Barron’s recently caught up by phone with the members of our January Roundtable, including Henry Ellenbogen, formerly manager of the T. Rowe Price New Horizons fund. Henry left T. Rowe Price in March and formed a new investment firm based in Washington, D.C., that will focus on public and private small-cap growth companies. It will manage investors’ capital as of the start of 2020. In the edited conversation below, he shares his market views and some stocks he likes.
Q: Henry, what do you make of the market these days?
A: Increasingly, the most unpredictable thing about developed markets is elections. At a time of very low unemployment in the U.S., you would expect more political stability. Instead, our politics are increasingly divided. Many businesses are undergoing tremendous change, which has bred uncertainty. An estimated 30% of the companies in the S&P 500 (.SPX) are in industries going through technological change and face obsolescence risk, and even stable businesses have to become more agile, which puts more stress on employees. Economic instability has led to political instability and pressure on central bankers to be more accommodative with monetary policy to drive economic growth and some level of stability.
All that said, corporate profit growth was slightly better in the year’s first half than people had expected. That growth is likely to continue. Real estate is one area of the economy that saw significant improvement, due in part to interest rates on 30-year mortgages falling below 4.5%. Yet, the stock market could be flat or down for the rest of the year. As investors look toward 2020, they are going to worry more about the presidential election and question what will drive economic growth, which feels muted in the U.S. The upside is predicated on interest-rate stability, trade confidence, and corporate reinvestment. China will be particularly important as we look toward 2020.
Q: Muted economic growth hasn’t restrained the stocks you recommended in January. Do you still like them?
A: Yes. Gartner (IT), Waste Connections (WCN), and SS&C Technologies Holdings (SSNC) are solid holds. They had a strong first half of 2019, and will continue to be solid compounders. All three companies have good franchises, generate internal growth with less-than-average cyclicality, and have CEOs with an ownership mentality. They own sizable stakes and think about extending and expanding their competitive moats.
Vail Resorts (MTN), my fourth pick, is attractive for new buyers. Vail is just wrapping up its fiscal year [it ends in July]. Despite a slow start to the year and some concerns about the ski-season-pass model, the company has had a good year. We expect Ebitda [earnings before interest, taxes, and amortization] to rise 15% for the year, and free cash flow to come in around $10 a share. There has been controversy around the stock for the first time since Vail introduced the low-cost season pass in 2008, as a competing product, IKON Pass, has entered the market. Vail missed its season-pass forecast this year by about 20,000 passes on a base of 935,000. We believe that when Vail reports results for the back half of the year, investors will see the advantage of its business model, and that two pass programs can co-exist. Ikon will end the year pricing its pass above Vail’s $900. Ikon doesn’t own its core ski resorts, as Vail does. As the market looks to 2020 and beyond, investors will realize that Ikon has a weaker mountain network than Vail.
Another thing in Vail’s favor is that the company introduced one-, two-, and three-day discounted passes in exchange for a pre-Thanksgiving commitment. This will allow it to continue to gain market share. Customers who pay less tend to have higher net promoter scores [a measure of customer satisfaction] and repeat purchase rates. Finally, Vail made a key acquisition in Australia earlier this year that will help not only its Australian business but Whistler, in British Columbia. Australian skiiers come there at off-peak times, and are the highest-value visitors.
Q: Vail’s shares are trading around $223. What sort of upside do you see?
A: If Vail can generate $12 a share of free cash flow in 2020 and $14 in 2021, the stock could rebound to $260 to $300 a share from a recent $220. It yields 3%.
I also like two small companies that could become much larger. FirstService (FSV) is a durable growth business whose chairman and CEO have an ownership mentality. They have been a team for 25 years. Redfin (RDFN) is an early-stage real-estate company that I recommended last July. The stock is at an attractive entry point.
FirstService, a real-estate services company, is using technology to turn a local-scale business into a national platform. Insiders own 20% of the company, which is in two businesses. The residential property-management business provides property-management services for 8,500 high-rise and condominium communities. Recently FirstService has been investing on a national basis. Tenants can download its app to track packages, make payments, and such. A centralized service handles customer service and billing. This allows on-site managers to spend more time with residents, which creates better customer satisfaction and lowers costs.
