Clearsign of growth

Clearsign Technologies (NASDAQ: CLIR) is the first pre-revenue company that I have invested in. The company is very close to commercializing a game-changing technology in combustion systems with ExxonMobil and other customers with significant scale. Clearsign’s technology costs much less, produces far less emissions, and presents as the sole viable update to a 65-year-old combustion treatment method that is as expensive as it is antiquated. Competent leadership, proper incentives, viable commercialization roadmaps, and environmental tailwinds support a $500m valuation (~3x current valuation).

Potential customers are industrial furnaces, boilers, refineries, and any facility that employs large-scale combustion systems. These facilities constantly balance between generating revenue and pollution: how long can combustion systems operate (ie revenue generation) while keeping NOx (nitrogen oxides) emissions low enough to comply with increasingly strict environmental regulations. The most common solution is a post-combustion treatment process. Run the combustion system; pass the resulting NOx into a catalyst chamber comprising porous ceramics, precious metals, and gases; circulate the mixture to reduce NOx before release to atmosphere. This process, known as SCR (selective catalytic reduction), is expensive because of the use of precious metals, cumbersome because of the need for gas circulation, and unstable because of the constant need to replace porous ceramics clogged by pollutants.

Clearsign provides an ingenious solution. Its key IP (known as Clearsign Core) allows the combustion system to produce less NOx in the first place, eliminating the need for post-combustion treatment.

Combustion begins with an ignition of a flame. This flame initially burns at very high temperatures that produces high levels of NOx. As fuel and air mix with the flame, temperatures decline and exponentially less NOx is produced. Clearsign Core reduces the duration and intensity of peak flame temperatures. The technology allows fuel and air to mix properly before starting ignition, resulting in shorter and lower peak flame temperatures and lower NOx emissions than standard combustion.

The technology has other means to reduce peak flame temperatures. It “separates” the source of a single, large flame into numerous, shorter flames that can be more easily mix with fuel to lower peak temperatures. Its mechanism also employs radiation cooling that cools the flame quickly.

Clearsign provides the aforementioned benefits at much lower prices compared to the current SCR solution. A third-party engineering consultant found that Clearsign Core (originally named Duplex) provided 80-90% lower startup and maintenance costs compared to SCR (see tables below). Clearsign Core is currently the most cost effective solution to meet strict NOx emission standards (under 2.5 parts per million, or 2.5ppm) set by California and Texas, which set the standard for the rest of the country to eventually follow.

In spite of valuable IP, Clearsign had a difficult start as a public company. Its IPO in 2012 was build on a ground-up, complex redesign of combustion systems. Its technology today started as an offshoot to the original technology. Clearsign invented a flame management system that significantly reduced NOx emissions as a complement. Clearsign did not sell any combustion systems, but found large refineries owned by Tesoro and Delek wanting its flame management system. However, all the company had to show, after 7 years and and 5 equity raises, was less than $2 million in cumulative sales. Its stock declined from $4 at initial offering to a low of $1 in 2018.

Poor execution capped the sales potential of its technology. Management failed to account for extensive pre-installation testing, after-sales support, and customization required by complex refinery operations. The high cost of failures in combustion systems made refinery operators extremely careful in adopting new technologies. They demand multiple demonstrations and field-testings, and require a comprehensive maintenance system. Clearsign, as a startup, had limited resources that were perceived as risky. The company required collaborations with other vendors to get to market, but was unable to find partners because of its insistence on standard licensing deals. A typical deal require partners to pay Clearsign large upfront cash as a licensing fee, but partners were unwilling to pay for startup technology without proven traction. Without partners, Clearsign could not commercialize its valuable IP.

The company’s fortunes began to turn when Robert Hoffman, a veteran investment manager, bought a 20% stake and joined the board in July 2018. He repealed the attempt of a ridiculous proxy battle by a sketchy investment banker. Anthony Digiandomenico was an owner of MDB Capital, focusing on micro-caps and purporting to be “Wall Street’s only intellectual property-focused investment bank” (not kidding), albeit with history of misrepresentation (see Red Flag #3 in link). Digiandomenico owned only 112,733 shares of CLIR (less than 1% of 1% shares outstanding) when he submitted a proposal to replace the board and management on November 9, 2018. Luckily for CLIR shareholders, Hoffman stood his ground, convinced Digiandomenico to back down, and prevented the escalation of the proxy battle to an all-out war.

I did not find information concerning Hoffman’s long-term track record. However, his written responses in the proxy contest showed him to have sound business logic, focus on fundamentals, a long-term outlook, and transparent communication (see highlights below from 14A filed on December 6, 2018):

The second most important decision that Hoffman made for Clearsign, after settling the proxy battle, was the hiring of Jim Deller as CEO in January 2019. Deller spent his entire career, all 28 years, in combustion systems and had a doctorate in flame chemistry. That Deller left a comfortable job as director at Honeywell to join Clearsign validated the company’s technology and sales potential. His deep understanding of technical underpinnings and commercialization processes made him the most invaluable addition to the company after Hoffman. Hoffman described Deller as such:

While younger investors might not grasp the analogy, Jim is the Bart Starr as opposed to the Joe Namath of the combustion industry. As investors get to know Jim, they will discover that he will never be like Broadway Joe and “guarantee victory”, nor will he ever be the flashiest guy in an investor conference. Conversely, like Bart Starr, he will be the understated field general getting the most out of his team while, at the same time, being the most important cog in driving that team to victory and making the clutch decisions when it is most important.” -Q119 earnings call

Clearsign has gained significant traction under Deller. He simplified the core technology for easier “plug-and-play” installation at customer sites. He found partners by abstaining from licensing deals in favor of revenue-share collaborations without upfront investments. He recruited leaders in sales and engineering. He steered the company through Covid-19 and secured a license to sell in China amidst complex US-China relations. Notable customers and partnerships include:

