Ben Axler founded Spruce Point Capital Management in 2009 following a decade as a banker at Credit Suisse and Barclays. Spruce Point runs a short activist strategy, and since its founding has exposed multiple frauds, forced over a dozen CEOs and CFOs to resign, and caused several companies exposed as frauds to delist from publicly trading. Empowered by the internet, most short activists disseminate their hard hitting research instantly to online communities of investors. Axler has shared 66 ideas to SumZero, and they on average have returned 15.97% versus their respective benchmarks.
This performance is especially remarkable given the recent bull climate. A rising tide lifts all boats, and serves as a strong headwind for any short focused fund.
Axler recently posted a short idea on U.S. Concrete (USCR) to SumZero. SumZero sat down with him to discuss the piece and more generally, his thoughts on short activism.
Luke Schiefelbein, SumZero: What about US Concrete initially caught your eye as an activist short-seller? What catalyzed your entrance into the position?
Ben Axler, Spruce Point Capital: USCR is a roll-up in a commodity industry. Spruce Point has had significant success identifying and shorting roll ups in the past when the evidence suggests that they are struggling. We came to the opinion that USCR’s roll-up was showing signs of financial strain when we observed its operating cash flow was declining over a three year period, and its Non-GAAP results were become increasingly “adjusted” with more add-backs. We also felt that USCR was become more dependent on larger and more questionable acquisitions fueled by leverage to keep its growth ambitions alive
Schiefelbein: What is the market missing? Why are sell side recommendations on USCR almost universally positive?
Axler: Analysts and investors are being left to fly blind in the dark by USCR. They offer no firm financial guidance. The limited guidance they’ve given on capital expenditures over the past few years has been horribly missed. Over the past three quarters, USCR has been missing analyst earnings estimates by a wider and wider margin. Analysts have been slowly cutting long-term estimates, but we think they are still too high and have room to come down further. Analysts remain universally positive on USCR because they are incentivized to do so. USCR’s liquidity situation is becoming worse every quarter. We look at its cash and borrowing capacity relative to its trailing 12 month revenues and find that its liquidity is worse today than years before when it headed into bankruptcy in the prior financial crisis. By remaining positive on USCR’s share price, brokerage firms are positioned to earn lucrative capital raising and M&A fees down the road
Schiefelbein: Why has sell side research generally positively covered companies at which you’ve exposed corporate malfeasance and fraud? Is this representative of a structural deficiency in the sell side research model?
Axler: Yes, we think there needs to be more independent research, free of conflicts that arise when research providers seek to do business with the companies they publish research on. We are not compensated by the companies we write about. We make money when our research is accurate and our thesis plays out.
Schiefelbein: What key metrics should investors be paying attention to as your thesis matures? What will catalyze US Concrete’s 60-90% negative price correction?
Axler: Investors should follow USCR’s free cash flow carefully. It has been declining since 2013 and there’s no reason to believe it won’t continue to decline. USCR is levered almost 4x Net Debt to a “highly adjusted” EBITDA. Its highly adjusted EBITDA is also showing signs of stalling. Realized YoY pricing growth for ready-mix concrete is also slowing, and hit a multi-year low of just 2% in Q1’18. This suggests to us that supply/demand are coming into greater balance. If and when the construction cycle turns, and prices and volumes decline, USCR’s leverage will rise rapidly and its share price decline will be swift.
Schiefelbein: Part of your USCR thesis alleges that the stock price is being driven up by ‘indiscriminate buying’ of the stock by passive investors like Blackrock and Vanguard. What broader impact do you think that the rise in passive management is having on the market?
Axler: Passive or index investing certainly has its critics. Barron’s cover story this week entitled “Jack Bogle’s Battle” focused on some of the issues. We agree with most of the concerns. We’re coming across too many situations where we find passive investors own >20% of the shares of mediocre companies. In some of these situations we are finding insiders fleecing investors with poor performance being masked by aggressive accounting or financial presentation, unjust compensation, and dumping of shares at inflated prices. Who’s speaking up about this? Certainly not the passive investors. This creates an opportunity for Spruce Point to highlight these companies with our activism to try to correct the problem.
Schiefelbein: Your thesis alleges that USCR may be overstating organic growth and using capital leases to inflate adjusted EBITDA. Did you come to these conclusions before or after you saw that management was compensated based on adjusted EBITDA growth?
Axler: We always like to understand what are the metrics that motivate management the most. In the case of USCR, it is clear that the sole factor driving management is Adjusted EBITDA. Therefore, we took a critical look into the levers management could pull to inflate this metric. Capital leases provide more benefits to Adjusted EBITDA than operating leases. Not surprisingly, we found evidence to suggest management has been more aggressively pursuing capital leases, while at the same time disclosing less information about the leases
Schiefelbein: How has your research process evolved since the early days of Spruce Point? What or who have been the biggest influences on you as an activist short investor?
Axler: My investment mindset has been shaped by my unique work experience. I worked through two of the largest investment banking acquisitions in Wall Street history: Credit Suisse’s acquisition of DLJ (2000) and Barclay’s acquisition of Lehman Brothers (2008). I’ve seen a tremendous amount of business failure first hand during my career, and have developed a deep rooted skepticism about the value that mergers and acquisitions (M&A) can bring to investors. This gets back to why I love shorting highly acquisitive roll-up stories. The narrative that investors love to hear is that deal making can bring great “synergies” and “earnings accretion”- CEO’s and analysts make it sound so simple, but it is not. In realty reality, M&A is difficult to execute because of the human element of integrating cultures, technology systems, and business processes often under intense timelines to appease Wall St. These factors can often lead to great disappointments.
Schiefelbein: Do you think that research being driven from activist short-sellers such as Spruce Point is a better model than from research being driven from sell-side brokers?
Axler: We believe the activist short-seller model is entirely superior to the current sell-side banking driven research model. Under our model, everyone is held more accountable. To illustrate, by making our research publicly available, we are trying to hold accountable and get more transparency from public companies to explain issues we are identifying. We try to hold the sell-side broker research community accountable for missing things and issuing overly bullish stock price assessments. We try to share our research with regulators such as the SEC, so they can continue to spot areas of concern, protect investors, and be held accountable so that they don’t miss the next Bernie Madoff. Lastly, Spruce Point is held accountable too and makes or losses money based on the accuracy of our research. The market can see our track record on short calls dating back to 2010, and the outcomes we have achieved.
Schiefelbein: What role do online research platforms play in your short activism? How integral have these platforms been to your success disseminating your research?
Axler: Online research platforms such as Sumzero are a valuable medium for us to distribute our ideas and engage with other investors to solicit feedback. As part of conducting our research process, we always try to understand the details of the bull case, and if a current bear case narrative exists. In order for us to really become engaged with a short campaign, we have to be able to successfully reverse engineer the bull case in order to disprove it, and also add new insights that materially strengthen the bear case if one already exists.