Description

Mr. Greenblatt, have I got a special situation for you. An investment vehicle managed by the next generation of the Buffett family is offering shares to the public next week at 1.2x net asset value, where 70% of that NAV = cash.

Looking backward, one might see a company that: began life two years ago via reverse merger into a public company shell and subsequently performed a 7:1 reverse stock split; generated operating income of -$2.7 million in 2016 on revenues of $6.3 million; is a controlled company with dual classes of voting stock; is led by an inexperienced and youthful management team who is investing rapidly in businesses that are highly competitive and largely consolidated by scaled incumbents; plans to issue stock to you at $14 versus the controlling shareholders’ average cost basis (purchased in 2015 and 2016) of $9.70.

This situation will not screen well from any angle.

Looking forward, one might see a management team that: has a decade of successful, niche financial services and media industry investing experience; has a large amount of personal skin in the game, as well as substantial capital and reputational backing (including the Buffett family); has copied their management partnership and investment philosophy directly from Uncle Warren and Uncle Charlie; has created an economic incentive structure identical to the original Buffett partnership; since gaining control in February 2015, has invested almost $50 million into high quality assets acquired at reasonable valuations that came with established management teams and long runways for incremental capital deployment; is increasing its public float by 250%, potentially creating trading liquidity in its stock for the first time while concurrently moving from the OTC market to Nasdaq.

Sound better?

Link to writeup and accompanying charts: https://drive.google.com/file/d/0B5AhopgMAgquTnJ0WnhMeWF3aFU/view?usp=sharing

For now, this is likely a personal account / micro fund trade as proforma public float should only amount to ~$60 million. But I submit this company as one for larger investors to put on their radar.

Background

Adam K Peterson (35) and Alex Buffett Rozek (38) are co CEOs of Boston Omaha Corp (Delaware) and also principal shareholders. In 2015 they acquired REO Plus, Inc, a defunct Texas entity with nascent real estate investments, and have subsequently recapitalized the company via multiple share offerings to friends and family over the prior two years.

Peterson worked as a financial analyst for Peter Kiewit Sons in Omaha before joining Magnolia Capital in 2006, a family office entity backed by multigenerational oil & gas industry wealth. As of September 2016, Magnolia had $288 million of AUM. Recent EDGAR filings can be found here https://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0001618333&owner=exclude&count=40 . Rozek worked at FBR and Water Street Capital before forming his investment partnership. While less active than Peterson, the two investors targeted a few of the same public investments prior to 2015, presumably together.

Rozek is Doris Buffett’s (sister of Warren Buffett) grandson. Doris was an investor in the original Buffett partnership, as were Warren’s first college roommate and his mother (Charles Peterson and Elisabeth Peterson). While lacking proof, I speculate Adam Peterson is an heir to the aforementioned Peterson’s, and Peterson and Rozek’s relationship draws upon this family connection.

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Investment Philosophy

So why should we support these two upstarts in their path forward? Well, at least thus far, they are saying all the right things and following through with their capital allocation decisions (more in the next section). Their most recent annual meeting in Omaha opened with the following slide:

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In their 2015 shareholder letter, management preached thrift, price discipline, outlined their thoughts on an asset’s intrinsic value, and stated how their performance should be measured:

“Since one of us was in Boston and the other was in Omaha, the name just made sense. It also appealed to our mutual thrift to save some money on high priced branding consultants. (The truth is we don’t know any).”

“We decide to invest based on our calculation of a business’s earnings power relative to the price we pay for those earnings.”

“If we are going to hunt for opportunity, in general we prefer to go where the crowds aren’t.”

“While management reports its performance using book value per share, it makes decisions for the company based on calculating intrinsic value. Intrinsic value can most simply be described as the present value of the cash that can be generated from a business over its life. To determine this value requires a set of assumptions and judgments. There are two managers at Boston Omaha, and we may come up with different calculations for the same investment. If we gave all the same information to five other people, they may come up with five different sets of assumptions. This intrinsic value calculation can be as varied and unique as the individual calculating it. So though it’s not much use to report intrinsic value calculations, you should know they are being made by us all the time relative to our decisions on allocating capital in Boston Omaha.”