  • ExxonMobil and Zeeco. The oil major will be testing Clearsign Core in calendar Q3 2021, after completing a year-long exhaustive qualification of the technology. If successful, this would be the most vital validation of Clearsign Core in company history. Equipment required for Exxon’s testing would be fabricated by Zeeco, a household name in the global refining and petrochemical industry. The collaboration with Zeeco in manufacturing, sales, and research is a transformative partnership that solidified Clearsign’s commercialization efforts.
  • An unnamed European oil major, likely Shell or Total. This company placed an order for Clearsign Core on February 2, 2021.
  • California Boiler and a North American major energy infrastructure company who purchased Clearsign Core in October 2020. The technology has been installed, and revenues would be recognized in financial Q1 2021. This project was sold by California Boiler, which is Clearsign’s channel sales partner.
  • World Oil and the California South Coast Air Quality Management District (government emissions regulator in Southern California). Clearsign Core is so promising that the emissions regulator in California had agreed to fund 1/3 of a demonstration project with World Oil, a recycler of motor oil and antifreeze. The demonstration has been delayed for a year because of Covid, and would likely be completed by early 2022.
  • Beijing heating district and Jiangsu Shuang Liang Boiler Company (simplified as JSL Boiler). Clearsign cleared government testing of its technology in China, and obtained a license to sell in China. The northern districts in China received central heating during winters from numerous industrial boilers (combustion system for heating) operated by the government, unlike individual boilers in homes in the United States. Clearsign had also signed a collaborative agreement with JSL Boiler, the top boiler manufacturer in China. Sales efforts just began in May 2021.

In thinking about valuation, I suggest readers consider Buffett’s quip: “you don’t need to know a man’s weight to know that he is fat”. Precision matters less in this thesis than directional accuracy. The most obvious markets for Clearsign are the 14,000 industrial combustion systems in refineries and petrochemical plants in Texas and California, and 350,000 heating furnaces in the northern districts of China. In the table below, assuming modest market shares and retrofit prices (about 10% cost of SCR), I estimate a near-$5-billion opportunity.

Combustion systems in CA and TX [A]14,000
Initial addressable market [B]10%
Revenue per retrofit ($m) [C]$1.0
Maintenance revenue over 10 years ($m) [D] $0.5
Revenue potential ($m) [A*B*(C+D)]$2,100.0
Firetube boilers in northern China350,000
Initial addressable market2.5%
Revenue per retrofit ($m)$0.2
Maintenance revenue over 10 years ($m) $0.1
Revenue potential ($m) $2,625.0
Total revenue potential ($m)$4,725.0

Three tailwinds may further expand the opportunity. One, pollution emission standards are expected to become more stringent over time in the US, China, and other developed countries, regardless of political affiliations. The regulatory tailwind would become stronger over time as more resources are devoted to managing climate change. Two, the slow pace of innovation and performance improvements in SCR provides a clear opportunity for Clearsign to take share. Providers of SCR are mature companies that compete largely on price. While the maturity of SCR presents a high barrier to entry, Clearsign has shown sufficient traction to be a viable substitute. Three, Clearsign is currently testing adjacent products such as flares and sensors that complement its core technology.

Clearsign is valued at about $160m today, which appears to significantly undervalue its potential. Judging from the $5-billion revenue potential over the next decade, it should be reasonable to estimate a valuation at $500m (1x annual sales). Margins are likely to be high (~30-40% EBITDA margins) given management’s plan to create an asset-light technology provider that relies on a network of partners for fabrication, sales, and customer support. In any new technology, commercialization is often the biggest risk. A successful demonstration with ExxonMobil in calendar Q3 later this year would significantly mitigate the risk and place Clearsign on the path towards realizing its true valuation.

Unique and hidden flywheel powers growth at Elastic

Elastic NV (NYSE: ESTC) is the most interesting enterprise software company that I have encountered. Its strong and improving financials are obvious. What is hidden is its unique flywheel, which relies on open-source and powers rapid innovation and growth.

Its core competency is in Elasticsearch, an open-source and near-realtime search solution that supports many applications in analytics, monitoring, security, and likely many more in the future.

The keyword is open-source. Elastic’s steadfast commitment to open-source has fostered a large and dedicated community of developers (150,000 and counting). Users provide rapid feedback, remove bugs, and guide feature development. Elastic effectively crowd-sources innovation from its developer community, taking cues on what to expand into and what to acquire. Crowd-sourcing innovation is also faster and more cost-effective than the traditional, “closed” corporate R&D model.

Another benefit of open-source is shorter sales cycles. The large and loyal base of developers enables an effective bottom-up “grassroots” (as opposed to top-down CIO-first) approach to sales and marketing, shortening the infamously long sales cycle in enterprise software. Elastic counts about half of the Fortune 500 and a third of the Fortune 2000 as customers, which supports high recurring subscription revenue (92% FY20 revenue). Elastic is growing rapidly (57% FY20 rev growth yoy, 45-55% rev growth yoy during Covid qtrs), and is still early in its growth journey because of the innumerable innovations that its community would eventually discover in the future.

Critics often question developer loyalty. Why would a developer release self-developed improvements for free? Because the developer must use Elastic software for projects. The developer has to reports bugs and suggest improvements so that projects can be completed. Elastic has shined in strategic execution to achieve developer mind-share when there are many other open-source search and analytics solutions. There are two subtle but visionary nuances worth discussing.

The first is straightforward (but not simple to execute): a relentless focus on developers. Shay Banon, founder and CEO, discussed how Elastic differs from its open-source competitors:

“One common open source business model, is to sell support subscriptions. Sadly, support-only business models trend towards a conflict between what’s best for the user and what’s best for the company. In these situations, the company isn’t motivated to make their products easier to use, more reliable, scalable because that would eat into their support profits.”

This makes sense. Open-source providers are incentivized to make products difficult to use, so developers must pay for support, discouraging developers from improving the software.

“[Elastic] was never, and never will be, willing to bear the tension of not making our software better in order to ensure that the company stays in business. We want to continuously improve and our goal with support is to make your project successful so that you are the expert in your Elastic Stack deployment. We want you to be successful so that you choose the Elastic Stack for your next projects too.”

Elastic encourages developers to improve its software by promising it would do the same. The software would always improve, and would never be held back for commercial reasons. Wouldn’t this reduce support subscriptions? Elastic’s answer is the second nuance to its strategy. It only sells support to the most intensive users (think Fortune-ranked companies). It also sells them access to some features that are high-value to them but used little by the larger community, who mainly uses the free core software.

