Remember when they said that what we want could never be done? Well, look who's laughing now. - Sleeping with Sirens
Frequent readers know that my style has rapidly evolved to generally to be understated and objective. I'm very cautious about assuming I ever have an analytical edge, or that the future ever looks much like I expect it to. So my default answer to a lot of investment questions tends to be pretty much "I don't know and I don't think I can find out" - which is obviously not the sort of pitch a lot of investors would deliver, given the buy side's focus on unearthing incremental data points and predicting the future down to the decimal point.
But when I know I'm right, I'm not shy about communicating that - and I was pretty unapologetic on my bullishness on Liquidity Services (NASDAQ:LQDT) earlier this year. While I received some positive feedback from a few current and former shareholders, response to the idea from many other investors was astonishingly negative. Most interestingly, one argued that LQDT was a credit risk that might be bankrupt in a few years - notwithstanding the $120 million in cash on the balance sheet and the very limited cash burn in current periods due to entirely discretionary investments in a new end-to-end technology platform, coupled with severe but temporary macro headwinds in two key verticals (scrap and energy) leading to pricing erosion and fixed cost deleverage.
Other conversations I had with those who were bearish on the business yielded a plethora of reasons not to buy - a challenged corporate culture (corroborated by high employee turnover and poor Glassdoor reviews), historically competitive industry dynamics, and so on and so forth.
This is the sort of situation where I shine, because the facts about this company are pretty simple: they're one of the few credible online liquidation platforms (the major players being Genco, IronPlanet, Ritchie Bros (NYSE:RBA), and maybe a few smaller ones like B-Stock and Optoro and Municibid and Proxibid). A substantial majority of liquidation and surplus asset sales still occurs offline or very low-tech online in venues ranging from local auctions to Craigslist.
In a cost-focused world where organic revenue growth is hard to find, organizations are increasingly focusing on wringing margins out of existing business - and the long-neglected area of reverse logistics is due for a major tune-up. All you need to win big is a decent platform, and LQDT's was considered to be best of breed even prior to their massive LOT investments.
Within this backdrop, founder Bill Angrick led Liquidity from a bootstrapped startup to a billion-dollar enterprise efficiently serving major clients like the DoD and Wal-Mart (NYSE:WMT) on the premise of network effects (see GovDeals testimonials). Just as the business benefited from the "halo effect" on the way up and investors failed to pay attention to the risks - i.e., contract concentration with major clients - the business, over the course of 2015 and into 2016, was left for dead by the market, as everyone searched for bearish arguments to justify an enterprise value that at one point dipped pretty close to negative.
When people are arguing that a company with a Ft. Knox balance sheet and a long-term history of cash flow profitability (driven by a founder who is explicitly focused on cash flow) is on the road to bankruptcy, you know you've found the perfect idea from a behavioral standpoint, because all the bearish arguments fail basic logic and are attributable to "making the facts fit your argument."
In all fairness, don't give me too much credit for the timing of my write-up - I purchased my first tranche of LQDT at around $10 literally the day before they lost the Jacobs/Wal-Mart contract, and have certainly learned a lot from the significantly extended timeline of LOT relative to initial expectations (as well as the tendency of analysts to linearly extrapolate data points even when the conclusion is logically absurd).
I've been buying all the way down, and from a long-term perspective, have what I consider to be an extremely favorable cost basis both personally and in my fund. Nonetheless, even with a somewhat more cautious outlook driven by management's continued opacity on long-term margins and their refusal to efficiently allocate capital to share buybacks, I believe Liquidity Services, under $10, remains one of the most compelling ideas available in the market today.
With a squeaky-clean balance sheet with over 40% of the market cap in cash, demonstrably increasing fundamental business momentum, a highly motivated (and seemingly newly optimistic) founder-CEO, and anywhere from 50-100%+ upside potential over the next few years depending on how the business plays out post-LOT, Liquidity continues to be a high-quality long-term growth story available for a deep value price.
For the sake of keeping this (relatively) brief, I'm not going to explain every last detail and will assume you are vaguely familiar with the company's business, the LOT initiative, and so on.