“If we are generally right about intrinsic value, it will show up over time in some combination of growth in per share book value, earnings power and/or cash flow. And if we are wrong there is nowhere to hide. It will show up in the same places.”

In the 2016 shareholder letter, management outlined their framework for decision making and defined their criteria for capital allocation:

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Finally, management summarized its overall strategy in the current prospectus:

“Our principal business objective is to increase stockholder value by profitably growing our existing businesses in out-of-home advertising, insurance and real estate. We believe that we will achieve this objective through organic growth of our existing asset base’s ability to produce a growing stream of cash flow, continuing to acquire complementary businesses to expand our geographic reach while allowing us to achieve economies of scale, and acquiring other businesses which meet our investment criteria. We look to acquire businesses that have consistently demonstrated earnings power over a long period of time, with attractive pre-tax historical returns on tangible equity capital, while utilizing minimal to no debt, and that are available to us at a reasonable price. However, we may consider minority positions in businesses when the economics are favorable. In certain circumstances, we may enter new lines of business when the opportunities and economics of doing so are favorable in comparison to acquiring the business, although we have no current plans to commence a new line of business.”

Investments Completed 

To date, management has raised $67 million of cash and invested $44 million into outdoor advertising structures ($26 million), surety insurance underwriting and brokerage ($17 million), and varied real estate assets and services businesses ($1 million). While Warren Buffett can attribute a large portion of his success to investments made in the insurance and media sectors, Peterson has also focused on these two sectors in a more niche way during his career as a public investor (possibly including a few write-ups published on a notable, members only, online, investment club). Thus, insurance and advertising make intuitive sense as initial targets for these investors.

The table below outlines the company’s sources and used of funds since Peterson and Rozek gained control. (Note: Magnolia is an investment entity controlled by Peterson, Boulderado is an investment entity controlled by Rozek).

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Insurance

Let’s start with insurance, as it’s the most interesting and complicated vertical inside of BOMN’s portfolio. Surety is a weird animal for a variety of reasons. There are both commercial and personal lines, but most surety demand across segments is driven by government regulation and industry risk practices. BOMN is targeting recurring, high volume, low individual premium size business, where examples might include real estate agents getting broker bonds (license necessary to sell real property) or gun owners seeking pistol bonds (necessary to buy a gun, or carry in public). Contrast these high volume, low premium type transactions with what BOMN is not seeking: a multi million dollar premium construction bond that a contractor must take out to bid on a once per decade infrastructure project for a local government. 

The surety segment of insurance presents several attractive characteristics as a current and future use of capital for BOMN, namely:  loss ratios are consistently the lowest (ie most profitable) in the industry, the segment is relatively small (less competition from large players) yet still very fragmented. Relative size and loss ratios by industry segment are displayed below:

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The top ten insurers wrote 64% of surety industry premium in 2016 and included giants such as Travelers, Liberty Mutual, Zurich and Lloyds. Based on $4.7 million of run rate annualized premium volume exiting December 2016, management ranks BOMN as the 72^nd largest surety underwriter in the US, which equates to less than 0.1% of industry premium of $6 billion. BOMN could quintuple its current premium volume and still have less than 1% industry share. Management believes there are approximately 200 firms currently underwriting surety policies in the US today.