Elastic’s strategy serves the entire spectrum from the large corporations, from whom it charges and financially profits, right down to the individual developer, from whom it does not charge but gains technically and intellectually. The flywheel starts with Elastic relentlessly improving the software and helping the developer succeed, incentivizing the developer to turn only to Elastic and nothing else. As more developers use Elastic, they improve the core software more effectively than competing software. Increasing developer usage improves the standing of Elastic at large corporations, which pay for support subscriptions to Elastic, who in turn uses the revenue to reinforce the flywheel.

Competitors to Elastic are specialized solution providers (Datadog/Splunk in application monitoring, FireEye/Checkpoint in endpoint security), some of which are built atop Elasticsearch. The key advantage of Elastic is its large and loyal community, enabling the aforementioned flywheel and unbeatable economics. The community is also its key defense against Amazon. Amazon forked code from Elasticsearch to build AWS Elasticsearch (thought Amazon insisted it wasn’t), but was unable to build a community around it (see approximate community size for Elasticsearch and AWS Elasticsearch here), riddling the service with numerous bugs. AWS Elasticsearch should be effective in retaining unsophisticated users in the AWS ecosystem, but is unable to scale quickly without a dedicated developer community that takes years and resources to build. Because AWS Elasticsearch is only of many AWS managed services, Amazon is unlikely to dedicate sufficient resources to mount a challenge to Elastic.

Elastic’s leading competency in search, open-source distribution, unique flywheel, and shorter go-to-market cycles would sustain growth for years. A reasonable bull case can be made for 30-40% topline growth for current applications in the next 5 years, multiplying revenues by 4-5x (forward EV/sales about 5x). 50-60% growth in deferred revenue and $350 million cash provide adequate funding, further supported by expected positive FCF in FY21. Assuming 4.5x growth in revenue in 5 years, steady-state 35% EBITDA margin, and 36x terminal growth multiple (r=9%, g=6% ~ 3x global GDP), the projected EV is about $16 billion, and target price is $185/sh. (32% upside).

The projection excludes the upside optionality of additional applications which Elastic’s community has yet to discover. The community led Elastic to its current applications in monitoring and security, which were built with a three-pronged approach: community development, internal R&D, and M&A (executed brilliantly by current management). It is likely that Elastic would find future revenue growth from additional applications from its community, continue its excellent execution with improving internal funding, and launch new offerings in years to come.  

Excellent progress made by this advantaged acquirer of healthcare IT

The story of MTBC Inc (NASDAQ: MTBC) keeps getting better. It is proving its potential to compound capital in the long-term as an advantaged acquirer.

MTBC has made plenty of progress since my previous article. It is executing its M&A playbook well. MTBC acquired Meridian Medical Management (a former GE Healthcare IT company) less than 6 months after its previous major acquisition of Carecloud. The acquisition is likely priced slightly above 1x sales. This is a cheap price compared to the industry average 2-3x, and is cheap likely because of the lack of profitability and sub-par topline growth. MTBC is the rare buyer who can solve both problems. It aggressively offshores without losing service quality to increase profits and retain customers. It is also bundling add-on services (eg telehealth) to its core RCM product to increase topline growth.

Investors are only starting to recognize the value of MTBC’s playbook. The stock moved from $6.50 pre-Meridian in May 2020 to about $11.00 yesterday after a series of sell-side commentaries. MTBC’s market cap has finally exceeded $100m, which is likely to attract more investors than when it was a nano-cap company.

Two weeks after acquiring Meridian, management guided to 30% higher annualized revenues and 600bps EBITDA margin improvement (from 12%). That management announced the margin improvement early in the integration process is a sign of confidence in cost reduction and a repeatable M&A playbook.

A notable feature of recent acquisitions involving Meridian and Carecloud is the addition of new services. Meridian added automation services and Carecloud brought telehealth services. Previous M&A had focused on strengthening MTBC’s core RCM products. The new leg of growth involving new services not only support organic growth, but also complement MTBC’s M&A playbook by broadening its target universe and accelerating inorganic growth. Investors should look forward to more sustainable growth as MTBC expands beyond RCM.

MTBC has already exceeded my target price in the previous article. I’ll provide a new target price after the company updates on its capital structure in the next earnings release.

David will win against the Goliaths in TV streaming

Roku Inc (NASDAQ: ROKU) is the market-share leader in connected TV (CTV) with a 47% share, impressively beating second-place Amazon (85x Roku’s mkt cap) that has 40% share. Roku grew topline by 3.5x and its share price by 7.5x in the past 4 years, despite going head-to-head against mega-cap media peers (Amazon, AT&T, Comcast etc). It will continue to capture the bulk of advertising budgets moving to CTV from linear TV ($70B industry vs Roku $1B revenue) as the largest CTV platform, enjoying a long growth runway. Its chief competitive advantage is superior technology, built on a programming language designed by its founder and CEO, Anthony Wood. Investors are under-estimating the potential of Roku in extracting excellent economics as the dominant provider of OS for TVs (think Microsoft for PCs, Google for Android mobile), and over-estimating the potential of competition to overtake Roku. Roku’s track record of growth-oriented innovations and potential to eventually “tax” every channel on its platform will serve high returns to investors for the foreseeable future.

Traditional linear TV is ripe for disruption. Its distribution system (cable/satellite) is expensive and outdated. Channel bundling forces consumers to pay for content that they don’t want. The lack of a recommendation engine makes content exploration difficult, which is unimaginable to the Netflix/Hulu user served with content aligned to viewing habits. Advertising on linear TV, dependent on Nielsen data, is no longer as effective as targeted ads in the digital age popularized by Google/Facebook.

Roku has disrupted linear TV and beat streaming peers using the cheapest prices in the market, the greatest variety of content, and the most user-friendly interface. A Roku device cost less than half of an Apple TV or Google Chromecast device. Amazon Fire comes closest to matching the price of a Roku device, but does not match content variety. Unlike Apple/Google/Amazon, Roku does not sell content, and thus can offer content from all platforms. Apple TV does not allow users to rent from Google Play. Amazon Fire does not allow purchases on iTunes. Roku, as the “Switzerland” in TV streaming, can offer the greatest variety of content and attract the most users.

