ValueWalk’s Raul Panganiban interviews Shree Viswanathan, founder and sole employee of SVN Capital. In this part, Shree discusses if there room for growth, his thoughts on working from home during the coronavirus pandemic, and opportunities in Copart and Heico Corporation. Transcript continues.

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Q3 2020 hedge fund letters, conferences and more

So just in regards to ideas, anything that you can discuss publicly or specifically, that you find attractive, and you'd like to share?

Sure. Um, you know, the Copart is, is a name that I've, that I've owned. It's a it's one of the largest salvage yard companies in the country. You know, when a particular vehicle meets with an accident, generally the insurance company will send an appraiser and evaluate make a quick evaluation as to whether they want to give you the policyholder, the money to go get the car fixed, or should it be totaled. So they make a quick computation, they know what the value of a car is, prior to the accident, they have through this appraisal, they have some view of what the cost of repairs, they make a mathematical computation and see how much they can get if they sold it to a salvage yard. And that salvage yard is essentially controlled by this company called port.

Now, you know, this is currently as we speak, this has somewhere between 40 to 60% market share, depending upon a couple of different metrics. So or being fair if we said, you know, they have a 50% market share another 37% is or controlled by another company called IA, which is here in Chicago. Essentially, it's a duopoly. The rest is all mom and pop salvage yards around the country. So this company Copart, they sort of have this relationship with the insurance companies, and they direct all these damaged vehicles to to Copart. Why do they send it to Copart? Well, as you can probably appreciate, you know, the type of technology that has been going into these vehicles.

Take a simple Kia car, for example. And I'd now has a rearview mirror with a 3d kit with three cameras in its bumper. And as it gets bumped into, or as it sort of backs into something, those cameras get down, not dinged and damaged. 10 years ago, even Mercedes Benz didn't have the kind of technology that a Kia has today. So the amount of technology that has gone into these cars, they make it difficult or more expensive for them to be repaired when they get damaged. So more and more vehicles are getting sent to these salvage yards. And cobalt is a is a big player in that area. What they do is collect the car. Think of Copart as a sort of an eBay for dinged and damaged vehicles. years ago, they used to conduct a sort of an auction on their salvage yard is to provide free coffee and dump and donuts. People come bid on a vehicle and take it away.

Now since 2003, they've been doing 100% of their auctioning through their own proprietary application through their own proprietary software. So there is no physical auctioning, it's global, it's online. And that online has made it global. In fact, Mexico and Dubai are two of the largest markets have grown nicely in UK and as we speak, they're growing in Germany. So this is a business that was founded by the current chairman Bill Johnson. His son in law, J Adair, is the CEO. Between the two of them, they have about little more than 12% ownership stake in this 25 $26 billion market cap company. There is no debt on the balance sheet or at least net debt. No net debt on the balance sheet. Generates an applause to little more than 20% return on capital. It's a little bit more capital intensive. Then, you know, typically what I'd be describing. But that capital intensity is essentially in terms of buying land. And I'll think of, you know, Seattle, or Chicago, these are the hubs where there are more vehicles and where there are, there is a higher likelihood of accidents happening.

Or, you know, think of Louisiana or Florida or Texas, where there is a higher likelihood of Hurricane coming through and damaging different towns and villages, or towns and cities. So those vehicles need to get moved into the no salvage yards. And Copart has done a very nice job of acquiring these land properties around various different parts of the country, little more than hundred and 80 yards around the country today and growing. So this is a business. But you know, back in February, March, for example, when the country went into a lockdown, or a global lockdown, for that matter, immediate fear was, there are, you know, that are not going to be any vehicles on the road, there weren't many. And as a result, not going to be many accidents, which in turn was viewed as a negative for Copart, because they were not going to be getting any new vehicles.

Obviously, that lasted for a little while, in fact, it did not slow down that dramatically, it did slow down, but it did not slow down that dramatically. But the stock price in the meantime, men down proximately, 50%, less, you know, a little less than 50. But this is a business that I had followed for a number of years. At Keeley, for example, that I weren't, we owned it. So I knew the business to a certain extent and had followed it for a long time. And it essentially, you know, fell on my lap. It's a fantastic business, good quality business that I can understand. Quality in terms of return generation quality in terms of the balance sheet, pre cash flow generation, and quality in terms of the management team, CEO, Jay Adair, gets $1. In salary, he gets stock options. But he gets $1 in salary. And this is the other point that's very unique about Copart is when I when you go through the proxy, typically, in a publicly traded company, the board the management team is looking to get some kind of compensation consultant to bless the compensation programme for the C suite members.

Our cohort is one where I noticed that they don't have they don't use any compensation consultant. The Board and the management team decide, you know what each one gets, which I think is fantastic. You know, one other name that jumps out that does that has been doing it for a long time is Berkshire Hathaway. But in any case, so it has, you know, good quality operation, good quality management team, and valuation fell on my lap has bounced back. But you know, I, it's become a reasonable weight in the portfolio. And it's a it's a it's a very, it's a very interesting, it's a typical sort of SPM capital kind of an interesting opportunity.