Surety bonds are more akin to credit issuance than traditional insurance. While the surety provider guarantees a specific commitment made by a policy holder, the surety provider is not responsible for any subsequent claims filed (ie the policy holder is responsible for loss claims). When a policy holders pay premiums, the economic transaction is similar to paying interest on a bank loan. Management dissects this dynamic inside of the surety ecosystem that keeps losses so low:

“The nature of surety is a little different than other lines of insurance, in that surety is designed to prevent a loss rather than cover a loss. Surety is a tri-party agreement, meaning that a surety company is generally guaranteeing a specific performance of the insured, (“Principal”), for a third party. In many cases, the ability of the Principal to stay in business demands that there are no claims outstanding on a required surety bond. The Principal often has a real incentive to minimize any claims for which they are bonded. In addition to this incentive, the surety company has a number of tools at its disposal, from taking collateral to replacing the work done by the Principal. These help the surety keep the dollar cost of losses down.”

The offset of losses being so low is that distribution costs (surety broker commissions) are among the highest in the insurance industry (as high as double that of more traditional lines of insurance). Surety brokers can charge a premium commission for delivering relatively sticky, highly profitable business to surety underwriters. And the smaller the premium amount and less standard the policy being written (UC&S has >10,000 surety bond types on file), the more manual the process will be for the broker, generating more relative expense versus a high frequency bond category supported by higher levels of automation.

Assuming high distribution costs would remain a constant in the industry, management sought to create an integrated surety underwriting and distribution platform to capture a greater cut of profits inside of the vertical, and gain more flexibility on the type of premiums it gets to write. Management recruited a seasoned executive (Michael Scholl, 49) in October 2015 to lead its insurance segment, formed an insurance holding company (General Indemnity Group), and acquired a surety focused broker in April 2016 (Warnock), followed by a surety underwriter (United Casualty and Surety Company, or UC&S) in December 2016.

BOMN acquired Warnock for 1.8x 2016 brokerage commission revenue (or 1.6x excluding an 18 month earnout) of $760k, a fair valuation for a small broker. Large regional broker platforms can trade from 2-4x revenue depending on growth trends and policy mix, and public comps currently trade in the 2.5x to 3.5x revenue range. Based in Georgia, Warnock writes policies throughout the US.

BOMN acquired UC&S for 2.4x tangible book value of $5.4 million at the date of acquisition, or 1.9x tangible book value adding back float (unearned premiums) of $1.3 million.  On $2.4 million of 2016 revenue, UC&S produced $900k of adjusted operating income (which excludes the founding shareholder’s large relative salary and transaction related amortization), implying BOMN paid 15x EBIT. This valuation appears full to excessive given the target’s small scale and lack of historical diversity (95% of 2016 premium was written in Massachusetts). Relevant public comps are primarily focused on real estate titles or municipal bond insurance and thus do not provide a relevant benchmark.

Since being acquired in December 2016, BOMN has expanded the number of states UC&S is licensed to issue surety insurance in from nine to 31 and intends to eventually be licensed in all 50 states and DC. UC&S was extremely conservatively operated under its prior leadership, demonstrated by its 1% average loss ratio over 28 years of operation and AM Best rating of A- (Excellent). For comparison, historical industry loss information is presented below:

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In line with the historical performance of the commercial surety segment, BOMN is targeting a 15% loss rate for UC&S going forward. As part of this premium volume push from both wider geographic coverage and less stringent underwriting, management invested $2.8 million of additional capital into UC&S, bolstering its tangible capital base by 51%. Loosening underwriting generally sounds like something to run away from… but this seems like an extreme example of conservatism, bordering on mismanagement, from what was a family operated business. Peterson and Rozek provide perspective: “Remember, 15% is 15 times the loss that UC&S has experienced on average in its 28 year history.” Even with its draconian loss prevention and historical willingness to turn away volume, UC&S produced 11% after tax ROE on tangible capital during 2016, a level similar to the public title insurers that operate at a much larger scale.

Billboards

Since July 2015 and via nine portfolio acquisitions, BOMN has acquired 498 billboards with 834 faces, 27 of which are currently digital. 404 billboards are located in Wisconsin, 53 billboards in Georgia, 40 billboards in Alabama, and one billboard is located in Florida. BOMN’s acquired billboard portfolio sits along main interstate routes that are heavily trafficked generally, but especially during holiday periods, connecting Southern Alabama and Southern Georgia to the Gulf Coast of Florida and lower Wisconsin to the Door Peninsula.

