Weekend thoughts: value signals across an industry $STER $HRT $FA

I wanted to do something a little different this weekend. There’s a sector / group of companies I plan on spending a little more (or perhaps a lot more) time diving into. In today’s post, I wanted to explain why I’m interested in the sector before I dive in.

Why am I doing this post? Two reasons

1. I think the sector is an interesting case study to show how an entire sector could show they believe they’re undervalued.

2. I haven’t spent much time on the sector (yet), and this blog has dozens of readers and many of them are quite sharp. If anyone has done work on the sector and wants to swap thoughts / tell me if I’m on the right or wrong track here, I’m always open to a dialogue!

Anyway, the sector is the background check sector. There are three main global players here (FA, STER, and HRT), though there are plenty of other competitors.

I’ve previously discussed “the proxy trick” to track share buybacks; that’s where you use the difference between the share count on the proxy and in the 10-K to see how many shares a company has bought back intra-quarter. I first stumbled on the background check sector when someone told me to use the proxy trick on HRT. HRT’s 10-K showed they had ~77m shares out at March 2, and that had dropped to 75.96m shares by March 31 in their proxy.

That’s >1m shares bought back inside of a month, or almost 1.5% of shares. On an annualized basis, the company would retire ~15% of their shares outstanding. Not bad!

And HRT has been clear why they’re buying back shares. HRT has a variety of options for their cash flow, including pursuing bolt on acquisitions (which are generally quite accretive). HRT knows that, but they believe the best option is buying back shares. Per their Q4 call:

We believe currently as we continue to evaluate cash allocation options, the repurchase program is the right use of our excess capital and reflects our confidence in our business prospects and our ability to generate ongoing positive cash flow. Looking ahead, we continue to see steady volume across almost every vertical, however, lower than the same period a year ago.

We could stop this post right now and HRT would be at least worth looking at as a value investment. Any company buying shares back at that pace is mildly interesting!

But the more I dug into HRT and the share buybacks, the more interesting the value case for HRT got.

Let’s start by sticking inside the proxy. HRT is basically controlled by two firms: General Atlantic owns ~42% of the company, and Stone Point owns just shy of 25%. That control makes the buyback even more interesting: HRT is controlled by sophisticated control investors / private equity firms. Private equity firms generally want to exit their investment over time; all else equal, they’d probably bump share buybacks to the end of their capital allocation priorities because buybacks reduce the float of the stock and make it harder for the PE firms to exit. For them to decide to buyback shares at HRT shows you what they think of value here, and the buyback becomes even more interesting when you consider that HRT’s free float outside of their top three shareholders is only ~18m shares. Remember, HRT just bought back 1m shares inside of a month; at that pace, they could soak up all of HRT’s free float by next summer!

Digging further into General Atlantic and Stone Point, we can see that both firms were buying stock on the open market decently aggressively in the back half of last year at prices well above current prices. Again, that’s interesting; PE firms are generally looking to get liquidity from their investments. They’ve got to be pretty convinced of the value in a stock to go the other way and buy shares up.

Alright, so HRT is probably interesting. The company is buying back shares aggressively, and those buybacks are directed by relative sophisticated / semi-control private equity owners who have bought stock on the open market at higher prices.

But things get really interesting when you consider the industry. Again, there are three big players here, and all of them have been decimated over the past year.

Like HRT, the other players in the space are private equity controlled (STER is backed by GS, and FA is backed by Silver Lake)….. and, like HRT, both STER and FA are aggressively buying back shares. Here’s what STER said on their Q4 call:

Our Board authorized a $100 million share repurchase program, as we continuously seek to increase shareholder return, while taking advantage of attractive equity valuation

And here’s what FA said:

We continue to prioritize deploying our capital in ways that create the most value for our shareholders, including returning a portion of our cash through our share repurchase program.

So if you summed it up, in STER / FA / HRT, we have three companies that are controlled by sophisticated private equity investors who will want to get out of the stock at some point. The stocks have been hammered over the past year, and all of them are choosing to buyback stock (and reduce liquidity) over a variety of other options.

No one is infallible. Just because a whole industry with sophisticated people backing it is buying back shares doesn’t mean the stocks will work. We could go into a depression tomorrow. Advances in tech could somehow displace HRT/STER/FA in background checks. The government could ban background checks for some reason. I don’t know; businesses fail out of no where for all kind of reasons.

But when you put the whole string of things together, I think you could do a lot worse as a starting point for looking for value than HRT / STER / FA.

Anyway, that’s my high level on why I want to look at the industry. I honestly have not done a ton of work on it yet; the questions I’m trying to think through are #1) how sticky is the product once you put it in (i.e. if Walmart decides to use HRT for background checks, does it get embedded into their hiring systems or could they easily switch to someone else) and #2) how easy is it for large companies to inhouse this versus outsource? Again, I have done very little on the industry so far, so these could be stupid questions and I might realize there are other, better questions to answer, but sitting here having read exactly one 10-K and two earnings calls those are the questions I have on my mind.

If you think you know the answer or that I’m on the right track (or just have other thoughts on these businesses), feel free to DM me and let me know!