And do you see it doubling within the next 3 to 5 years or is there room for growth?

Yeah. So, you know, there is absolutely room for growth, both from the US and particularly from the International standpoint. As I said, they've grown, they've continued to grow in, in UK, they're growing the book in Germany as we speak. Mexico is another market that they have a bigger presence. And so, yes, the number of the type of, you know, service that they provide, at the cost that they incur, and the margins that they generate, you know, absolutely. It's a business that I do think and easily double within the next 3 to 5 years or 5 to 7.

What are the kind of risks that you see? And does like with COVID, with more people working from home, if that kind of trend will have any effect on usage, and then and then Uber as well. And if or delivery as well, like, I guess that whole dynamic of how we're switching more towards I guess being more at home?

Yeah, good question. So, um, yeah, any business for that matter will have certain risks associated with their business model? Um, you know, yeah, COVID related, lockdown scenario is definitely a is definitely a risk in that, you know, overall, what is on the road has decreased, it has improved quite a bit relative to what it was in, you know, March, February and March timeframe. But overall, working from home sort of brings that volume down. However, the other aspect of damaged vehicle damaged vehicles, you know, it comes from natural disasters, you know, fires in California, or in canes in southern part of the country. Tornadoes in the Midwest, when these things generally damaged vehicles to a large extent, and that's another source of vehicles for them. That hasn't been negatively impacted by COVID.

The other technology standard from a technology standpoint, you know, newer vehicles seem to have, you know, for example, auto braking facilities in braided into these newer vehicles. In fact, the company went to the extent of studying it, you know, what sort of what sort of detrimental impact do some of these newer technologies have, they came out with a, not just the company, but there is an outfit called CCC Information Services, which sort of tracks the entire equals ecosystem of vehicles, Damage Repair and insurance, they came out with a study saying, even if those types of technologies are adopted, 100% adopted, the volume declined from that improvement is going to be somewhere between 10 to 15%.

So, yes, it is, you know, the generally speaking, the frequency of accidents, it has been on a sort of a downward trend. I'm continuing to keep an eye on the frequency part of it. However, the severity of those damages, has continued to go up because of the new technology that I talked about. So, there's an offsetting trend to this downdraft from lower frequency. But those are the, those are the risks that I'm keeping an eye on. Competition is always a factor that I'm keeping an eye on, ay ay ay, which actually was recently spun out of a company called KARS is the, you know, advertisement that you might have seen on TV.

So competition is always a factor that I'm keeping an eye on. However, I until the scoreboard was forced upon them, was actually doing its auctions both in person as well as an online that was a little bit less effective in terms of operating margins, more capital, or less capital intensive from IAS standpoint, in that they were leasing the land as opposed to copart buying the land. However, because of the nature of how they go about auctioning vehicles, cobalt has been able to kind of put up much better returns. So those are the risk factors that I'm keeping an eye on.

And then you mentioned the M&A idea, or for the inorganic versus organic growth. Can you tell me more about the company that you're looking at with in regards to into that and is that an exception to what you're what you're truly looking for?

Sure. Yeah. So this is a company called Heico Corporation. It's based outside of Miami, Florida. What they do is essentially parts for aircraft. You know, years ago, I used to follow the entire aircraft space very closely. There is a demand for newer and older aeroplanes. Graphed because of the increase in consumer or commercial passenger traffic. But, you know, this company focuses on manufacturing aircraft parts for you know, they have two different segments in one segment, they essentially cater to the commercial passenger operators, and in the other segment, they cater to defence space and with lesser extent medical technology, still manufacturing similar type of, you know parts I think of in the commercial side of it, and I think of an unknown, you know, the food tray in in in front of your seat and it gets banged up pretty regularly, it needs to get replaced, the airline company has a couple of different options.

One, it can go to the actual OEM and get the replaced, or they can go to somebody like a high call to get the part replaced. Now, OEM for a variety of different reasons, their pricing is going to be definitely a lot higher. Heico Corporation, on the other hand, produces the same part at somewhere around 50 to 60% of OEMs cost. Now, the unique aspect of this kind of an operation is any single any art that goes into an aircraft, even if it's a small screw or a bolt, and I need to get approved by FAA before it can be put into the pie. And so whether it's a nose cone or a food tray, you know, it has to be approved by FAA. So there is a specific term for these types of manufacturers, these types of pouch manufacturers or PMA manufacturers approved. And there are only a limited number of guys who are approved for that.