Consistent with the early days of Ted Turner, billboards remain an attractive business with high returns on tangible capital. In the media business, technology and consumer trends can alter the demand for various forms of advertising in a short period of time. But demand for well located, outdoor advertising surfaces has grown at rates greater than GDP (4% CAGR since 1990 versus 2.3% for GDP) while other forms of legacy media have declined (chart below per OAAA, data through 2015). 

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Billboards present one of the lowest cost options for local advertising, remain a staple of national brand advertising, and generate customer ROIs higher than most legacy media advertising. The robust industry customer base below (2016 data per Kantar Media) supports that advertisers continue to see value in billboards:

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A recent report by MAGNA highlighted continued growth for outdoor advertising revenues during 2016 of 3% and projected similar growth over the next five years. Drilling down on the OOH cohort in the below table, digital billboard revenues grew 14% in 2016 while traditional billboard revenues grew by 1%. Movie theater advertising also grew by 1%. Digital billboard revenues are projected to continue LDD growth in 2017. 

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So billboards are still a growth business, or at least not a declining business. What else is attractive? Barriers to entry for new structures are extremely high due to multiple layers of government regulation and NIMBY politics. For a well located billboard, there are few local substitutes. On average, both the advertising customer base and the materials supplier base are highly fragmented. Capital intensity is very low (PP&E = wood and steel; little working capital required for growth) and traditional billboards are long lived assets (25 to 50 years) requiring low maintenance capex.

In addition to the industry characteristics above, BOMN’s existing portfolio presents numerous opportunities to reinvest capital at high incremental rates by increasing the number of displays per billboard. Just 5% of its existing plant is digital today. An old Morgan Stanley note reported 30% ROIC and a three year payback on the capital necessary to convert legacy print billboards to all digital. In addition to providing more advertising inventory (at almost no incremental operating cost) to the billboard owner, advertising customers have been very receptive, eg using the ability to change pricing multiple times in the same week in response to local competition (fast food restaurants) or advertising one day only type sales. Other initiatives, such as geofencing the area around a billboard, provide advertisers with both the ability to target mobile users who may be passing a specific billboard and an additional set of analytic data to determine the effectiveness of their advertising spend. Finally, as both telecom operators and cell tower owners continue to invest in infrastructure capable of supporting the surge in wireless data consumption, billboards located in urban geographies present attractive options for the placement of small cell receivers.

What’s not to like? The market is extremely consolidated, with Lamar, Clear Channel and Outfront controlling 67% of the industry (though only 63% of digital structures). For national advertisers who would like to negotiate with just one person to put up signage in 50 cities, this scale is a material advantage for the incumbents. Shared regional infrastructure, especially teams of salespeople, over a bigger portfolio also provides lower relative operating costs than mom & pop billboard owners. REIT structures are also typical, providing a cost of capital advantage when bidding for assets. Market consolidation does provide one silver lining to BOMN: any regional or national billboard portfolio acquisition by the Big 3 usually comes with regulator induced divestitures, providing small operators with buying opportunities from forced sellers.

Land expense is the largest operating cost for a typical billboard at ~25% of revenues on average, but can vary wildly from site to site. Lease terms can range from one to 20 years (plus renewal options). Management avoids individual leases which have a term of less than 10 years without an extension option. Although 95% of BOMN’s billboards reside on leased property, management states “our billboard assets have a lower than industry average lease cost due to land ownership and numerous fixed rate leases.” This statement implies the real estate owned in BOMN’s billboard portfolio sits under its most productive and valuable billboards. Acquiring land underlying its existing portfolio also appears to be a future high return use of incremental capital, consistent the recent focus made by the public cell tower owners and complaints of rising site lease expenses from the Big 3 billboard owners.