The most important advantage that Roku has is also the least understood. It has the most user-centric interface because it is the only OS (operating system) built for TV. OS only work when it is purpose-built. Think of Windows for PC and iOS for mobile phones. Microsoft dominated personal computers, but failed to migrate Windows to mobile phones (remember Windows phones). Apple dominated mobile phones, but could not attract a loyal following for Apple TV, which uses the same interface as iPhones. Competitors are lagging Roku chiefly because they are attempting to re-purpose OS, not designed for TV, for TV. Roku was designed from scratch for nothing but TV. The 5,000+ apps available on Roku is powered by Brightscript, the in-house programming language created singlehandedly by Roku’s founder and CEO. According to this programmer, Brightscript Components are written exclusively in C, which is an incredibly powerful, fast, efficient and portable programming language. It is also an accessible language for most programmers, underlying the potential of Roku to attract more developers and more creative content.

Roku extracts incredible economics as the dominant OS for TVs. Its high-margin (70% gross margin) and recurring revenue stream comes in the form of advertising revenues (Roku calls this platform revenues). Roku shares advertising revenue produced by AVOD (advertising video-on-demand) channels. AVOD is the fastest-growing format because it offers free content to consumers in exchange for display advertisements. The growth of AVOD (eg Tubi, Crackle) is also supported by excessive competition in the familiar SVOD format (subscription video-on-demand eg Netflix, Disney+, HBO etc). Consumers are likely to be reluctant to add new SVOD services after budgets are exhausted, implying that some SVOD players may embrace a pure AVOD or hybrid AVOD/SVOD format (similar to Hulu), and aid the growth of AVOD and ultimately Roku.

Behind Roku is Anthony Wood, an incredible founder and CEO who has the rare combination of technical prowess and business leadership. Wood reminds me of Tobias Lurie, founder and CEO of Shopify. Both started as technically proficient programmers, and created the programming languages that eventually powered their companies (Wood created Brightscript and Lutke created Liquid). Both picked up management and leadership skills after starting their companies, and retained significant ownership throughout the rapid growth of their companies. Wood had started two companies before Roku and even worked under Reed Hastings at Netflix to develop Roku. Investors should be confident of Wood’s ability to lead Roku. The early partnerships with TV manufacturers and retailers to quickly distribute the Roku OS was an effective strategy that Google is trying to replicate now (but likely can’t reach Roku’s success because of OS mismatch). The recent acquisition of Dataxu and partnership with Kroger to advance CTV advertising data analytics is ground-breaking in tech-retail collaborations, and is another proof of Wood’s innovative and effective leadership.

Valuing Roku, like its high-growth TMT peers, is not straightforward because of its heavy investments and low profitability. Because DCF works with positive cash flows, Roku should be valued as if it had achieved steady-state, characterized by normalized investments and profitability. Hence the quantitative valuation of Roku relies on a key qualitative assumption, that is Roku’s current investments are effective enough for the company to achieve steady state in the future. In this model, I assume that Roku grows topline by 30% CAGR and achieves steady-state in 8 years, and generates 30% EBITDA margin (similar to the Trade Desk, the current de facto CTV platform leader). With a terminal multiple of 17 (r=10%, g=4%), Roku is worth about $180/sh (50% upside from current price).

The price target likely underestimates the potential of Roku because of the company’s track record in innovation. It was the first to license OS to TV manufacturers, the first to initiate a major tech-retail partnership in advertising, the first to feature 100+ live channels for free in an intuitive interface, the first content-neutral platform, and the first platform (but not the first channel) to benefit from the fast-growing AVOD format. Investors should expect more growth-oriented innovations in the future. If Roku continues to strengthen its dominant position, it would become the default OS for smart TVs, and extract “taxes” in the form of advertising revenue-share similar to what Google/Apple does for mobile apps today. Every AVOD channel will have to be on Roku and pay “Roku-taxes” because its platform will be the most widely distributed. This is a capital-efficient model that will serve high returns for many years to come.

Expect hearty returns from this healthcare IT firm with a strong M&A platform

MTBC Inc (NASDAQ: MTBC) is a healthcare IT company that provides SaaS-based critical back-office services to physician groups and hospitals. The company has emerged as an advantaged acquirer of providers of backend healthcare technology. It acquired 5 companies from 2006-14, and accelerated the pace of acquisitions to 15 from 2014-20 after going public in 2014. The M&A playbook relies extensively on quality and low-cost labor (2400 full-time headcount primarily based in Pakistan, 8x headcount in US) to reduce operating expenses by 50-60% at acquired companies. The fragmented industry provides a long growth runway, which supports increasing operating leverage and potential in reducing funding costs significantly (11% preferred equity is the sole “debt”) to further M&A. MTBC stands out from peers with high 17% ROIC, substantial insider ownership (49%), and proven senior management (3 out of 4 members has executed the M&A playbook together since founding in 2006). Most notably, the company possesses the potential to compound capital in the long-term as an advantaged acquirer.

The B2B, non-consumer-facing nature of MTBC’s services may be unfamiliar to readers. MTBC improves the medical billing reimbursement process, increases collections, and reduces errors in submission, collectively known as revenue cycle management (RCM) services. Complementing the core RCM are practice management services and EHR. Practice management involves patient scheduling, insurance analysis, and other day-to-day workflow functions. EHR, or electronic health records, conducts patient communications and clinical charting electronically to support the billing and reimbursement processes. The RCM industry is stable and mature, growing at low to mid-single digit annually, which implies that consolidation and cost-cuts are central to profitability. Customer retention is usually high (80-95%), highlighting the importance of M&A for growth.

Its latest acquisition involving Carecloud, a high-profile acclaimed SaaS platform, proves the value of its cost-cutting playbook in an increasingly costly RCM industry. Carecloud, which raised a cumulative $150m as of 2019, was sold to MTBC for only $41m, implying large losses for venture capital investors (but great for MTBC) even when Carecloud earned excellent reviews for its product. VC investors likely approved the loss-making sale because of a cloudy outlook for profits from expensive technology and labor investments. RCM providers face several cost-increasing industry trends. Health insurers have complex reimbursement processes because of new laws and payer requirements. Medicare, Medicaid and commercial insurances are increasingly requiring proof of adherence to best practices and improved patient health outcomes to support full reimbursement. Moreover, the recent shift to new insurance codes has dramatically increased the complexity associated with selecting procedure and diagnosis codes needed to support claim submission and reimbursement. Therefore, automated SaaS billings must be complemented by laborious, time-consuming, and expensive human expertise in keeping up with insurance claims and reimbursements practices. MTBC has cracked the code to reduce costs by training a horde of full-time skilled and low-cost labor, based in Pakistan, to handle analytical tasks that support customer-facing personnel based in the US.

