Weekly Thoughts: Icarus, Gigi, and Barbell Markets
Here are three things that caught our eye this week:
Like the rest of the financial world, we have spent recent weeks observing the drama surrounding SunEdison’s rapid fall from grace. A high flying hedge fund darling just months ago, on Thursday the company filed for bankruptcy protection amid accusations of inadequate disclosure and inappropriate coercion of affiliates. More fundamentally, investors lost faith in the core strategy of the alternative energy developer which involved selling completed, cash flowing projects to publicly traded “yieldcos” that could then pass those cash flows on to investors via high dividends. From the Base Hit Investing blog:
“The scheme works as follows: a company (the “parent”) decides to grow rapidly. To finance its growth, it creates a separate company (the “yieldco”) that exists for the sole purpose of buying assets from the parent (usually at a hefty premium to the parent’s cost). To source the cash needed to buy the parent’s assets, the yieldco raises capital by selling stock to the public by promising a stable dividend yield. The yieldco uses the cash raised from the public to buy more assets from the parent, and the parent, in turn, uses these cash proceeds to buy more assets to sell (“drop down”) to the yieldco, and the cycle continues.”
The underpinnings of SunEdison’s strategy make a lot of sense. Well underwritten solar or wind projects should generate meaningful cash flow, and matching those cash flows with investors searching for yield, while freeing up the developer’s balance sheet to pursue other projects, seems like a win-win. However, like most tales of financial disaster, the problems begin when a good idea is taken to extremes. The lure of easy financing naturally drives a desire to rapidly expand the project portfolio which in turn can lead to inflated deal prices, acquisitions outside a core competency, or reduced maintenance capex spend as cash is funneled toward dividend payments and debt service. SunEdison, it seems, was particularly prone to the first two of these. From the Wall Street Journal:
“As SunEdison’s acquisition fever grew, standards slipped, former and current employees, advisers and counterparties said. Deals were sometimes done with little planning or at prices observers deemed overly rich. In 2015, J.P. Morgan Chase & Co. decided not to participate in a loan to fund future SunEdison acquisitions after becoming uneasy with the company’s deal-vetting practices, people familiar with the matter said. Some acquisitions proceeded over objections from the senior executives who would manage them, said current and former employees.”
We were particularly interested in this case because we can see elements of our own strategy in the company’s initial good intentions. As investors focused on stable cash generative businesses, there is potential to expand our portfolio more quickly by sharing some of that attractive yield with third parties. Studying SunEdison helps us understand where the potential pitfalls of pursuing such a course might lie. Clearly a strong focus on disciplined deal making and responsible use of cash flow are important, but it seems the biggest lesson involves the dangers of hubris. As Fortune noted, “The disaster stems from a company that tried to reach too high, too wide, and claim the mantle of the world’s largest clean energy company. Now it’s the largest clean energy failure in history.” We hope that we can learn from this cautionary tale so that going forward we don’t fly to close to the Sun(Edison).
Unless you frequent dairy farms, you likely have not realized the physical change in many of today’s domestic Holsteins, the breed of cow that makes up the majority of the US’s dairy production. Like any farmer looking to increase productivity, dairy farmers have long been looking for ways to get more milk out of their cattle. In the beginning, tweaks were largely external — barn design, feed composition, and milking schedules — but in the last 30 years, the most substantial gains have come from changes made directly to the cow’s genetics. The result is Gigi, the most prolific producer of milk the dairy industry has ever seen. At 5’2” and weighing one ton, Gigi is about a third bigger than the average Holstein, and produced a staggering 75,000 pounds of milk this past year, over three times the national average.
As you might expect, public opinion about this utterly large milk producing animal is divided, with some claiming a victory for modern farming practices, while others lament the continued industrialization of Big Ag. Regardless of your personal views, a quick look at the data paints a picture that is hard to ignore: the US has gotten staggeringly good at producing more from less.
The driving factor behind this production efficiency, especially in the last decade, is almost purely attributed to genetics. A recent NPR article about Gigi gives a glimpse as to just how specific dairy farmers can be when it comes to selecting cow attributes:
“These days, the largest cattle genetics companies…hand out catalogs to prospective semen and embryo buyers, with charts for studs and dams with measurements on everything from teat length to udder depth to rump width…Farmers are also trying embryo transfer technology and sexed semen, which is processed to allow dairy farmers to only create daughter calves.”
