when the FDA calls.’ Another remarked, ‘Between Parexel and [a second retained clinical outsourcing partner], I expected Parexel to outperform, and they have.’ That’s not to say that Parexel is without faults. All of the top five CROs can adequately service a multi-national client, and over time the CRO group must become more cost efficient. But Parexel appears to have positioned itself ahead of these trends: it has nearly quadrupled the size of its low-cost India staff, from 200 in 2010 to roughly 900 today. We think this broad-based labor expansion, especially those in low-cost jurisdictions, may predate both near-term growth and margin improvements.
While we’re excited about Parexel’s near-term growth prospects, we’re also encouraged by the stickiness of the current revenue book. Parexel’s backlog measures at $5.2bn versus $2bn of annual revenue. The trailing twelve months book-to-bill ratio resides at 1.2x and the historical range measures 0.9x to 1.5x. Augmenting the core CRO business, Parexel also runs a 45-50% gross margin software business – pieces of which, like the data-monitoring tool Perceptive MyTrials, are used by the top 15 pharmaceutical companies – and a consulting group that captures regulatory and commercialization business. The consulting outsourcing market is projected to grow from $2bn in 2014 to $4.5bn in 2020, a 15% CAGR – twice as fast as CRO services.
If its prior success holds, Parexel can continue to reduce industry-wide costs while helping companies innovate. With the business priced at under 2x revenue alongside recurring cash flows and an unlevered balance sheet, we expect superior shareholder returns over time.
We continue to be confident about the composition of the current portfolio. Regardless of how the overall market performs, we expect our portfolio to fare well over the long term.
Thank you and please don’t hesitate to contact me with any questions.