Nothing is better at proving MTBC’s value and the industry’s difficulty to cut costs than athenahealth, a RCM industry leader taken private by Elliott Management for $5.5B. athenahealth had targeted 30% operating margins, but could not achieve greater than 16-17% before the transaction. MTBC reported 11%, which was an admirable result before the benefit of scale (athenahealth was 70x the size of MTBC). Excellent execution is rare in the RCM industry because of the increasing complexity of regulations. Hence investors should give MTBC’s industry-leading execution more credit than they do today.

In valuing MTBC, inorganic growth must be considered. Management guided for an additional $100m revenues from M&A by FY21, expanding current revenues by roughly 3x in 2 years (MTBC reported FY19 results in Feb 2020). Management reiterated guidance made in Feb 2020 during the covid-19 debacle, a testament to its excellent execution and stable industry dynamics.

Assuming that revenues reach $170m in FY21 (roughly $100m higher than FY19 revenue and $70m higher than FY20), MTBC is expected to pay $70m at 1x revenue. Judging from previous transaction, $5m of $70m would be in contingent payouts. The $65m would be financed from a combination of preferred stock, cash flow from ops, and cash on balance sheet. The estimated preferred stock raise is $26m with current $35m cash on balance sheet (leaving $4m to maintain day-to-day operations) and assuming FY20-21 cumulative $4m levered FCF.

Based on management guidance in FY20 and projections of $170m revenue in FY21, standard DCF (r=10%, g=3%) results in $240m NAV. Backing out $4m cash and $129m preferreds (incl the est $26m raise) results in about $115m market cap, representing about 46% upside potential.

The calculation above, though based on reasonable assumptions, understates the return potential of MTBC as a long-term compounder. Advantaged acquirers, such as Pool Corp and Watsco, with a sustainable M&A platform are rare. The streak of M&A can be interrupted by the reduction of targets, lack of cheap capital, and executive turnover among other factors. For MTBC, its M&A streak is unlikely to end before reaching a billion-dollar valuation. MTBC is executing in a mature, fragmented industry with few competing acquirers; not dependent on cheap capital for M&A; and having 49% insider ownership that strongly discourages turnover.

Get hooked to this maker of tobacco alternatives

Turning Point Brands (NYSE: TPB) is a manufacturer and marketer of OTP (Other Tobacco Products) and hemp-derived CBD products. Attractive product economics, in the form of non-cyclical demand and strong brand loyalty, support pricing power, consistent margins and cash flows, and high returns on capital (~40% gross margin, ~10% FCF margin, 20% ROIC). TPB stock increased from $10 to $55 between 2016 and 2019 on the back of strong growth in vaping, but cratered to $20 after rising teen addiction and increasing lung injuries from illicit vaping products in Q419. The FDA banned most e-cig flavors on January 1 2020, and required manufacturers to go through an arduous, expensive approval process (ie PMTA) to continue sales of e-cig. FDA approval, though costing $10-20mm, will ultimately benefit TPB and other well-capitalized survivors by shutting numerous small players and legitimizing surviving vaping products. The vaping debacle had taken attention away from the established OTP segments that provide at least $50mm FCF (and may account for the entire current value of the company) and the company’s strong balance sheet ($140mm available liquidity), which provides ample liquidity for PMTA approval process and a free call option in the form of transformative M&A targeted at vaping products (ie NewGen segment). As proof of non-cyclical demand and brand loyalty, on April 2, TPB affirmed Q1 guidance, first made in February 26, implying that impacts from Covid-19 are minimal. Valuing the OTP segments as strong cash-flowing businesses and the NewGen segment at cost (ignoring the potential for transformative M&A), the stock provides 77% upside.

The OTP segments – Smokeless and Smoking – generate stable cash flows ($50mm FCF) that fund the growth engine, which is the NewGen segment housing proprietary brands and distribution of third-party brands related to e-cigarette, CBD, and other vaping products (50% revenue CAGR 2014-19 before disruption. More on this later). The OTP segments contain dominant brands in the categories below:

-Chewing tobacco (part of Smokeless). Brands: Stokers (20% market share, 2nd largest in industry), Beech-Nut, Trophy, Durango, Wind River. Collectively 29% market share. Chewing tobacco is cured tobacco in the form of loose leaf, plug, or twist, delivering nicotine without smoke associated with traditional cigarettes. Industry growth is about low single digits;

-Moist snuff (part of Smokeless). Brand: Stoker (4.5% share, one of fastest-growing brands in the market). Moist snuff, also known as snus, is cut tobacco that can be loose or pouched and placed in the mouth. Industry growth is about low single digits;

-Cigarette paper (part of Smoking). Brand: Zig-Zag (35% share in premium market, largest premium brand). Industry is shrinking in low single digits;

-Cigar wraps (part of Smoking) Brand: Zig-Zag (75% share overall).

Buffett said that one may assess the quality of a business by the ease with which it raise prices without losing customers. By this benchmark, the Smokeless segment is a quality business because it raised prices by 4.3% and increased volumes by 3.4% from 2016-19 on average, while expanding EBITDA margins to 38% from 32%. Moist snuff was the key driver, contributing 54% segment revenue. It is manufactured and packaged in the company’s Tennessee and Kentucky facilities in a proprietary process that results in a superior product. In addition, smokeless products align with increasing smoke-free ordinances and increasing consumer awareness of relatively lower health risks compared to traditional combustible tobacco. The Smoking segment is a lower quality business in which revenue has been stagnant since 2016, but it still delivers admirable ~40% EBITDA margins. Smokeless and Smoking collectively generated ~$50m FCF in 2019.

Standard DCF with conservative assumptions shows that the OTP segments are worth at least the entire company value ($400m mkt cap at time of writing). This implies that the market ascribes zero to negative value to TPB’s growth engine, the NewGen segment, and assumes the segment to be consistently loss-making. This dire assessment is very unlikely to play out because of a strong track record of execution, ample liquidity to survive the PMTA process, and favorable competitive dynamics post-PMTA.

