APi Group: Safety Services at Scale - [Business Breakdowns, EP.205]

26:03They've cut a ton of costs. They've gotten rid of a lot of unprofitable business. And I would say that they emerged through 22 and 23, pretty strong with low leverage. And then in 24, more accelerated tucking M &A program, I think they probably put $300 million as a capital on the ground in tucking M &A. And then obviously they bought elevated, which is their elevator service in maintenance business of characterized 2024 is like, hey, let's clean up the capital structure. We got rid of the Blackstone Praff. We raised common equity to buy elevated the great cash conversion this year and Accelerated tuck in M &A which gets us into 2025 where the businesses arguably Underlevered I think on my math don't quote me on this.

26:47I think they've had about 2 .3 billion dollars of debt Not on clean the cash generation the fourth quarter so call a couple billion EBITDA as I said before is probably over a billion probably like around 1100 So maybe a little bit more. So it's nicely squarely under two times debt to EBITDA. And they're gonna generate about pick a number. They're gonna generate about $800 million of free cash. And hopefully if they can deploy, it's gonna probably be hard to deploy $800 million in tucking M &A, but look with their chub platform in Europe and Asia plus US, could they get to 300 or 400 million sure?

27:21So they should be able to buy $50, $60 million, hopefully of EBITDA through the tucking program. and then they will opportunistically buy other platforms. As the business become more recurring revenue and less prochitoriant it, the argument would be that they can run it with higher leverage probably more three times. So they're probably looking to do maybe another $500 million of what I would call sort of medium sized deals. They would be interested in buying another platform. When I think about the other platforms that exist, I would think about US Alarm and Monitoring and Security. I think in Europe they have job, which is more of a mononying security business.

27:58They don't really have a huge security in the long and monitoring business and that's obviously highly recurring revenue and low capital intensity in high margin. So I would say like a natural area in addition to acquiring more elevator assets, read the alarm and security and monitoring business. So they may end up paying a little bit more to get control of one of those things and then do bolt -ons around that. But yeah, look, it's a unique creative time for API group because a lot of the private equity back peers have a lot of leverage. I think the hope is is that they're focusing on their balance sheets and focusing on managing their capital structures While we sort of have an under levered balance sheet.

28:31So the hope is is that private equity over the last year has really paid Out huge numbers for deals. I think the KKR paid 22 times for a company called Marmic Which I think Russ would tell you is a piece of crab This is we're hoping and I think maybe it's just not hope maybe it's just belief But this is like a golden age for that because the private equity guys are swimming in their adjustable rate mortgages so to speak. And APIs got a nice balance sheet and good access to capital and generating good cash. So what does my grandfather used to say when chance meets opportunity? They're now in an NBA bull spot where multiple should come down and less competition for deals and they're sort of well capitalized.

29:04When you look at the way that Martin Franklin participates in the upside, I know it's somewhat atypical to what you normally see in some of these back combinations. Martin has a critical track record of value creation. Can you just discuss a little bit about how the structure works and how his incentives kick in. He gets, quote unquote, 20 % upside on the founder shares. So by design, as the company gets larger, the dilution gets smaller. So there were 140 million shares when it started founder shares. As he executes, he gets a carry on those founders shares. So when this guy goes from 10 to 20, there's $10 of gains.

29:40So be 10 times 140 is this is an extreme example that be like $280 million. dollars. Those get issued in shares and then the share count grows by that amount. So he only gets paid on the 140 million shares. And then the shares that get issued over time in connection with M &A, they did the Chubb deal. They raised equity with city group. They did elevated. They raised common equity. So the Blackstone Prefer got converted to common. So the idea is that the number of shares that he gets paid on goes down as the company gets larger. And that's by design that shares that get issued to him. He doesn't get promote on those.

30:13the shares that get issued in conjunction with Transactually doesn't get paid on those. So as time wears on, the quantum of delusion on a percentage basis goes down as the business gets larger. Does that make sense? No, absolutely. If I look at the fully deluded share count today, what percentage broad shirts of the business does Martinone? Well, he gets paid on 140 million founder shares, but I think he has, again, I'm just doing this for memory. But my guess is, is he's probably got ownership across everything of probably close to like 30 million shares. I bucket Martin, Jim, and Ian all together.

30:47That's what I would call the Mara Posa team. It's worth pointing out that SPACs have a bad reputation because people have used it to take low quality companies public and then dump shares on retail shareholders where Martin uses SPACs as moral of permanent capital vehicles. And you pointed out that he has a great reputation. At Jarton, he compounded his shareholder capital at 34 % over a K -GRO over 16 years, but it hasn't always been smooth that some of the other companies that he's taking public via SPACs. One is element solutions. He got a little over his use on some acquisitions and didn't acquisition with a lot of debt and preferred shares.

