The challenging economic environment in the US has forced many companies to reexamine the way they do business. Some enterprises have decided to move into new markets, make management changes or even recreate themselves. The transition can be painful, but the upshot is a reinvigorated firm and happy investors. Stephen Lieber and Sarah Hunt, co-managers of Alpine Dynamic Transformations (MUTF:ADTRX), oversee a concentrated portfolio of 30 to 40 companies that are either transforming themselves or the way consumers behave. We recently spoke with them about what they look for in transformational investments.
How do you define transformational investment?
Lieber: Investing in companies that are transforming their business should provide exceptional growth opportunities. That gives us wide latitude.
Our view of transformational strategies could include Howard Schultz, the founder of Starbucks Corp (NSDQ: SBUX), waking up one morning and saying “business ain’t what it’s supposed to be, I’d better do something different,” and closing 900 stores.
It could include an automotive company like Tenneco (NYSE: TEN) deciding that the industry is in trouble and it had better concentrate on emissions and ride control products. Those are transformational events.
We’re also looking for evolutionary developments in an industry. Snap-on (NYSE: SNA) is a classic example. People are probably familiar with Snap-on’s white and red trucks that visit auto dealers and repair shops selling wrenches and other car repair equipment.
We bought the stock when management identified auto engine diagnostics as the greatest growth area in servicing vehicles. Now Snap-on sells more than $15 wrenches; the firm sells a computer that you plug into the engine to tell you what’s wrong. This major transformation also involved bringing in a new president and building an innovation center in Kenosha, Wis.
We see opportunities in fundamentally healthy businesses that don’t have the dynamics management had projected for them, as well as those that are in a stage of innovative growth. So our holdings range from Priceline.com (NSDQ: PCLN) to Westport Innovations (TSX: WPT, NSDQ: WPRT), which specializes in special emissions control devices for diesel engines.
Would it be fair to characterize this as a value strategy?
Hunt: It’s a combination of valuation, what the company is doing and whether the markets recognize it yet. The majority of earnings generated by the companies we hold may come from places that weren’t traditionally a part of their earnings stream. That becomes a very interesting change in their revenue profile. Sometimes the market doesn’t pick up on this change until it’s well on its way.
Lieber: Autoliv (NYSE: ALV), a Swedish-American company that started out as a seatbelt maker, is an excellent example of changing earnings streams. It went on to become an airbag maker and now produces sophisticated airbags and safety-detection devices that use infrared technology. That’s adding a whole new transformative growth opportunity.
What’s your outlook for the US economy?
Lieber: In a recent meeting of our research and portfolio management group, we used atypical economic language and described the economy next year as likely to be “creepy-crawly.”
Creepy describes a slowly advancing, somewhat struggling economy trying to overcome unemployment, the reluctance of consumers to spend and their predilection to save.
Crawly refers to the stimulus of international trade and the opportunity for US exporters to enter stronger markets.
How does that outlook affect the companies in your portfolio?
Lieber: It’s a motivational impulse. Let’s say you’re running a business that’s going nowhere in a struggling economy and you ask yourself what you can do to get your business going. Often the answer is to think of how to transform your business and get it back on track.
That sparks product innovation and operational changes that can create distinct competitive advantages.
Can you provide some examples of transformational companies?
Hunt: Cummins (NYSE: CMI) demonstrates a combination of a couple of different factors. The firm’s core business is providing US companies with truck engines. Navistar International Corp (NYSE: NAV), a truck manufacturer and key customer, changed how it sources its engines, which looked like an issue for Cummins.
In the interim, Cummins had worked on expanding internationally and adding to its product portfolio. Now half of Cummins’ earnings before interest and taxes come from joint ventures that are outside of the US, including in India and China.
Additionally, there’s a set of global regulatory reforms in truck emissions standards that’s driving a replacement cycle for truck engines across the world. Cummins adapted to these new requirements and has an offering for almost any country. The firm also has entered new markets like marine and oil and gas.
This is a company that responded to a set of business challenges in a variety of ways changing the nature of its earnings profile.
The stock has reacted strongly to the numbers the company has. While the fundamental demand in the businesses they serve has advanced modestly, the firm’s stock price and earnings have increased dramatically.
Atlas Air Worldwide Holdings (NSDQ: AAWW) is a company that performed some charter services. It bought a giant freight charter company in Alaska called Polar Air but wasn’t making money on its regularly scheduled freight service. Management quickly realized the firm was running like a hamster on a wheel, so they blew up the company’s legacy business model.
Now the company runs planes on a “wet charter” basis for airlines such as British Airways (London: BAY) and Singapore Air (Singapore: C6L). Atlas Air Worldwide provides the crews, and the company pays for fuel and is guaranteed a certain amount of airtime. The firm has entered some of its planes into the military flying pool--a highly lucrative business.
Management’s moves transformed the company from one that barely brought in enough money to one that has a more dynamic revenue steam and is growing earnings.
We’ve owned the stock for the last 18 months, and the change in Atlas Air Worldwide’s earnings profile has enabled it to outperform its peers. The firm continues to add planes in this business model and is branching out into other business models as well.
Traditionally, operators in this space have struggled to make money, but Atlas Air Worldwide’s management has found a business model that makes it much easier to pay for the planes and grow earnings.
Lieber: Everyone has read the story about Oracle (NSDQ: ORCL) and [former Hewlett-Packard CEO] Mark Hurd. Oracle has partially transformed itself from a software company into more of a hardware company. We think that’s a very interesting development, and we’re as intrigued as everyone else by how quickly Hurd moved from Hewlett-Packard (NYSE: HPQ) into Oracle management.
We think Oracle’s CEO Larry Ellison has run a brilliant program of constant transformation with the acquisition of 65 companies over a period of years. But this time he’s made a very fundamental shift as evidenced by the Hurd hiring. He will attempt to increase margins at the recently-acquired Sun Microsystems, a relatively low-profit hardware company, from 40 to 60 percent. It’s a multiple transformation.
Is your investment strategy risky given the weak economic environment?
Lieber: The opposite is true because we’re not starting until the company has a decent base, and if that base can be transformed into a growth vehicle, then we’ve got it. So in a way, you have a value proposition in starting with a dull company that transforms into an innovative company. This should result in lower risk than what’s typical.
For example, we own shares of a tiny company called HearUSA (AMEX: EAR), a retail hearing aid business. They’ve just started a deal with the American Association of Retired Persons (AARP) under which the AARP will promote hearing aids through HearUSA’s retail facilities. It’s a small-time business, but nonetheless, it’s an incrementally interesting growth opportunity because the AARP is known for being able to drive demand.
What’s your best piece of advice for investors over the next year?
Lieber: Going back to our “creepy-crawly” outlook, look for companies that don’t depend on the general pace of the economy for recovery, but have unique strengths that they can exploit.
Hunt: We’re talking about companies where growth is driven by something beyond simple GDP growth. Potential drivers include regulations, a change in the way people do things, or a secular story that isn’t only dependent on volume growth. Companies that are making sales outside of the US to countries that are experiencing economic growth are worthy of attention as well.
Disclosure: No positions