Cadre Holdings Inc. (NYSE: CDRE)
Foreword: I first heard of Cadre Holdings while reading Maran Capital Management’s 4Q21 letter1 to investor partners. Dan Roller, Maran’s Founder and CIO, laid out a pretty compelling investment thesis which led me to dig more into the company. The work that follows summarizes many of Dan’s points from the letter, the prospectus, additional company disclosures, as well as other material I thought was worth sharing. It ends with outlining two scenario’s that I’ve modeled which try to demonstrate the range of potential outcomes that an investment in Cadre Holdings could generate if held for the long-term, allowing for the company’s M&A strategy to unfold and allowing the stock to compound over time.
Intro
Cadre Holdings Inc. is a holding company that has acquired a portfolio of brands that manufactures and supplies safety and survivability equipment for first responders (law enforcement, fire and rescue, EMS, etc.). Serving as a one-stop shop for their customers, Cadre’s main products include body armour, explosive ordnance disposal equipment and duty gear while supplying a wider range of other products (uniforms, boots, ammunition, etc.) through partnerships with third parties. The company has been around for over 50 years and is led by its CEO and Chairman of the Board, Warren Kanders (more on him later). Several tailwinds that should help propel revenue growth for the foreseeable future include 1) increased law enforcement budgets & law enforcement labour force growth, 2) the need for regular equipment replacement cycles and equipment modernization, and 3) accretive M&A that expands the product portfolio, increases wallet share with current customers and reaches new geographies.
1. Increased Budgets & Labour Force Growth
Despite calls across the U.S. to “defund the police” in the summer of 2020, law enforcement budgets have actually been increasing since that time from an increased emphasis on public safety. The year 2020 saw a historic rise in homicides (an increase of 44% since 2019)2, with the trend continuing in 20213. In President Biden’s State of the Union Address, he stated the American Rescue Plan provided for $350b to hire more police (among other things), a direct response to the recent increase in crime seen in 2020/21. Unfortunately, with the US and many countries in the world likely heading toward a recession, crime rates are likely to continue to increase which should provide an incentive to not only maintain but increase law enforcement budgets4. The charts below show major U.S. law enforcement budgets from 2008-2020, exhibiting strength during recessions and posting a respectable CAGR of 2.9% in that time, in line with GDP growth. In terms of size of labour force, the U.S. Bureau of Labour Statistics expects the number of law enforcement personnel to increase at a faster rate than the broader labour market over the 10-year period from 2019-2029, from 813,500 to 854,200 (~5%)5. On the companies 4Q21 conference call, management called out that the U.S. is currently experiencing a shortage of officers which will take years to revert to acceptable levels. This all points to a steady supply of law enforcement labour for the foreseeable future. Additionally, the war in Ukraine has heightened European countries attention to the risks of war. With 20 NATO countries still not meeting the agreed upon spend of 2% of GDP on defense and security, this new threat has caused many countries to contemplate increasing their military spend6. The nations of Denmark and Germany have both recently made statements acknowledging their need to increase investment in military, with Danish PM Frederiksen commenting “this is the largest investment in Danish defense in recent times” and German Chancellor Scholz stating, “it is clear we need to invest significantly more in the security of our country”6. Again, this all points to increased budgets and spending on many of the products that Cadre manufactures and supplies.
2. Equipment modernization and refresh cycles
With Cadre’s products being mission critical (i.e. literally saving lives), stringent safety standards and customary warranty provisions create standardized refresh cycles on ~80% of revenues. The demand associate with these refresh cycles drives a highly predictable recurring revenue stream. In addition, Cadre’s customers tend to stick with their products as most departments seek uniformity across the equipment used by their labour force. Due to the refresh cycles, switching equipment away from Cadre would constitute a switch away from Cadre for all the equipment they supply to that customer, a costly and time-consuming endeavour. This creates stickiness for Cadre’s products and provides them the ability to improve margins via gradual price increases, as their customers are unlikely to switch due to small price increases. Additionally, Cadre has long term customer relationships with over 23,000 first responders and federal agencies both domestically and internationally. Their global presence spans 100+ countries predominantly in Europe and North America, among other regions5. The predictability and stickiness of revenues (as well as geographic mix of revenue) should garner Cadre a premium multiple in the market, similar to how ARR in tech stocks garner higher multiples due to the higher visibility of future revenues.