Even before the vaping debacle in 2019, the NewGen segment has generated consistently positive EBITDA and FCF from 2016-18. Management balanced product and marketing investments in vaping with profits, displaying shrewd capital allocation. 2019 was the first year in which NewGen suffered EBITDA losses. When vaping sales were disrupted in Q419, management quickly shrunk exposure to the vaping distribution business. They consolidated 4 warehouses into a single facility, eliminated low-margin platforms, and wrote off unsalable inventories because of the FDA flavor ban. The PMTA process will likely cause a large reduction in vaping brands and declining distribution profits. Management has responded optimally by investing more in proprietary brands than in distribution capabilities moving forward. It is unusual for a small-cap company to display a strong track record of execution. This is likely made possible by executives who have decades of experience seeing major shifts in the tobacco business. Larry Wexler, CEO, spent two decades at Altria and 17 years at TPB. Graham Purdy, COO, spent 7 years at Philip Morris and 16 years at TPB.

A major transition in the vaping business is underway. In August 2019, the CDC reported increasing lung injuries associated with vitamin E acetate in THC-containing e-cigarettes and vaping products. It is essential to differentiate between THC and CBD because marijuana-derived THC is illegal (except in low concentrations and when prescribed in certain US states) while hemp-derived CBD is legal (See Appendix for technical information). TPB only deals with CBD, not THC, in vaping products. Furthermore, legal vaping products do not contain vitamin E acetate. TPB has clarified in a statement that it does not sell e-cigarettes and other vaping products containing THC or vitamin E acetate.

Yet TPB and other legitimate manufacturers are subjected to regulation designed to weed out illicit production. To protect consumers from illicit THC/vit E acetate-containing e-cigs and vape products, the FDA requires all vaping manufacturers to receive marketing authorization for vape products through a Premarket Tobacco Product Application (PMTA) pathway. The PMTA is an exhaustive and expensive scientific study that considers the risks and benefits of the tobacco product for public health. The US subsidiary of London-based British American Tobacco, an $83B company, submitted 150,000 pages for its VUSE vaping product. At an estimated cost of $120k per product, a standard vape manufacturer with 10 flavors available in 5 capacities and 3 levels of nicotine content can expect to spend $18mm (10*5*3*120k). Numerous legitimate, in addition to illicit companies, but under-capitalized companies in the fragmented vaping market will either shut down or curtail production, leaving well-capitalized peers with significantly reduced competition. For a $400mm market-cap company, TPB is well-capitalized with $95mm cash, ~$45mm in undrawn revolving credit, and ~$50mm FCF from its OTP segments, more than the $20mm expected in PMTA expenses. TPB has the management capability and liquidity to be successful in the PMTA process.

(As a side note, the FTC recently sued Altria to undo its $12.8B investment in Juul. Should the lawsuit succeed, the largest e-cig manufacturer with >70% market share will lose the backing of one of the largest tobacco companies, further tilting competitive dynamics in the favor of TPB.)

The strong balance sheet provides ammunition for transformative M&A. TPB might had completed deals in Q419 if not for the vaping disruption. Senior management appeared to be on the prowl for strategic acquisitions:

We are in deep dialogue in several potentially transformative acquisitions. That does not mean we are certain of the outcome, but we’ll most certainly continue to pursue accretive opportunities that can further propel company growth. We have the access to capital, and we will efficiently deploy those resources to accelerate the company momentum.” -CEO Larry Wexler, Q419 earnings call.

“And Jamie, at the end of the day, like I think you guys all are aware, like vape gate was extremely disruptive. We terminated 60 people, right? And we run a tight ship. And so we have real deals in the pipeline, but they require management to push them through. And if it wasn’t for vape gate, we would’ve had deals done in the fourth quarter. So we — the pipeline is, frankly, stronger. We did move management around where we’ve dedicated some resources solely to getting deals done. And those are moving forward.” -CFO Bobby Lavan, Q419 earnings call.

The topic of transformative M&A deserves attention because studies show that the majority of deals destroy value. TPB appears to have defied the curse so far. It has spent ~$50mm in acquisitions since 2016, of which $26mm was spent to develop the NewGen segment from scratch and the balance in a bolt-on acquisition for chewing tobacco (part of Smokeless segment). The NewGen segment was created with three M&A deals, thus it serves as a useful benchmark in assessing management’s ability to create growth from M&A. Against roughly $166mm ($26mm acquisitions + $115mm debt increase from 2016-19 assuming that new debt is taken solely for NewGen + $25m cumulative interest expenses 2016-19) invested on building NewGen since 2016, TPB generated a cumulative ~$393mm revenue and ~$93mm gross profit. This means that in 3 short years, TPB has recouped about 55% of its investment in NewGen before operating expenses (~18% “return on capital”). Excluding expenses associated with the vaping disruption, the figure would be 70% (~23% “return on capital”). We used gross profit as a measure here because TPB reports low capex relative to revenues (capex ~1% revenues), so “growth capex” is likely to be in operating expenses. Gross profit can then be thought as a proxy to profits before growth investments.

The high “return” metrics showed that NewGen had excellent product economics similar to the OTP segments. Shareholders should feel assured that TPB management would continue to engage in value-additive deals. CFO Bobby Lavan seemed eager and excited yet careful about the deal pipeline (likely to be focused entirely on NewGen):

“But deals, you never want to be forced to do deals. The pipeline is strong. The — frankly, it’s — there are a bunch of companies that I bid for in sort of late summer that have come back and said, is that offer still on the table, which is an interesting dynamic. And so we are sort of evaluating that. I will tell you, there is carnage in the street, blood everywhere when it comes to these cannabis in CBD companies. It is — the opportunity set is massive. We’re just — it’s just a capacity issue … So we’ve got this quarter through. We’ve cleaned up our books, reset the business. We moved Jim Murray straight to deal making, which is awesome, and it’s — we’re going to get stuff done.”-CFO Bobby Lavan, Q419 earnings call.