31:26And it ended up being painful for common shareholders for a while, but he stuck with it. And he didn't and tump it along the way. He stuck with it and turned it around and it ultimately got back to above water for shareholders. I appreciate why they're occurring in revenue business so strong. I think if you look at what organic growth is trended like over the past quarters and years. Clearly, there's an aspect of this business that has some cyclicality. I guess how do you think about the puts and takes on what is cyclical here and what's not? And the exposure to different end markets and what you guys need to pay attention to as you continue to monitor the growth of the business.

32:00I think the organic growth has been the hot button issue for the company over the last few years. In 20 and 21, you sort of had a lot of inflation. So when you think about the structure of a lot of the projects, especially on the life safety side, I think it's something around especially side as well, but it allows for material cost pass through. And so what you saw is very high rates of revenue growth, but not the same margin contribution. So you saw these 15s and 18s. My brush strokes was a real revenue if it's just material cost passed through an inflation. So I think there was decent revenue growth in the 2021, 80 and even into 22 period.

32:35In 23 and 24, I think that there was a very great emphasis as they were thinking about how do we generate better cash generation and quote unquote better margin and predictability. I think you saw this on the HVAC side. You see this on the fire side and on some level, I think you're seeing it on the specialty side. They'll just get out of the business if it's not generating the right returns on capital. But I'd say over the last couple years, the big focus has been getting the right margin project work and getting it and Focusing the branches on getting inspection because when you get into the branch and you sell an inspection You see all the products that aren't working so that allows you to get what you would call service work Which would be like repair so you come in there and you say all the fire panels broken I'll sell you a new fire panel and that's the business that's recurring in nature.

33:21Maybe it's not a contractual recurring, but you come in there and it's what I would call the break fix work and it's higher margin and you're dealing with the building directly. You're not dealing with some construction company when you're dealing a project. What ends up happening is the developer goes to a contractor. You're dealing with a contract with the contractors trying to make money. So it's more of like a bit out process as opposed to like, hey, let's deal with the company directly. Remember, you're usually working with either the building owner or property management from you'll go in there.

33:46you'll get the inspection work, it'll be small share of wallet, two, three thousand dollars, maybe less. And you're dealing with that company and whether it's the owner directly or the property management company, they want to know that they're dealing with the same person. So you come in, they get some of the inspection, they say, hey, these guys are competent. They know what they're doing. And they say, hey, you need to repair this. And it's a much more familial and recurring relationship. The company, I think, over the last couple of years has really been focused on getting to an inspection first model, not wasting time and resources on project stuff because there is overlap in terms of the technicians between project and service.

34:19So when you devote too much resource to a project, those are resources that can't be used elsewhere. So what I would say is, and I think what Russ would say is it'll be quote, pruning or recalibration of the business mix that's really taken place over the last couple years, both on the M &A front and on the bid out or project internal resource development. I think that's largely behind us. Unless you have another huge spike of inflation or deflation, we should return to more normal reported organic revenue trends. And obviously Russ has been with this business now for I think, almost 30 years.

34:52He's seen the evolution from what was really a construction business and a local services business to one that's a global fire and safety focus business with obviously Jason Lines that are growing. Can you just talk about how the Chub acquisition changed the profile of what they have here and how it's enabled them to have grassroots in other spots of the world. And Chubb is on some levels in a typical acquisition for API group. And I think Russ would also tell you on some levels it's about the fair way. Chubb is a very neglected asset inside of carrier because it really was part of United Technologies and sort of very neglected inside of United Technologies.

35:29And they had a fire extinguisher manufacturing business. The whole fire segment inside of UTX was just all over the place. So they stuffed it inside of carrier because I think they were like, well, it doesn't really going to Otis, it wasn't an elevator business, it doesn't really go into Raytheon which is really more of an aerospace business so they're like all right let's just stuck in the carrier, they'll figure it out, they'll sell it or whatever. So it definitely was an orphan neglected asset. API group did have a European business so they didn't know the business because they bought SK which is in Benelux and then they had a decent business in the UK.