3. M&A Strategy
A large part of this story comes down to growth through acquisition. From 2012 to 2017, the company completed 12 transactions5 and targets making 1-4 acquisitions per year adding between $50-100m in revenue annually. At an 15-20% EBITDA margin, that adds anywhere from $7.5-$20.0m in EBITDA per year. The CEO Warren Kanders has had prior success completing roll-up strategies at both Armor Holdings and Clarus Corporation which I’ll quickly touch on below.
Armor Holdings - Kanders took control of bulletproof vest manufacturer Armor Holdings in 1996. At that time, the company generated $11m in sales and $0.5m in earnings. Over the next 11 years (through both M&A and organic growth), Kanders grew the company into a defense supply conglomerate growing sales to almost $2.5b (~200x increase) and net income to over $100m. Kander’s eventually sold the company in 2007 to British defense contractor, BAE Systems. In that time, the stock went from $0.75 to ~$88.00 a share, a greater than 100x return (CAGR of ~50%) in less than 12 years.
Clarus Corp – Kanders (along with several partners) took control of Clarus Corp in 2010 after many years of proxy battles. By that time the company was a shell of its former self with significant net operating loss carryforwards7 which Kanders’ used strategically to re-invest for growth. Kanders used Clarus as a platform to acquire outdoor recreational equipment companies and remains its executive chairman to this day. Although not as successful (in terms of share price appreciation) as Armor Holdings, before the market correction starting in October 2021, the stock was up over 400% over the last 5 years.
Similar to serial acquirer Constellation Software, Cadre aims to buy businesses with a leading market position in their respective vertical that are mission-critical to their customer. Additionally, they look for businesses with strong brand recognition, a recurring revenue profile, attractive ROIC, best-in-class technology, resilient through economic cycles and with no large-cap competition. In their recent 4Q21 conference call, management described the company’s targeted approach to M&A and provided three key characteristics they look for when acquiring a business.
1) Focused on geographic expansion and expanding core products into new markets
2) Introducing new products to existing core markets (expanding wallet share)
3) Expanding the safety product portfolio outside of their current law enforcement and military markets into attractive adjacencies within the safety and survivability landscape
I’ve not analyzed each of the company’s previous acquisitions to determine if each has “checked the boxes” of this stringent check list, but since going public Cadre has provided a quick overview of each acquisition. Below we see an example of Cadre’s self assessment of their acquisition of Cyalume Technologies, a leading manufacturer of chemical light solutions.
Unfortunately, I am not well versed in chemical light solutions or in first responder/military gear in any capacity to make a call on many of the qualitative assertions made about Cyalume Technologies in the slide above, nor does the company provide financials to assess its quantitative characteristics. From the press release8 we are told the company is expected to generate ~$25m in pro forma revenues for FY22 and that the purchase price paid is $35m (subject to working capital adjustments) which gives us a revenue multiple paid of 1.4x. Without other acquisitions to compare this figure to, its hard to make any sort of statement as to its attractiveness (or not). Being a highly acquisitive company, I’d welcome management providing more disclosure on their acquisitions to provide us the ability to evaluate their transactions on our own vs simply taking their word for it.
Finally, there appears to be a large pipeline (see table below) with many attractive opportunities for acquisitions and consolidation in both the U.S. and international markets for Cadre. With ~$40m remaining from the ~$90m raised in the IPO late in 2021, the company has sufficient fire power to continue its M&A strategy in the short term, and we anticipate an additional 1-2 acquisitions this year to compliment the 2 already completed so far in FY22. As international expansion has been highlighted as an area of focus by management, we would not be surprised to see future acquisitions this year being completed Europe. From the company’s prospectus, management noted that “the international market is poised for growth as foreign government face increasingly complex safety challenges and seek to replace legacy equipment” and pegs the total number of law enforcement personnel outside of the U.S. to be ~9.6m, about 10x the number within the U.S. Clearly a substantial market opportunity.