In July 2015, BOMN formed its subsidiary Link Media to acquire billboard assets. It recruited James McLaughlin (67), a former CEO of two different outdoor advertising platforms from 2004 to 2012 and 2013 to 2016, to lead Link in March 2017. To date, prices paid for individual billboards have ranged from $2 million to $20k. In aggregate (through May 2017), BOMN has paid $25 million to acquire a billboard portfolio generating run rate revenues of $4.2 million and normalized EBIT (per management margin targets) of $1.9 million. These amounts imply management paid a 13x EBIT multiple, or a 7.6% unlevered cash yield, which is in line w valuations of public peers but materially less than other forms of real estate with similar characteristics:

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Real Estate

Management has made three small real estate related acquisitions to date, none of which are material to BOMN’s current investment portfolio. The CEO of Logic, a commercial real estate brokerage and property manager focused currently on Las Vegas, is a BOMN board member and shareholder, and BOMN owns a 30% interest in Logic. RE brokers are traditionally considered transactional in nature and highly cyclical, and are very reliant on a few key executives, especially the smaller brokers. Thus, similar to public comps CBG, JLL, and CIGI, valuations tend to be low relative to historical cash flows. However, being a scaled service provider to commercial property owners can be a very high quality business with recurring revenue generated by multiple sources of fees from leasing, financing, construction management, insurance placement, grounds maintenance, etc. These businesses also generate float. The industry remains fragmented (especially property management, eg FSV) even though there is a concentration at the top. Based on the above characteristics, which have financial and market dynamics similar to surety insurance and outdoor advertising, I would expect BOMN to invest more into this sector going forward.

Management Incentive Structure

In addition to being shareholder friendly, BOMN has created thoughtful and well aligned incentive compensation plans for key members of management. Rozek’s and Peterson’s mimic the original Buffett partnership, while Scholl’s and McLaughlin’s are also direct profit sharing pools requiring a minimum performance threshold for eligibility.

Rozek / Peterson:

“The management incentive bonus plan provides for a bonus pool, determined on an annual basis by the compensation committee of the board of directors, equal to up to 20% of the amount by which our stockholders’ equity for the applicable fiscal year (excluding increases or decreases in stockholders’ equity resulting from purchases or redemptions of our securities) exceeds 106% of our stockholders’ equity for the preceding fiscal year.”

Scholl:

“Under the annual cash incentive bonus, Mr. Scholl is entitled to receive an annual bonus in an amount equal to twelve and one-half percent (12.5%) of the difference, if any, between (x) the pre-tax earnings of GIG for the applicable calendar year (determined in accordance with U.S. generally accepted accounting principles) minus (y) an amount equal to ten percent (10%) of the Company’s average total equity for such calendar year, as calculated on a quarterly basis. Mr. Scholl is also eligible to receive a long-term cash bonus, the receipt of which is subject to vesting. The long term bonus, if any, with respect to any particular calendar year will equal ten percent (10%) of the increase in book value for GIG based on pre-tax earnings commencing at the end of the calendar year following the year in which the long term bonus was earned. The long term bonus is reduced by any annual bonus paid to Mr. Scholl.”

McLaughlin:

“Mr. McLaughlin will be eligible for a fee of 0.5% in connection with the sourcing of certain acquisition targets. In addition, Mr. McLaughlin will be eligible to receive an annual incentive cash bonus equal to 25% of the increase in annual earnings against a defined baseline, which baseline shall be subject to a minimum threshold and shall be mutually revised to the extent that capital investments or acquisition activity impacts the earnings of Link Media Holdings, LLC (although the amount of such annual bonus for calendar year 2017 will be at the discretion of Link Media Holdings, LLC).”

Stock Offering, Capitalization and Valuation

Management is raising incremental capital to fund anticipated growth, create a liquid (or at least, much more liquid) security that will attract public investors, and provide an additional form of currency for acquisitions and employee incentive compensation. Concurrent with the offering, BOMN will also relist from the OTC market to Nasdaq. Assuming a $14 offering price and full share allotment, total shares outstanding will increase from 7.0 million to 13.3 million, while capital employed will increase 125%, from $67 million to $152 million.