36:03So it wasn't like they were totally foreign into that. But the thing about Chubb that I think is interesting is that it's more of a route based business. So you put a guy, he goes into the van and he checks all these different things. It's more route based. It's got alarm and monitoring, which as I said, is not a huge mix in the United States. And I think what Russ saw as an opportunity, he says, look, there's a lot of unprofitable business and this, but we'll basically get the pricing right. We'll fire some customers. We'll get the route density right. And And then once that gets where it needs to be, we can start doing Tuckin M &A, both in Europe and in Asia.

36:40And I think for what it's worth, I don't think there's as much competition. And as you know, Europe is big into regulations and all this nonsense. And so I think probably they look at it and say Europe is a high big time regulatory place. There's less competition for assets. So maybe they can execute or they will execute on the same business opportunities in Europe, they execute in the United States in terms of Tuckin M &A. Does that mean elevators? does that mean water stuff? There's less competition for assets and that's a good place to start. And if you try to like look at the financial profile of the acquisition, I believe at the time they acquired the business, they bought it at like a pretty healthy multiple.

37:16I think over 14 times pre -sinurized, I believe they found something like $100 or $125 million plus of savings taking even out from $200 to over $300. But Adam spoke about earlier the profile of acquisitions on the large your side paying higher multiples, but able to tuck in things at lower multiples. How do you think about the juxtaposition of those two capital allocation decisions? So again, I'm doing this for memory, but I think they paid 2 .7 or 2 .8 billion for a job. And then I think there was a working capital component to it. And then of course, you also had to put money into it to basically fund all the restructuring because you had to spend a few hundred million dollars to get this energy.

37:54So the way I think about it is you paid roughly around three billion dollars for the company. and again, from memory, it was doing about $200 million of EBITDA. Now that was during COVID on a lower number. So I think it was $2 billion euro, maybe a little bit more in the sub 10 % margin. I think the idea was that you'd get the business to at least $3 billion euro. So maybe you call that $3 .5 billion over time, getting the pricing right, coming off of COVID, whatnot. So the idea would be you get the business to about three to three and a half billion US. And then what they said publicly at the analyst day is that shop would be 15 plus percent.

38:34So their business would have the same. In fact, they have higher gross margins of shopping. They do at core API life safety because of the alarm and monitoring, which is a very, very high margin. The alarm business, I think, can get 60 percent gross margin. It's crazy. So they have higher gross margins. So it's really just utilization and GNA to really do it. But yes, can shop get to 20 percent EBITDA margin, it should be able to. I think it'll have probably structurally lower growth just because Europe grows less. It'll have good price, but it won't have a ton of new units because Europe is just rusty and old, but I think the price will be good.

39:05So it probably grows slower than Core API, Life Safety. I don't know if Core Lite, ApeGuy Life Safety grows 5, 6, 7, 8, and maybe it goes 3 or 4. It will be less. But the idea is that if I can get the business to 3 billion in sales, steady state before you sort of do the organic compound, you get the business like 15%. That's 450 of EBITDA at 20 % at 600. Let's put the baby call it 500 million. Yeah, the condition is they do 500 million of EBITDA. Did they pay 3, 3? I mean, yeah, it's all nice on a spreadsheet. It's not as easy as that, but I think that was the underwriting case that, hey, where else are we going to be able to deploy $3 billion?

39:41And whether the number ends up being 400 or 600, you can't deploy that type of capital and get that type of return. If you think about it, they paid 14 times or whatever it was for elevated. It was 13 times. And I think that business was going to do this year or 24 to 50 Vibhidhan and the idea would be about 60 this year. So they paid a pretty big number for that business. So look, they bought it because they wanted a platform that they could do tuck -ins again. But in general, I look at it and I say to myself, it's like buying an unoccupied building. If you can stabilize and unoccupated building, you can go and get it to like a 12 or 15 cap on lever, but you got to go and roll up your sleeves.

40:19And I think that's exactly what Chubb was. It's like, hey, we'll pay you a big number on reported. Perhaps even a number that private equity couldn't even pay because they don't have the capabilities and they don't have all the GNA and the savings and the systems, but they paid a high reported number. But I would say to you, even if they got the low end of my EBITDA expectations, I still think they paid about seven and a half times for a large amount of EBITDA. And more importantly, they basically got a big platform. Think about it. What was Core API before chop? Now they've done acquisitions and grown subsequent to that.

40:52But let's say Core API was 450. You arguably bought a business post synergy equal to your business and maybe even more. It's very rare that you can buy a business of the same size or greater at a lower multiple than what you're trading at. Now we can argue as to whether API, pre -2022, when they bought a job, we can argue as to whether API was trading at 10 times or 12 times or whatever multiple you want to argue. It wasn't trading at six or seven. So they were able to raise press equity from Blacksion of Viking in a very low coupon. And they were basically able to finance it really intelligently.