So that's the barrier to entry as far as high core is concerned. Now, you know, the commercial passenger traffic obviously came to a screeching halt. And it is still only trying to improve from a very low level at this point, at least in the Western world, China has improved quite a bit, but the rest of the world is still trying to catch up with volume. passenger volume has been pretty low, expected to be low until at least a vaccine This is discovered. So this is another name that was part as a result of this lockdown in the endemic business that is run by a father by a father and two sons.

Father was Mendelssohn is a he was a CPA from New York moved down to Florida stumbled on this entity which existed before they took control in 1990. I'm the father and two sons, they own close to 18% of the company, it's about 14 and a half billion in market cap. It started off as providing engine parts for Pratt and Whitney back in the early 90s, when Pratt and Whitney had problems with their engine manufacturing, and they did a phenomenal job. And as a result, we're able to kind of grow that, you know, the PMA part of providing these parts, it became so attractive, that Lufthansa from Germany actually stepped in to take an equity stake in that segment, they still own a stake in that in that segment of their operation. So it's a it's a no fantastic business in that.

Particularly at a time like this, you know, countries, countries, typically, any country for that matter, you know, there are three things that they want. One, they want their own flag. Number two, they want their own airline. And number three, they want their own beer. And you know, countries and operators at a time like this are going to focus a little bit more on their cost. Even though their planes are not running quite as extensively as they used to. It's a matter of time before travel sort of comes back. And even as it comes back and sort of ramps up these operators are going to look for keeping their costs low. So I think this PMA kind of a product from Heico Corporation would be very attractive.

And again, it's a business that has is it on the on the Commercial, you know, airline focused segment, they generate approximately, in our high teens kind of a return on capital on the defence and space part of it, it's closer to 30%. So combined, the commercial passenger side used to be a bigger chunk of the overall business, it's now become almost 5050. Combined, it's still a very healthy, mid to high teens, kind of a total return no debt on the balance sheet. Now, this is a business where they've grown and continue to grow through acquisitions. The family's very comfortable doing it, in fact, they have done a little more than 85 acquisitions since they took control back in 1990. However, while my my sort of risk or constraint still exists, the type of acquisitions these people are very different.

What do I mean by that? You know, they don't acquire all the they don't acquire 100% of the target all the time. They leave 30 to 40% of the company from the selling management team, you know, that allows them to remain invested in the business and fact many of the selling management teams today, they make, you know, between the between their equity stake and overall compensation, they make a lot more than the three that are actually running the company, the three Mendelssohn's. So, you know, so they constantly look for these smaller businesses that are involved in a variety of different aspects of airline operations. Why do they look to go sell to Heico Corporation, I'll think of an engineer coming out of, you know, Northrop Grumman, or Lockheed Martin. And no one picks up three, four engineers along with him, sets up shop in his garage or, you know, sets up shop in a small place and grows over a period of time. And then it's a sort of a ceiling ceiling in terms of distribution or capital or whatever that may be.

At that point, he's looking to kind of expand his base. And that's where I go kind of steps in, the management team sort of maintains a relationship with a number of different businesses that are that they are interested in. And when they when they selling when the management teams are ready to sell, they pick up the phone and call a Piko. And typically, that's how that's how these deals get done. And, as I said, the most interesting aspect is they leave a piece for the selling management team, which makes it very, very unique. And you know, I've spent a number of fears in the financial services area. There's a company called affiliated managers group in Boston, which has done something very similar within the asset management space. So it's a very attractive feature of Heico Corporation. Again, it goes back to the point about understanding the business good returns, good quality management team with skin in the game, and reasonable valuation, you know, the stock got hit during the February March timeframe. And while one part of it is still somewhat suffering through this pandemic, the other part is actually making up for it very nicely.

Yeah, that is amazing. And I just want to double check the checker on that one is Heico Corporation?

Heico Corporation. There is a there is a similar there is another, there are two classes of stock. Heico Corporation is the common mode or common. The other one is HEI.A. And that's another interesting or interesting aspect of this company. I generally do not necessarily like dual class listings. You know, most most print organisations, newsprint organisations, and as a result as an extension of that many technology companies have taken on that dual class ad claiming that it protects them from editorial power. I generally view that as you know, there was an insurance newsletter writer, cheers me, but I never read chef. Um, back in the 70s and 80s. He actually said, when you invest in a dual class stock, you're actually asking the management team to take advantage of you fully subscribe to that viewpoint.

However, in this case, The reason why they have two classes is not because they want to have some sort of a control over the outcome or equivalent of an editorial control. It's because in the late 90s, they were trying to make an acquisition. And the seller wanted the potential seller wanted specific stock and specific tax protections and things like that. So they created this other class, that deal did not go through, but post that, it became a little bit more cumbersome convoluted, who can convert that, you know, HEI.A back into the common, they've just let it go. And interestingly enough, there is still a sort of a spread between the two HEI and HE.A, when you look at the price, there is a little bit of a spread between them in the public mark, but I own the Heico Corporation management team owns both.

Transcript continues.

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