Because the PMTA process is likely to reduce the number of vaping manufacturers significantly, TPB has made the logical decision to pivot from solely being a distributor to a manufacturer and marketer of proprietary vaping brands. Future deal-making is likely to focus on acquiring growing vaping brands. There is little doubt that vaping would continue to grow in popularity, despite the interruption from lung injuries. Stimulant drugs like nicotine are very difficult to quit because of withdrawal symptoms. That is why nearly 40mm Americans still smoke after a 30-year nationwide campaign against smoking. Smokers are always looking to minimize harm when feeding their nicotine addiction. Vaping reduces harm by delivering much less carcinogens and no secondhand smoke compared to combustible cigarettes. The vaping population grew 7-fold from 2011-18, and is likely to continue growing.

In thinking about the valuation of TPB, it’s best to see the company as having 3 businesses with separate risk and growth profiles. The Smokeless segment is established with ~40% EBITDA margins, above-industry growth, and a clear expansion pathway in moist snuff. The Smoking segment is also established with ~40% EBITDA margins, but has a weak industry backdrop and no clear growth drivers. The NewGen segment arguably has the best growth potential, but also the most uncertain future with M&A integration and developing regulations. Each segment is valued below. Summing the below, TPB provides ~77% upside, which excludes the upside potential of transformative M&A in NewGen.

-Smokeless: r=9%. g=4% (2x global GDP). TV multiple=20.8. NPV=$626mm based on historical 7% revenue growth and 40% EBITDA margins.

-Smoking: r=10%. g=0%. TV multiple=10.0. NPV=$288mm based on historical 0% revenue growth and 40% EBITDA margins.

-NewGen: NPV=$166mm (at cost approximated using cash spent on M&A, debt, and interest expenses). Shareholders should be at least confident that management won’t destroy value.

TPB makes products with great economics but unloved dynamics in the current social context. Chewing tobacco and moist snuff are profitable but dirty. Vaping presents great growth prospects but involves addiction, death, federal agencies, and the revival of Big Tobacco. Investors ought to look past the smoke of temporary dynamics, and stare at the long-lived economics of TPB products.


Cannabidiol (CBD) is a compound found in hemp plants and most commonly used to produce CBD hemp oil products. CBD is non-intoxicating and, when derived from hemp, is legal under U.S. federal law. Tetrahydrocannabinol (THC) is a compound found in marijuana plants and is responsible for the euphoric “high” that people experience when they ingest or smoke marijuana. The legal status of THC products differ from state to state.

Airport operator ready for take-off

Corporacion America Airports SA (NYSE: CAAP) is the largest private operator of airports (by number of airports), having a concentration of concessions in Argentina and Latin America. The airport operator has a resilient, utility-like business model with limited competition and high returns through the cycle. The icing is a capable, long-term-oriented controlling shareholder (>80% stake) who is among the wealthiest people in Argentina with a great track record in building value. Airport businesses are rarely for sale, but this one is because of two temporary demand shocks that can’t happen simultaneously at a better time – macroeconomic weakness in Argentina and travel depression related to Covid-19. CAAP generates $280m unlevered FCF relative to $1.4Bn EV. Even using very conservative estimates (5% declined in FCF over 2 years and zero growth in perpetuity), the stock has 80% upside (Target price: $6.70. Current price: $3.70).

CAAP operates 52 airports in 7 countries through government-granted concessions that lasts at least 10 years. CAAP pays “leases” for airports to governments in exchange for the right to collect fees from airlines, passengers, and businesses for their use of airport facilities. Airlines are charged for every take-off, landing, and parking. Passengers are charged fees, which are typically bundled in the cost of air tickets, for the use of airports. Businesses pay for cargo storage, warehouses services, and leases to operate retail stores in airports. By geography, airports based in Latin American accounted for ~90% revenues, in which 60% was from Argentina. By business line, aeronautical revenues contributed 50%, commercial 35%, and construction services 15% of revenues.

Airport operators are recession-resistant businesses that maintain high returns even during economic slowdowns. Argentina has been mired in recession since 2018 (GDP declined by 9% in 2018), yet growth in operating statistics remain strong. Passengers, cargo volume, and aircraft movement showed growth in 2018 (6/5/3% growth respectively). However, it is easy to miss the strong resiliency because revenues showed 15% decline in 2018. The real decline is actually only 0.8%, which supports the resilient picture shown by operating statistics.

Out of the $176m decline in revenue in 2018, $112m was related to the application of IAS 29, an accounting principle required for hyperinflationary economies like Argentina. IAS 29 applies most to companies that receives revenues in Argentinean pesos but reports in other currencies (CAAP reports in USD). Hyperinflation depresses the value of pesos, hence revenues must adjust for the depreciation. However, CAAP receives ~80% revenues in US dollars, so its adjustment for peso depreciation should be much lower than what IAS 29 requires. This means that the nature of the $112m decline was accounting-related, not economic related. Another portion of the decline concerned a $55m decline in construction service revenue, which was really capital expenditures rather than revenue (more on this later). Excluding the two declines, the real decline was $9m (<1% decline), not $176m (15% decline).

The resilient fundamentals were accompanied by ~14-16% returns-on-capital, which were maintained even during recessionary periods. Returns are defined as after-tax adjusted EBITDA minus capex, and capital as the sum of debt and equity. CAAP applies IFRIC 12 like many infrastructure companies, which makes the calculation of ROC more complex. The key point to note in IFRIC 12 is that all investments required by the concession agreement are recognized as revenue, and the actual cost of these investments are recognized as cost. Companies typically do not recognize investments as revenues because investments do no immediately result in revenue. Yet those who apply IFRIC 12 are typically toll-like businesses that can quickly gain revenues from investments. For example, a busy airport may invest in a parking structure that can realize revenue quickly upon completion.

To adjust EBITDA, I treat “construction services cost” as capex (on top of what CAAP already reports as capex) because this is the actual cost of investments, and discount “construction services revenue” to a present value. Going back to the previous example, the airport building the parking structure should only recognize additional revenue from parking fees after the structure is completed, but not before. We can discount future revenues to present by using a factor of 0.5, which roughly corresponds to revenues coming 9 years later and an 8% discount rate (discount factor=1/(1.08)^9=0.5), both of which are conservative estimates considering the low-risk nature of the project. Based on the table below, 2018 adjusted EBITDA should be ~$350m (=445.9-196.3+0.5*198.4) before tax/working capital/reported capex, and not the stated $445.9m. These adjustments, plus tax and working capital changes, result in ROC ranging 14-16% between 2016-18. To achieve 16% ROC in 2018 when the key country reported 9.5% decline in GDP in the same year is formidable, demonstrating a recession-resistant business model.