41:26And I think that the idea was is that even in a really, really, really catastrophic scenario, it was very unlikely that they would be creating the business at a higher multiple than what API was trading at. In fact, it was almost impossible for them to create it at a multiple that was not significantly lower. I mean, it's not without heartache. They took on the term loan. They levered up into an interest rate cycle, but because they financed the deal intelligently with the prefect equity and the term loan with the swap, it was just a market market pain, not an actual financial pain. And as you think about the United States going forward, doing tucking M &A will continue to exist.

41:59but I don't envision them taking a big business bet in the United States unless they can create it. Unless the juices worth the squeeze. Does that make sense? No, absolutely. If you think about it from a relative value perspective and trying to determine how to think about valuation for the company broadly, route -based businesses, recurring revenue, demand, incredibly high multiples both in the public and private markets. There's a list of private market transactions in these end markets anywhere from 15 to 20 times Zibidah, obviously many of which were completed in a different interest rate environment.

42:30But I guess we should look across the spectrum, public and private on comps. Let me just cut you off. Part API group is trading under 11 times Zibidah. So the point you're trying to make is the point that Chad and I joke around with is why is API group trading at if you include the cash flow from the fourth quarter, it's trading at under 11 times Zibidah. And you'd say, well, look at first service, look at Otis, look at Sintas, look at all of them. And I think look, a couple of that is just track record. And I think over time as the company continues to deploy the capital intelligently. I think we're hoping that that multiple gap will narrow to be fair.

43:02The specialty business has been unpredictable in 2024. So I would say that specialty is weighed on investors even though as a percentage of EBIT as I said, it's really only 10%. But again, it's always as you know, in these public companies, it's always the weakest 10 % that gets everybody's eyeballs. But yeah, I don't have a great answer for it. API groups multiple will continue to appreciate as As the EBITDA and EBIT margins continue to improve, once the consolidated organic growth gets reported, regardless of how the growth profit growth and margin all that has played out, like lowest common denominator, as the reported organic regardless improves, I think that will give investors comfort that the business grows organically.

43:43Investors probably put a too big of an onus on the incentive fee structure in terms of of what's being paid to Mariposa. And remember that incentive structure is only on for 25 and 26. So what I would say is I'd say, look, as we get through 25 and really get into 26, the emphasis on the incentive and carry will come down. And I think whatever discount institutional investors are putting on to the quote unquote delusion from Mariposa will go down. So I think over the next couple of years, it's gonna be really an interesting time for API group because they're working through Chubb, getting to the other side of it, the restructuring costs will come down.

44:20The cash conversion will continue to improve. Hopefully, the competitive landscape for M &A will improve just as a function of the weakness of the private equity as we've discussed. So as they continue to put that capital to work and the organic growth steps up, the hope is that you will get multiple convergence and Martin Franklin will likely do things to increase value per share and even more incentive us to do that after 2026. I guess in an effort to tell both sides of the story, if the thesis is not played out as contemplated or said differently, what do you see as the primary risks to them not being able to execute on their plan?

44:58I don't actually think that there's a risk of them not being able to execute on the plan. If child border were blown up, it would have happened already, so it would have happened in 2022. Look, I don't see a ton of risk at child. Does it grow 2 % instead of growing 3 % or 4 % entirely possible? But I don't see that as a big issue. Again, Russ has been running USAPI now for 20 years, so I'm not super worried about the US fire business either. Again, whether you're achieving the multiple in the public markets, that's something that, as my friends used to say, that's a conversation between me and God and the world.

45:34And you see tons of companies that just never escape velocity. but by the time the promote rolls off in 2026, I think they'll probably be a big universe of people that will be able to own this thing. But I think the universe of M &A opportunities is still large, the company generates cash, they'll buy back stock, if the stock trades cheaply, it's not leveraged. And I would say that if they don't have M &A to do, which I find hard to believe, they'll solve the company. But I just think that you look at the TAM, you look at the end market, I do not think fire is getting disoriented media by AI. You've got data from industry reports showing what pricing is in the industry.

46:12I don't really look at this and be like, there's a real operational execution risk. I think there's the Maylays Lezet Fair attitude towards the public markets and whatnot. And I can say that about many companies in the middle market. You'd like to think the $10 billion market cap is a company that people can own. But as you know, the market cap that is addressable to investors is that number that just keeps increasing. So what I would say is I'd say, look, is this a company that could get acquired by a strategic or a consortium of private equity firms if this company continues to not get valid in the public markets?