Prior to this offering, BOMN had raised three rounds of capital. The initial capitalization included the B shares being issued to the co CEOs. B shares have 10 votes versus just 1 vote for A shares; otherwise, the share classes are identical. The last round in February 2016 valued shares at $10.15 and was the first time capital was raised from outside (non Peterson / Rozek) investors. In this current round, Peterson and Rozek have submitted nonbinding interest to purchase $48 million (or 54%) of the $89 million total; I assume they split this down the middle. Public float will increase from 1.2 million to 4.1 million shares (or $57 million). 

An ownership table (proforma for the offering) is presented below:

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Using the face value of acquisitions made over the prior 24 months, cash on hand as of May, and anticipated net proceeds from the current offering, proforma net asset value would be approximately $11.50 per share. Cash on hand would comprise 70% of NAV, creating a SPAC like situation but for a management team that has established, growing operating assets. At $14, shareholders will be paying 1.2x proforma NAV or 1.5x projected GAAP book value. A proforma NAV calculation is presented below:

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The use of proceeds includes the following:

“As of the date of this prospectus, we have entered into four nonbinding letters of intent to acquire billboard assets and one nonbinding letter of intent to acquire a surety brokerage firm. We believe each of these proposed acquisitions is consistent with our growth strategy. We also intend to continue our efforts to selectively assess and acquire additional billboard assets and surety brokerage firms.”

And while management has not used any equity or debt financing to date to fund acquisitions, it notes:

“We currently expect to finance any future acquisition with cash and seller or third party financing. In the future, we may satisfy a portion of the purchase price for a property with our equity securities.”

Pre Mortem

A relatively unproven management with a limited history of successful acquisition experience accelerated capital deployment into cyclical industry segments at cycle peaks. These actions impaired shareholder capital as existing large incumbents remained well capitalized and took meaningful market share during the ensuing low period while BOMN was undercapitalized.

Mitigant: To date, management has acquired assets producing stable revenues and has not paid excessive valuations.

Mitigant: The surety and billboard segments have demonstrated consistent growth over time and appear to be non cyclical.

Mitigant: The majority of BOMN’s asset base is in cash and the company has no debt. 

BOMN has generated very little operating cash flow since inception. Despite clear communication from management regarding the stabilized economics of its underlying assets, said economics were not supported by reported financial statements and never materialized as hoped.

Mitigant: Management’s targeted economics for both its surety and billboard assets are supported by comparable industry data.

The company’s primary existing operations are in industries that are highly concentrated, not terribly large (<$10B end market for each of surety and out of home media), and growing slowly. BOMN had less room for organic and acquisitive growth than management originally projected.

Mitigant: BOMN is microcap company whose revenues equate to a very small percentage of its targeted end markets.

As a controlled company with dual class, supervoting shares, management entrenched themselves against the public wishes of independent shareholders and pursued a set of priorities materially different than what was originally “sold” to shareholders.

Mitigant: Management likely has a large portion of its net worth invested in BOMN.

Mitigant: As the initial launch of an investment vehicle with ties to well known families (including the Bloombergs and the Kenan-Flaglers), management will be highly incentivized to foster a favorable reputation in the investment community.

Due to very small float, BOMN stock ownership became problematic during times of needed liquidity and mark to market dates.

Additional Information

2015 shareholder letter 

http://www.bostonomaha.com/documents/4/737caf67180abb8331823c97252a3851.pdf

2016 shareholder letter

http://www.bostonomaha.com/documents/51/ed7ffdd5e40f3cc0ee01dcbd7ab9df34.pdf

Catalyst

Relisting from OTC to Nasdaq

Increased stock liquidity 

Acquisition announcements

Increased public disclosures / shareholder communications 

Creation of an institutional following