With Or Without LOT, A Compelling Value Proposition For Clients
When analyzing companies, I spend a lot less time thinking about periodic trends - which can often be skewed by randomness and timing - and spend much more time thinking about the durability of intrinsic business characteristics and what kind of fundamental outlook that suggests over a reasonable forecast period (and the long term). In the case of Liquidity Services, I don't think anyone would give me much flak over arguing that one of the most durable trends in human existence is the increasing penetration of technology - notwithstanding Luddites here and there, we will use more technology tomorrow than we do today.
That's really what underpins the growth story for Liquidity Services: Will surplus asset sales move offline to online the same way every other kind of transaction is moving offline to online? The logical answer is yes, and the increasing online penetration at places like Ritchie Bros, following on the historical success of companies like Copart (NASDAQ:CPRT), corroborates this.
Liquidity's results over the past couple of years have been muddied by several macro issues:
- Declining metals prices have severely pressured sales volume, velocity, and profitability in the scrap category.
- The same has happened in energy (line pipe, etc.) thanks to oil prices.
... as well as several contract issues:
- The repricing of the DoD surplus contract and splitting off of the rolling-stock piece of the contract to IronPlanet.
- The loss of the Wal-Mart contract at Jacobs Trading (and eventual disposition of the business.)
These factors, in total, led to a significant reset in revenues and catalyzed the decline in share price.
But significant research - both by me and other shareholders - led us to believe that these contract challenges were idiosyncratic issues that did not reflect any lack of customer satisfaction with Liquidity Services, but rather organizational politics at selected large client organizations (Wal-Mart and the DoD). What remains with the de-emphasis of those clients is a much more diversified business. Over the past year, Liquidity Services has been signing up many new clients.
After a lag period, those clients are now translating into revenue. Even without the additional features unlocked by the Liquidity One Transformation, the company (on a comparable basis) is posting strong growth, as explained by CEO Bill Angrick on the call:
Adjusted for the divested Jacobs Trading business, our commercial and municipal government business collectively recorded its highest GMV results in six quarters. Our energy vertical grew 22% year over year in Q3; and our industrial, retail, and municipal government verticals all grew GMV in the double digits year over year on a comparable basis in Q3.
Admittedly one quarter does not make a trend, but in terms of "body language," Bill sounded noticeably more enthusiastic than he has on previous calls. He's an understated Midwesterner and comes off extremely non-promotional, but having listened to their calls for several years, you could hear the traction in the business in his voice. He cited numerous examples of clients receiving above-expected recovery for surplus assets, and this is the core value proposition - the network effects of the business scale and get stronger over time.
While I'm only writing mid-high single-digit revenue growth for valuation purposes, I believe Liquidity Services - particularly with the additional service offerings unlocked with LOT, such as the portability of the GovDeals self-service platform to the commercial middle market, has a good shot at growing revenues at a double-digit rate for a decade or two.
Margin Opacity Frustrating... But If You Do The Work, The Answer is Obvious
One of the major issues that continues to frustrate me as a shareholder is management's patent refusal to commit to any long-term margin targets. Every other small-cap I follow with a significantly evolving business model is capable of coming up with a slide that says "hey, in 3-5 years, we want to be doing X in revenue and Y in EBITDA." Liquidity Services mumbles and jumbles about contract changes and whatever, and refuses to provide segment-level reporting.
As a result, relatively lazy analysts/investors refuse to put forth any effort thinking about long-term margins, and have, over the past year, gone with the easiest assumption - that the future looks like the present and there won't be any. I've spoken to numerous buysiders who agree with me that the business story here is incredible, but that they're not trading on this due to the difficulty of modeling the opportunity.
If you're willing to take the Munger/Jacobi approach and "invert, always invert," valuation gets much easier. The current enterprise value, by my math, works out to around 0.2-0.25x forward GMV (the better top line to use than revenue, given the dual purchase/commission model). This is a business that should grow at least mid-single digits, if not double digits, with very low capital intensity. As such, a ~10x EBITDA multiple is seemingly pretty fair (if not conservative). As such, to justify the current valuation, Liquidity Services only needs to do 2-3% EBITDA margins over time.
