Barron’s recently held its 2019 Roundtable, a gathering of 10 of Wall Street’s smartest investors. Here are the stock picks of Henry Ellenbogen, portfolio chief at the T. Rowe Price New Horizons Fund (PRNHX).
Q: Henry, give us your thoughts today, please.
Henry Ellenbogen: We’ve talked about the uncertainty in the world. That uncertainty has multiple dimensions. One of the largest is business-model disruption, which isn’t only a business issue, but also a political issue.
Investors should own companies that can compound and generate growth internally. They also should own companies that—if 2019 proves to be a down year—they’d want to dollar-cost-average down, because they have a superior business model. I have four companies today that fit our definition of compounders. We have owned them for a long period. We still like them, and we think they are going to be compounders in the future.
Every company is trying to figure out how to use technology, internally and externally. One play on this is Gartner (IT). Ninety percent of Gartner’s earnings before interest and taxes comes from its research business. It has two parts. Because of the demands that all companies have to use technology better and understand how their competitors are using it, the research product has transitioned from one that was nice to have to one you need to have. You can see it in Gartner’s numbers. Last year, it had over $2 billion of revenue and grew more than 13% organically. It’s a global business. We believe that it is going to continue to be a strong double-digit growth business.
Q: How do you explain the growth?
Ellenbogen: The average customer spends $180,000 for Gartner research. They want to know what technology providers they should look at to answer their key questions. How are other people using technology and on-boarding it? How can they drive technology into a business line to get efficiency?
The other 20% of the research business is where the controversy has been. We have owned the stock since 2010. It has compounded at well over 20% since we’ve owned it. In the past two years, Gartner’s performance has been weaker, because it bought Corporate Executive Board, or CEB, a business best-practices consultant outside of technology that helps functional groups in a business understand issues in their areas.
Gartner instituted a turnaround at CEB. The product was fine, but it had to change the go-to market. They were selling by individual site license, as opposed to role-based pricing, and had to re-energize the sales force. A lot of costs have come into this division, with only modest improvement in growth; that’s where the controversy is. But Gartner now has an excellent franchise in an area that is becoming increasingly important globally.
In addition, Gartner has deleveraged. The leverage was about four times. It is now 2½ times, and the company is deleveraging at more than one time per year. They are back to buying back stock. We see low-$4 earnings per share in 2019. Free cash flow historically has been 130% or greater, because customers pay upfront. Next year, we see low-$5 EPS and close to $7 of free cash flow, and expect the company will return to trading at 20 to 25 times free cash flow, versus 18 times now.
Waste Connections (WCN) is my second pick. Picking up trash is a business that we don’t think is going to be disrupted by the technology-platform companies; it’s a very simple business. Having the right strategy, having the right people culture, controlling people costs, and doing thoughtful, patient capital allocation is where most garbage companies have fallen down and why they have not been good stocks. Waste Connections went public in 1998, and T. Rowe Price New Horizons fund (PRNHX) has owned it since its initial public offering. It’s one of our top 10 holdings. The company had more than $100 million in revenue when it first went public; in 2019, it will do over $5.4 billion. My sense is that if I talk about Waste Connections two years from now, I will almost be talking about the exact same story. That’s how consistent and how disciplined this management team has been.
Q: How do they compound wealth in an area that’s so commoditized?
Ellenbogen: It starts with focus and strategy. They have two types of markets. They have franchise business markets, largely on the West Coast, in which you’re given a monopoly to pick up trash in a geographic area. In these, you are held to very high service standards and get only CPI [consumer price index]-like price increases. That’s about 43% of their business. Municipalities do not want people buying or bidding for franchises unless they have experience in local areas, because in granting the contracts, they are taking a lot of political risk. The fact that they’ve been there and done that gives them a tremendous advantage in making acquisitions in franchise markets.
Q: Yes, voters don’t like breakdowns in garbage collection.
Ellenbogen: The other 57% of Waste Connections’ business is in competitive markets. But within 80% of that portion, the company controls the garbage disposal. That’s key because, otherwise, you pay a very high cost for disposal. That’s where other people have fallen down. To give you a sense of how disciplined this company is, almost three years ago, they announced that they were buying Progressive Waste Solutions. When they bought Progressive, it did $2 billion of revenue, $300 million of Ebitda, and $150 million of free cash flow. Waste Connections changed the regional management. They focused on improving operational execution, so safety incidents were cut by more than 70%. They improved employee retention, which improves margins by cutting turnover costs. And they disposed of lower-quality markets. Fast-forward to the end of 2018: We forecast that the same asset base was down in revenue to just shy of $2 billion, but that they doubled Ebitda to $600 million and that free cash flow also doubled. Effectively, they paid nine times free cash flow for this asset.
We expect to see more of the same out of Waste Connections. You are going to have a little bit of volume growth; you are going to get pricing increases of 2% to 3%, and they’ve already announced 4% to 5% of revenue growth from acquisitions in 2019, which continues to be core to the strategy.