Potential Large Contract - Blast Sensor Technology
Potentially a huge tailwind for the stock but not mentioned in the intro, Cadre is currently in the running to be awarded a $500m multi-year contract with the U.S. armed forces for one of their subsidiaries’ blast sensor technology products. With only one other supplier capable of producing a similar product, Cadre has a real chance of winning which would materially impact the top line growth of the company. The contract is to be reward sometime in 2023 and if won, could provide tremendous upside to the stock. So much so that it led me to model out the two separate scenarios, one where Cadre wins the contract and the other where it loses. For simplicity’s sake, in the scenario where Cadre wins the contract, I model $125m of revenue generated per year to the end of the forecast period.
Additional Competitive Strengths
Dominant Market Positioning
· Based on data collected by the company, Cadre holds leading market positions across multiple product categories through their superior quality and performance
· Cadre sells concealable tactical/hard amour to 34 of the top 50 police departments in the U.S.
· Cadre sells duty retention holsters to 48 of the top 50 police departments in the U.S.
· Cadre is party to multi-year contracts for the largest bomb suit teams in the world including the U.S. Army, the U.S. Marine Corps, and the U.S. Air Force
Large Mix of Recurring Revenue
With Cadre’s products being mission critical (i.e. literally saving lives), stringent safety standards and customary warranty provisions create predictable refresh cycles with over 80% of Cadre’s product line tied to these cycles
Impressive Free Cash Flow Generation
The company reports FCF as Adjusted EBITDA less capex and boasts an impressive FCF conversion of over 90%, pointing to a business that is highly efficient and noncapital intensive. Very impressive indeed. However, when using the more conservative (and conventional) FCF formula of net OCF less capex, we arrive at a less robust yet still impressive conversion range of between 50-70%, and FCF as a percentage of sales in the range of 8.5%-10.5% (over last three years). This FCF helps CDRE support a modest dividend of $0.32 (~1.2% yield) per annum as well as support the companies M&A growth strategy.
Risks
Below I outline some key risks associated with an investment in Cadre Holdings. The prospectus and financial statements provide a more extensive and fulsome list but ones’ I’ve listed below are the few I deem most important to highlight.
Key Man Risk
· As was alluded to earlier, a large part of the bull thesis is CEO Warren Kander’s ability to recreate the success he has had at Clarus Corporation and Armour Holdings. If he were to suddenly pass or become incapacitated, investors could become spooked and dump the stock in a hurry as the remaining management could be viewed as being incompetent in executing his tried-and-true roll-up strategy. That leads to the second risk…
Failure to Execute Acquisition Strategy
· The inability to execute on the M&A strategy could greatly impact the company’s growth. Several factors that could lead to a failed acquisition strategy include the inability to find suitable acquisitions, greater competition forcing higher acquisition multiples, failure to integrate acquired companies effectively, as well as acquiring companies that do not generate a sufficient return on investment.
Changing Attitudes Towards
· Although previously rebutted as a nonconcern at present, there is a real risk that movements similar to “defund the police” regain traction in the future and call for the disarmament of law enforcement. This would potentially lead to large losses in revenue for Cadre, as the company generates a material amount of its revenue from law enforcement within the U.S (for FY21, revenue generated in the U.S. accounted for ~75% of revenues).