Is that reasonable? Very easily so. Here on Seeking Alpha, I've previously discussed and analyzed peer Ritchie Bros, which is less of a competitor to Liquidity Services than people believe, as Liquidity hasn't historically played much in "yellow iron" except for some service for government clients (although recently filed trademarks and some employee LinkedIn profiles and Glassdoor reviews suggest Liquidity may be moving into this market.)
As I've pointed out - to an audience that wouldn't listen - Liquidity Services has occasionally talked about its "take rate," which equates to Ritchie's reported ARR. Depending on the vertical and the level of value-added services, I believe Liquidity's commercial/municipal government businesses deliver anywhere from high-single digits to low 20s take rates, with the average being in the mid-teens. This was corroborated by commentary on today's call from Bill:
Our pricing for these services, as well as the sales channels, has been very well received. Our [take] rates are mid-teens and higher. So we believe the brand and solution is well positioned in the marketplace with the large local companies
First of all, RBA manages to translate low double-digit take rates into 4%+ EBITDA margins (relative to gross auction proceeds, their equivalent to LQDT's GMV). Second of all, Liquidity's digital-native business model is significantly less capital and people-intensive; while RBA is moving into the online world, Liquidity was born in it. As such, with higher take rates, Liquidity Services - at scale, over the long term - should at least be able to deliver comparable EBITDA margins to Ritchie.
At 4-5% EBITDA margins (in which I include stock-based comp as a real expense), growing HSD or LDD annually, Liquidity should be worth at least half of GMV - equating to a fair value of $15 in the next 12-24 months. I should also note that LQDT is spending $7MM+ annually on LOT project spend, not to mention it's also bearing the costs of supporting two platforms at once. While new terms on the DoD contract will offset some of this, I anticipate LQDT to go from roughly break-even to ~$10MM of Adjusted EBITDA (at the current size of business) simply from no longer having LOT.
Over the longer term, based on previous commentary from management as well as my understanding of the business model, margins should likely scale towards the high-single digits, as incremental EBITDA margins are likely 10%+ outside of GovDeals (which is lower given the lower penetration of value-added services - it's mostly an eBay (NASDAQ:EBAY)-like pure listing model). While I'm not underwriting this personally from a valuation perspective, I would note that a capital-light business organically growing HSD/LDD with operating leverage is not going to be trading at merely 10x EBITDA.
However, given the opacity I discuss, I think it's prudent to first get to $15 and take it from there. Nonetheless, with the stock under $9, clear business momentum, and fundamental downside strongly limited by the $4+ per share in cash on the balance sheet and the platform's enormous strategic value to a number of potential acquirers, that >25% forward annualized return (to a conservative price target) is exceptionally attractive in context of the low fundamental risk and very high quality of the business and management team.
In the longer term, if LQDT performs the way I expect, a $20-$30 share price is quite reasonable. However, for now, I'm focused on getting through LOT and seeing what the steady-state business looks like this time next year, heading into FY18.
There is no perfect idea, and I continue to be annoyed by LQDT's lack of share buybacks and clarity on long-term margins. Nonetheless, if you had to draw up an ideal investment idea on paper - large moat, big growth potential, highly free cash flow generative, fantastic management, can't miss price, etc., Liquidity would be pretty darn close to perfect. If I had to put all of my money into one security for the next 10 years, this would be it - and while I don't know if I'm planning to hold LQDT for 10 years, it continues to be far and away the largest position in my fund and my personal account.
Disclaimer: Investing is inherently subjective and this article expresses opinions. Any investment involves substantial risks, including the complete loss of capital. Any forecasts or estimates are for illustrative purpose only. Use of this opinion is at your own risk and proper due diligence should be done prior to making any investment decision. Positions in securities mentioned are disclosed; however, the author may continue to transact in any securities without further disclosure.
This is not an offer to sell or a solicitation of an offer to buy any security. All expressions of opinion are subject to change without notice and the author does not undertake to update or supplement this piece or any of the information contained herein. All the information presented is presented "as is," without warranty of any kind. The author makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use.
Disclosure: I am/we are long LQDT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.