46:42I'd say, yeah. In January 1st, 2027, I'd say, yeah, open for business. And just our concluding question in these conversations, we're both through separately, or lessons that you can take from this investment and apply to others from either an operational perspective or purely from an investment playbook perspective. I'd say that when you're investing in roll ups and companies with promotes, I think it's really good to buy them when they're below watermark like hedge fund managers. The time to buy a PI group was when we didn't participate, but there've been great opportunities to buy a PI group.

47:14I think one was during COVID. Another time was during 2022 after they had levered up to buy a job, but clearly they had their arms around it. That's just been a lesson where it's like when you're buying companies that have these carry an incentive structures. There's obviously an incentive to get the thing back over watermark. So I think the time to buy them is when they're below. It doesn't mean that you're slave to that rubric, but I would just say that if you're weighing the pendulum, I think buying it below water has been a good thing. And obviously on a rebalancing side, the more it gets above water, you sort of save yourself.

47:42Are you not aligned with the other guys who may be trying to put capital to work at lower prices because they want to extend the length of the runway? That's why I said, everything evens out in 2027. You don't even have to really think about it. But this has been a phenomenal investment. The executive management team has done a very nice job throughout a challenging period of high -end COVID, high inflation, high interest rates. And I think as Jim would say and Russ would say, we haven't really operated this company publicly in a normal environment. So I don't know when that will happen, but I suspect at some point things will be normal where interest rates aren't moving crazy and inflation is moving crazy.

48:16But it's been a good experience more so. I think what What we've learned is that over this last couple of years, it's just shown how there just isn't a ton of demand for companies of this size. I think the major lesson is that you'd think that a company $10 billion would have a investor universe, but the size, the concentric circles, the size of addressable investors. And I've learned this really through API group. It's like, oh, it gets five billion, it gets to 10 billion. It's like, yeah, the addressable market of investors for companies like this has just shrunk dramatically. And I think to your point, it's like, well, what happens if it never trades at the multiple private markets?

48:48I'm like, yeah, that's the risk that you have and you have to believe that you're with people that are aligned to Extract that value either through share repurchaser through a sale of the company It's one of the things that we ask ourselves in any of our investments Which is if the multiple gap doesn't converge and you don't really get the true cost of capital is the man's Routine and board aligned with you in terms of doing everything in their power to extract the value and that's the thing that we've taken away from this experience how hard and how high the bar has been for companies to get what I would call on the conveyor belt.

49:20Well, the first one from an investment standpoint is that the headline can drive the narrative as opposed to the fundamentals. So one example of this is when the first quarter that the company reported after they closed the child acquisition, it looked like API produced very little free cash flow, which was the headline and the narrative and that drove the stock price down for a good amount of time. And in reality, Chubb was delivered to them with a low amount of working capital, and the purchase price was adjusted down radically for that. But when API made the investment into the business to rebuild the working capital to a normalized level, it just came out of cash flow from operations.

50:01But I could say the purchase price offset that, and the investment that ran through the cash flow from investing was lower. So the narrative should have been API paid a discount not for a job, not that their pre -cash flow was light. But as an investor, if you're longing it, that can be frustrating, but if you have the ability to deploy more capital into the opportunity, then it can be a gift. The second lesson I would say is that stocks can be mispriced for a long time. And particularly in today's market, you see stocks that have high valuations that seem to perpetually have those valuations, and you see great businesses that are trading at low valuations that seem to not be able to expand or multiple.

50:34So if you're looking for multiple expansion to make sure you have a catalyst and an API's case, Maybe we have a couple coming up. They have an analyst day in May where I'm sure the revenue growth that they're going to present will be strong They're likely to take the margin targets up from 13 % to maybe 15 % and then you have a capital structure that seems to be getting simpler in the next couple years Or maybe there's a couple of catalysts out there But otherwise you need to look for Investments returns from earnings growth and or share price or share account reduction So in the case of API, well, I would like to get some multiple expansion and maybe we will.

51:11I'm hanging my hat on earnings growth. Well, I appreciate you both for coming on and having this conversation. I think very often it's become a joke to affect what would be a private equity style investor in the public markets. Surely there's no better opportunity than one where you're effectively doing that. Obviously, this story has a lot of likes to it. Next two years it'll be interesting given the carry -in -promote structure of the sponsor. So I look forward to tracking. Thank you, Zach, for having us on. Great to be with you again, Zach. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out JoinKalosses .com.

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