The company generates free cash flow of about 120% to 130% of earnings per share because they are disciplined buyers. We think it’s about a $3-a-share-in-earnings company in 2019, going to $3.40 in 2020. Free cash flow will be $3.75 to $4.20 in 2020. Because of the consistency of its double-digit growth, Waste Connections merits about 20 times free cash flow, or around a low-$80s stock price at the end of this year.
Next, I talked about Vail Resorts (MTN) last year, and I want to update my thesis and recommend it again. Vail Resorts was a very good stock in the first half of 2018, like a lot of relatively expensive consumer stocks, and then it was not a good stock in the back half. And so it ended marginally up for the year.
The core thesis is they’ve transitioned what used to be an economically cyclical business to a subscription business by locking in season passes right after Thanksgiving. This past year, they sold 925,000 season passes, locking in close to over a half-billion dollars of revenue before anyone knew what the ski conditions would be. The controversy was that their units were up 8% and revenue was up 10% in the core season-pass business, while the market expected 1% to 2% more, or about 20,000 more season passes sold.
Much of the weakness was due to the historically bad weather out West, which affected pass usage, especially in the Tahoe region on the California-Nevada border. And when they were trying to close out season-pass sales around Thanksgiving, there were all those Western fires. When the West is on fire, you are not exactly thinking about a lush ski year.
The second reason was that a rival introduced a competitive season pass. The shortfall of 20,000 season passes came from the local-pass business. That’s important. Vail is unique in putting together a national network of resorts, and it is the only company that attracts destination season-pass holders. That is the underpenetrated part of the market, and that is also where you get the most ancillaries. When you fly in from a distant place and stay at a resort, you spend more on high-margin items like food and ski school. A destination pass owner is preferred over a local.
Also, season passes are half of lift revenue. Growing 10% when you are half is just about as valuable as growing 12% when you are 40% of revenue. We think the shortfall in season-pass sales isn’t going to impact 2019 numbers. For any durable company, there are times when the competitive moat gets tested. You can assess whether the business model has withstood the competition. We think Vail did and will grow by double digits this year.
In addition, the balance sheet is in very good shape, and we believe that 40% of Ebitda growth over the past 10 years has come through acquisitions, and they’re an advantaged acquirer. They bought Whistler in 2016, which makes the season pass more valuable, and they also bring a database asset to Whistler that no one else has. On operating earnings alone, we think that EPS will be $9 this fiscal year ending in July and about $10.50 next year. Free cash flow is about 25% better because it is a subscription business. In fiscal 2020, we see around a $13 free-cash-flow number. We think the stock holds at a 22 to 25 multiple, which means $250 to $290 a share.
Q: Do you have another?
Ellenbogen: When we think about compounders, the two key factors are ownership’s mentality and the durability of growth. My next pick, SS&C Technologies Holdings (SSNC), came public for the second time in 2010, and we have been owners since the second IPO. Despite a mediocre 2018, the stock has compounded wealth at 24% since the IPO.
Q: What does the company do?
Ellenbogen: SS&C does fund accounting. It provides the pipes on the technology side and the service side for hedge funds. It’s the leading provider in the country; a lot of people in this room probably use them. And they are also the leader for private equity, and early last year, they bought DST Systems, which provides these services for mutual funds. A disclaimer: T. Rowe Price (TROW) is a customer.
Mario Gabelli: I have a disclaimer, too—they are too high-priced—but go ahead.
Ellenbogen: Bill Stone started the company in a classic American way, by getting a second mortgage on his house in 1986. He still owns 13% of it. Even in an industry where growth is neutral or negative, when you get into the plumbing, people can’t really take you out. You have a revenue stream, and you have pricing power. People worry about the health of their customers. But even under modest volume, Stone is going to have pricing power. If you change your back office and your accountants, you get all sorts of questions from your customers.
People are very concerned about the capital markets. But 10% of the company’s revenue is tied to market sensitivity; 90% isn’t. That’s about $50 million of Ebitda, if you assume a 30% correction, about 40% incremental margins. On the flip side, we believe that DST could yield an additional $50 million to $100 million of synergies beyond market expectations.
Another concern is that SS&C is 4.7 times leveraged, and the market doesn’t like leverage. This is the only highly levered name I am going to mention, and there are three reasons. First, Stone is investing his own money alongside other people’s, and he is very focused on paying down the debt. Second, the business is a very low capital-intensive one that is very sticky, and we think under normal operating situations, the leverage will be below four times by the end of this year. Third, when Stone bought DST, he got DST Health, which does $100 million of Ebitda and is a noncyclical business. If he wanted to, he could sell it at 12 to 15 times Ebitda, and that would instantly deleverage the company below three times. So he has another road out. We believe that SS&C Technologies will earn about $3.70 a share this year and $4 to $4.10 next year.
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