Description

When idiosyncratic issues are coupled with macro malaise it can create a perfect storm where short-term reactions create an attractive opportunity for the astute and long-term investor. One big macro issue that has been weighing on the world has been the will they/won’t they divorce of the century – “Brexit”.   As with any tabloid divorce if you can ever name drop and tie it with other topical stories that helps sell a few more papers.  In this case tying one of VCP LN’s largest shareholders, Invesco, with Neil Woodford and creating a run on VCP LN’s stock helped add quite the spice to this story. 

Great ideas at first can look ugly – ugly enough that people often walk all over the idea. Fortunately for this pitch, a flooring products company in the UK is precisely the type of idea that could benefit from these temporal headwinds.

VCP LN is a manufacturer, supplier and distributor of carpets and ceramic tiles targeting the mid to high-end markets in Europe and Australia. The company was established in 1895, originally listed in 1963 and then listed on the AIM in 2013. Using Bloomberg data – the farthest we can see back is their stock price in 1989 when it traded around 34p. At the end of 2014 the stock price was at 65p for a 2.5% annualized return (EBIT actually was about £3mm both in 1989 and in 2012).  In 2012 Geoff Wilding approached the company to become its CEO and through a minor activist campaign was successfully put in place as CEO.  Geoff then arranged a compensation plan that would give him a large stake in the company if he improved operations. Geoff previously had run two other roll-ups (one successful: Pacific Print and one failure: CommSoft). Geoff likely saw what the team at Mohawk Industries (MHK) and Shaw Industries (a subsidiary of Warren Buffett’s Berkshire Hathaway) have been benefiting from for years – a highly fractured market that benefits from local density with low terminal risk of online disruption.

In the six years after becoming CEO of VCP LN, Geoff increased revenue and EBITDA by 5.5x and 11.5x with the stock price up 16x at its May 2018 peak (64% annualized return).  Geoff was able to achieve this through a combination of operational improvement and acquisitions. VCP LN’s stated strategy is to “create wealth for shareholders by constantly increasing earnings per share and cash flow via acquisitions and sustainable organic growth.” In the last 5+ years, VCP LN has completed 13 acquisitions to build scale, extract synergies, increase margins and increase free cash flow. VCP LN is the #1 carpet and underlay manufacture in the UK (revenue of £280.5mm with EBIT of £17mm); a leading European ceramic tile manufacturer (revenue of £193.9mm with EBIT of £48.2mm); and the #2 carpet manufacturer in Australia (revenue of £100mm with EBIT of £6.8mm).  VCP LN famously provides the royal family with carpeting for all its needs – Prince William and Catherine Middleton used VCP LN red carpet at their wedding.

Since May 2018, a confluence of events negatively impacted VCP LN’s stock price (down ~50% from the May 2018 peak). VCP LN’s stock was impacted by the following events:

1.       Reporting weak 2H’19 results (FYE 3/31) and reducing guidance in both October26 and February27 due to margin dilution from a deliberate pursuit of market share in the UK and logistics/raw material headwinds.

2.       A perfectly timed short report from UK based short-selling firm “The Analyst”.

3.       VCP LN levered up in 2018 when they made two large acquisitions of tile companies Saloni and Keraben. In November 2018 VCP LN pulled a bond offering.

When we see a decent business with a high-quality management team that has been knocked down, we gravitate towards it like a hippie to shag carpeting.  Before we plug in our lava lamps we first have to see if the carpet matched the… valuation.

We were able to quickly quash #3 – management indicated that they pulled the debt offering due to unattractive rates and seemed to prove this when in April 2019 they successfully refinanced the debt at more attractive rates than were being contemplated in the fall.

Point #2 proved interesting as Geoff decided to publicly respond to The Analyst and offer a point by point retort. While one should never take management solely on their word it is nice to see an upfront and unemotional response to an active short seller (much preferred to the rancor we have seen other CEOs foolishly employ). Whenever management teams get emotional towards short sellers they tend to take their eyes off the business which invariably strengthens the short argument.  Geoff’s response was heavily grounded in fact and he even admitted failure where applicable, “CommSoft was, following initial success, a failure… As CEO, I accepted responsibility for the poor credit control and resigned in November 2000.”

Despite the pain that MHK is seeing, the EU market is not impacted by low cost Chinese imports as transportation costs to Europe were too high and tariffs prevented Chinese manufacturers from dumping product and impacting prices. Further we spent a lot of time trying to better understand the acquisition machine (both targets and cost rationalization) and we were very encouraged wih discussions with former employees and competitors. 

So where does this leave us?  VCP LN has a leading position in the market in both market share and on costs/margins – with just 13% of the business at fixed cost and the remainder at variable (46%) or semi-variable (26%) cost. Having multiple production sites allows VCP LN to create flexibility in capacity and an ability to vary production based on costs. VCP LN will organically grow by ~3% per year with substantial potential to roll-up the fractured end market. VCP LN has purchased leading assets at around 7.5x EBITDA (and smaller companies for far less) and has then extracted substantial synergies bringing the post-synergy cost substantially lower.  It is easy to see how one could be floored with the opportunity to invest in a leading business with long-term tailwinds at an attractive valuation.

We think VCP LN can do £172mm in FY22 EBITDA (£130mm from FY21 + £7.5mm from growth + £35mm of M&A). For the last five years VCP LN has traded at an average EV/current annual EBITDA multiple of 10.8x and currently trades at ~8x.  If we assume VCP LN gets back to 10x, below its historical multiple, against our £172mm in FY22 EBITDA, that results in an EV of £1,722mm less projected net debt of £440mm, which results in a stock price of 1,370 pence vs 420 pence as of this writing.

Geoff owns ~18% of the company and he along with other senior members of the management team have been buying stock, so it doesn’t appear that they are just sweeping problems under a rug.

Catalyst

The temporary factors weighing on the stock will abate right around the same time VCP LN's most recent acquisitions start to flex their earnings power resutling in a coiled spring effect.