The real-estate services business is five times bigger than its nearest competitor. Yet, it has only a 6% market share. Organic revenue could grow by 4% to 6% a year, with solid operating leverage. Historically the company has made attractive acquisitions in a disciplined fashion.
Q: What is FirstService’s other business?
A: The brands business is 35% of revenue and 43% of Ebitda. It comprises six brands, including California Closets, Paul Davis Restoration, and Century Fire Protection. Some brands, like California Closets, were traditional franchise businesses. FirstService is now acquiring the franchisees and becoming an operator. FirstService has been centralizing manufacturing to lower costs and improve quality, while allowing local stores to drive sales and design. The brand has been growing through acquisitions, and acquired markets have seen double-digit revenue growth and improved margins.
In June FirstService acquired Global Restoration, a commercial restoration company. It is basically a local-scale business that requires strong execution and relationships with insurance companies. FirstService is focused on creating another national platform. It is growing organically and through acquisitions. Despite the market-leadership position of several FirstService brands, the company still has less than a 5% market share in any one category. That suggests there are years of growth ahead.
FirstService could earn in the low-$3 range this year and in the high-$3s next year. We expect earnings to compound for a long time. The acquisition of Global Restoration has made the portfolio less cyclical economically, which we also like. FirstService is a good operator. It buys businesses and invests in them. In service businesses, investment in your employees and consistency of human capital are distinguishing factors—and a reflection of an ownership mentality.
Q: For sure. How about an update on Redfin?
A: Redfin’s stock has fallen in the past year for two reasons: The real-estate market weakened in the back half of 2018, although it has strengthened lately. And the company, which operates a real-estate brokerage, announced it is going to invest roughly $40 million in marketing, which will put profitability further into the future. Also, a secular change is occurring in residential real estate. Companies such as Opendoor and Zillow Group (Z) are buying up homes directly from owners for a fee, and selling them to buyers. This shift has caused investors to question what these changes mean for the industry.
Even so, Redfin had a good year. It continued to gain market share, although its share remains below 1%. The CEO and board are disciplined. Redfin has demonstrated an ability to leverage technology to make its rea-estate agents two to three times more productive than other agents on a per-unit basis. This is important because it allows them to retain good agents. The company charges a 1% to 1.5% sales commission, instead of the traditional 2.5% to 3%.
Q: What are Redfin’s main markets?
A: Its leading markets are the Washington, D.C., area and the Seattle area. The company has a market share of close to 5% in the Seattle region. Historically for an e-commerce company, going from 1% to 5% of the market takes a lot of time; 5% to 10% happens much faster, and 10% to 20% happens even faster. This is likely to happen with Redfin. They now have the agent and market scale that allows them to invest in national TV to drive branding and awareness. Second, when you have scale in real estate, people start seeing your yard signs more often. You get more word-of-mouth referrals and repeat transactions. Moving up the curve on market share is critically important, and Redfin is at an attractive point on that curve.
Also, the company can drive more business by differentiating its service. It recently launched Redfin Mortgage and has been integrating the lending platform fairly fairly seamlessly into its home-buying service. Earlier this year Redfin introduced Redfin Direct in Boston. It enables someone to buy a Redfin-listed house without the involvement of a buyer’s agent or associated fees. In a traditional transactino, the seller of a home pays the fee of both his agent and the buyer’s agent. Taking out the buyer’s agent would save the seller a 2.5% to 3% fee. The company has expanded the service to Virginia. These products demonstrate Redfin’s advantage as a low-cost provider, and how innovative the company is with technology.
Looking out three years, normalized profit margins in the business could be in the low-10% range. We expect Redfin to do about $1.2 billion to $1.3 billion in revenue in the 2022-23 timeframe, which will represent less than 2% of the total market. The company could have many years of growth in front of it.
Redfin’s stock could trade for 15 to 25 times underlying Ebitda, or for $2.5 billion to $3 billion of enterprise value, versus its current enterprise value of $1.5 billion. On a share-price basis, that’s between $23 and $31, versus a recent price of $18.
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