Dairy farmers have gotten so good at extracting milk from their cattle, in fact, that the industry is suffering from structural oversupply. A Bloomberg article last summer highlighted that the imbalance was getting so bad that producers, unable to sell excess at any price, were pouring millions of gallons of milk into manure pits, and a Food Business News article from this month calls for the oversupply, and the resulting multi-year lows in dairy prices, to last until 2017.
While supply-demand imbalances are nothing new to economic markets, what struck us about this story is the degree to which dairy farmers have become a victim of their own success by focusing on the wrong metric. Gigi is now known throughout the world of dairy farmers because she produced so much milk in a 365 day period. What is left out is that the larger Holsteins of today’s dairy farms are productive for far fewer years than their smaller, less genetically modified counterparts. Temple Grandin, a Colorado State University animal science professor noted in the NPR article that “If you go for the big, gigantic Holsteins, you only get two years of milking.” Also quoted in a Wonkblog post on a similar topic, Grandin continued saying “smaller cows might not produce as much milk as their larger counterparts, but they tend to live longer and be more fertile. It may not be as profitable right away, but it pays off.”
Reading about Gigi and the state of the dairy industry got us thinking about the difference between maximization and optimization. Because of their focus on maximization, dairy farmers are forced into bringing such substantial quantities of milk to market so quickly that they risk never seeing prices rebound to turn a decent profit. The same principle is true of any business where short term profits can come at the expense of long term gains. As small business investors, we see ourselves as business builders, and remain committed to choosing optimization over maximization wherever possible.
As residents ourselves, we were proud to learn that Portland, Maine was recently ranked the number one beer city in America owing to an abundance of independent craft breweries. While we are particularly fortunate, it turns out the dynamics we experience in Portland are not an anomaly, but rather reflective of broader trends in the beer market. According to a recent report from The Brewers Association, despite declines in overall beer sales in 2015, small and independent craft brewers saw a 13% increase in volume and a 16% increase in retail dollar value. These figures are a continuation of a steady increase in craft brewer share gain, which has increased from 6% in 2008 to almost 21% today.
While large beer companies still hold majority share, in terms of business count, small and independent breweries make up 99% of the market. In fact, as shown in the Bloomberg chart below, there are now more operating breweries the US (4,269) than at any other point in recorded history, which is incredible given that the state of 19th century transportation (horse-cart) and refrigeration (non-existent) basically required brewing to be a local business:
For us, one of the most interesting aspects of this data is that outside of the thriving small brewery space, the market is dominated by two behemoth players (Anheuser-Busch InBev and MillerCoors), creating a “barbell” like industry structure. SmallBizLabs.com, which introduced us to this framework, has repeatedly written that this phenomenon is not limited to brewing, but rather is part of a larger trend. While plenty of attention is directed toward consolidation of global mega-corporations, the growth of these firms seems to come at the expense of mid-size businesses, while leaving room for relatively small businesses to thrive and grow. Deloitte’s Center for the Edge — which researches corporate growth — elaborates further:
“… a new economic landscape is beginning to emerge in which a relatively few large, concentrated players will provide infrastructure, platforms, and services that support many fragmented, niche players. In this way, both large players and small will coexist and reinforce each other.”
While the majority of popular commentary focuses on entrepreneurship in the context of startups and venture capital, we have observed that the barbell industry structure applies equally to existing small operating businesses. For instance, the property services industry has witnessed private equity backed consolidation amongst the larger players, but there still exists a thriving market for smaller players in what is mostly a niche geographic business. We view this as an opportunity. The Deloitte study notes that “entrepreneurs or small businesses need access to four primary resources to commercialize an idea: Financing, Infrastructure, Talent, Customers.” If we spend the majority of our time seeking to acquire companies that already have a stable customer (revenue) profile, and then focus on providing those companies with support in finance, technology, and human resources, we believe we can meaningfully contribute toward the growth of small businesses while expanding our preference for barbells from the gym to the office.
Have a great week,
Your Chenmark Capital Team