 $ m2015201620172018
Reported adj EBITDA277427462446
Reported capex-8-10-12-15
Additional capex (Construction services costs)-177-164-249-196
Discounted future revenue (Construction services revenue)898312599
  Discount factor applied0.500.500.500.50
Tax expense-45-56-47-14
Change in working capital (receivables and inventory only)-60-96-79-43
Unlevered FCF76183200277
Interest expense-69-118-115-96
Levered FCF66585181
Total capital1,3231,3091,6871,569
ROC (unlevered FCF/total capital)14%15%16%
ROE (levered FCF/total capital)14%19%39%

(As a side note, ROE was even higher than ROC because of declining tax expenses caused by over-payment. The focus here is on ROC because of significant debt and interest expenses.)

The growth runway in airport fundamentals generally correlate to macroeconomic growth, so it is necessary for CAAP investors to consider the economic growth of Argentina (60% 2018 revenues). As mentioned, Argentina is mired in recession and hyper-inflationary territory. Its debt has been declared unsustainable by the IMF, which lent a record $44Bn to the country. However, the current administration is the first ever in Argentina making credible moves to restore economic growth. It has demonstrated an ambitious start by setting a two-month timeline to restructure $67Bn debt by March 2020 to keep interest expenses manageable for economic growth, and already announced the hiring of advisors in the first week of March. The timeline keeps the administration accountable, and is far more preferable to the mysterious, hostile tactics during the 15-year odyssey of Argentina’s previous default in 2001. For the first time in its history, the country also agreed to Article IV talks that would allow the IMF to inspect Argentina’s accounts before a new agreement is signed, surprising the market because it has almost always been hostile to IMF scrutiny. Article IV talks would assure bondholders as they head into restructuring talks that Argentina is under IMF supervision.

Perhaps the most promising is the appointment of Martin Guzman as finance minister . Guzman has an impressive resume. He is the protégé of Joseph Stiglitz, a Nobel laureate and influential economist. He is a leading expert on sovereign debt policies, and has testified before the US Congress on Puerto Rico’s debt crisis and at the United Nations about the need for a better international system for resolving sovereign debt crises. Most important, he demonstrated a sound understanding of the importance of coordinated policy action and sustained growth, instead of mere monetary tightening, to combat inflation in this op-ed. There is no doubt that Guzman is the best chance for Argentina to get back on sound economic footing.

CAAP is cheap on an absolute basis (I’m not a fan of relative valuation). Assuming no growth and a 10% discount rate, a 3-year DCF results in $2.8Bn EV (~2x current market value). The same DCF produces 140% upside from current price when growth is assumed at 2% (roughly the growth of global GDP, which is a low estimate). Current valuation implies that CAAP shrinks FCF by 9% annually in perpetuity, which is very unlikely given the mission-critical nature of airports, low risks of disruption and substitution, and strong tailwinds in air travel. To allow for the temporary disruption of Covid-19 and recession in Argentina, I assume a 5% decline in FCF per year for the next two years and zero growth in perpetuity, resulting in an ~80% upside from current price.

The target price does not account for upside related to actions from management, which has proven competent for the past 20 years since the founding of CAAP. Management is aligned with shareholders because the founding and managing family owns 82.1% of CAAP while public shareholders own the balance. CEO Martin Eurnekian is the nephew of founder Eduardo Eurnekian, who had a great track record in building value (net worth: $1.5Bn) from diverse business interests in media, energy, infrastructure, and finance as a shrewd entrepreneur. Management transition had been stable without typical family strife with only one CEO transition in the history of the firm. Eduardo had led the company since its founding in 1998, and passed the CEO position to Martin after the IPO. Martin, now 40, had started his first job at CAAP when he was 18, and spent the past 22 years “doing everything one could imagine” at CAAP.

In 2020, it is irresponsible to discuss a travel-related business without thinking about disruptions from Covid-19. The virus, about 5-10x more contagious than seasonal influenza, has almost reached the proportions of a global pandemic. Experts estimate the mortality rate to be ~1% or lower (the current rate announced by the WHO is 3.4%. This is too high because it is based on backward-looking data). I cannot offer more insights concerning the virus. What I can do is offer some extent of clarity based on current facts:

-Covid-19 is infectious but not deadly to most people. This means that most of us (about 90%) can resist the virus. This also means that Covid-19 does not constitute an end-of-the-world-as-we-know-it event.

-A vaccine is possible. Estimated time to production varies from one to two years. What is important to know is that the human race has her best minds working on this day and night. Betting against the human race (ie shorting the market thinking that the virus would destroy the global economy) is unwise.

-Every government and central bank is ready to unleash significant monetary and fiscal stimulus to combat the impact of the virus. Betting against the Fed, ECB, and their peers is foolish.

-The world seems to be over-reacting with mass quarantines, but over-reaction is better than under-reaction. China under-reacted at first by suppressing information about the virus, then the country over-reacted by placing 50 million citizens in mandatory quarantine. It worked – the growth of new cases stalled. Italy under-reacted at first too, then over-reacted by enforcing quarantines and travel restrictions on the entire country. The US over-reacted in a different way by having the Fed cut rates and the White House floating stimulus measures. Over-reaction is good because it preemptively reduces the impact, biological or otherwise, of the virus. But over-reaction can also be misunderstood as a signal that the virus is an end-of-the-world-as-we-know-it event. Over-reaction stops the virus from becoming worse, but does not indicate a worsening of its impacts.

It is easy to be pessimistic by reading headlines showing the relentless growth of new cases. However, reality is often a lagging indicator of our efforts. You exercise to lose weight, but your body typically does not show weight loss until later. Humankind is racing to contain the virus, which will eventually be conquered. The only question is when. I am optimistic knowing what will happen but not knowing when.

CAAP generates high returns through the cycle, owns valuable airport concessions, and demonstrates incentivized management with a good track record in building value. When the sky clears of temporary demand shocks in the form of macroeconomic weakness in Argentina and reduced travel from Covid-19, the stock will be ready for takeoff.