Financial Model & Two Scenarios
What I have tried to do with these two scenarios is demonstrate a truly base case vs a truly bull case. I have chosen 3 key variables to focus on that I believe will move the stock:
1) Winning or losing the ~$500m Blast Sensor Technology contract
2) Organic growth of current business
3) The number of accretive acquisitions per year
Scenario 1
This scenario assumes:
1) The company does not win the lucrative ~$500m Blast Sensor Technology contract in 2023 mentioned earlier in the report
2) Both segments (Product & Distribution) grow at 3% organically per fiscal year starting in FY23
a. Note, for simplicity’s sake, the “organic growth” yoy growth rates have been propped up in Q2, Q3, and Q4 in FY22 to account for the 2 most recent acquisitions (results in 5% organic growth rate but one that is not fully “organic” in nature)
3) Minimal M&A – 1 acquisition per year (vs the max 4 communicated by management)
a. I have assumed that in FY22 no other acquisitions have been made, as Cadre has already completed the acquisition of Radar Leather Division (back in 1Q22) and is set to close its second acquisition of the year (Cyalume) imminently
b. I’ve assumed that the average acquisition contributes $25m in revenue per year to Cadre’s gross sales, and allocated 80% to Product and 20% to Distribution
c. I’ve assumed that each acquisition has net sales that are 94% of its gross sales (similar to the “reconciling items” that Cadre subtracts to get to its net sales figure) and that each target acquired has an EBITDA margin of 20% on that net sales figure – I’ve then used a 6.0x multiple of EBITDA as the total consideration paid which flows to the CF statement
Below is a screen shot of the P&L. As you can see the gross revenue found in scenario 1 flows through to this tab, is then netted down, then works its way through the remainder of the P&L to arrive at net income and adjusted EBITDA. I have assumed a slight step up of 0.5% of gross margin per year, and a similar step down in SG&A expense per year. Statutory U.S. tax rate of 21.5% is used throughout, and no share-based compensation is assumed, although as is evident from the 1Q22 statements, it appears as though SBC will become a more regular occurrence going forward. Until some sort of pattern or consistency emerges, it would be prudent to not make any assumptions here in my opinion. Included at the bottom is the more conservative FCF calculation (Net OCF – Capex). As can be seen, its not as impressive as the absolute FCF figures or conversion percentages that Cadre proclaims in their disclosures. However, at above 50% FCF conversion and accounting for ~10% of net sales, the FCF profile is still quite impressive.
In terms of the valuation for scenario 1, I have modeled a simple 5-year DCF below which suggest an intrinsic value $28.20 per share - upside of approximately ~12% from the closing price of $25.19 on May 31, 2022. I used a discount rate of 9.0% (calculation in later table), and a terminal growth rate of 3.0%. Additionally, using a helpful table found in all of @borrowed_ideas’ models, I’ve calculated the 5-year IRR to be 14.8% assuming a terminal FCF multiple of 25.0x (for simplicity’s sake, I’ve assumed the stock is purchased at the end of FY21 making the IRR calculation take 5 full years into account).
Scenario 2
This scenario assumes:
1) The company does win the lucrative ~$500m Blast Sensor Technology contract in FY23 – I accounted for this by adding $125m to the company’s gross revenues from FY23 onward (shown as a separate line item on the P&L)
2) Both segments grow at 5% organically per fiscal year starting in FY23
a. Note, similar to Scenario 1, the “organic growth” yoy growth rates have been propped up in Q2, Q3, and Q4 in FY22 to account for the 2 most recent acquisitions (results in 5% organic growth rate but one that is not fully “organic” in nature)
3) Maximum M&A - 4 acquisitions per year (matches upper range as shared by management)
a. Similar to Scenario 1, I have assumed that in FY22 no other acquisitions have been made
b. I’ve again assumed that the average acquisition contributes $25m in revenue per year to Cadre’s gross sales, and allocated 80% to Product and 20% to Distribution
c. I’ve again assumed that each acquisition has net sales that are 94% of its gross sales and that each target acquired has an EBITDA margin of 20% on that net sales figure – I’ve then used a 6.0x multiple of EBITDA as the total consideration paid which flows to the CF statement
Below is another screen shot of the P&L, this time with Scenario 2. As you can see the gross revenue found in scenario 1 flows through to this tab, is then netted down, then works its way through the remainder of the P&L to arrive at net income and adjusted EBITDA. I have assumed the same slight step up of 0.5% of gross profit per year, and a similar step down in SG&A expense per year. Statutory U.S. tax rate of 21.5% is used throughout, and again no share-based compensation is assumed.
As we can see, with the $125m per year additional sales from the BST contract and the additional revenue contribution from M&A, the companies EBITDA (and Adjusted EBITDA) explodes to $110m for FY23 and to over $200m by the end of the forecast period. However, there is a problem with the company’s ability to pay for all that M&A. Even if we assume the company draws the entirety of the debt available to it (approximately $72m by my calculations – as of March 31, 2022 the company had ~$97m of availability according to their 1Q22 financial statements. I assume the company draws $25m in 2Q22 to help pay for Cyalume), the company will still run out of money sometime in FY23. Not unless we assume the company starts paying only 4.0x EBITDA on average per acquisition AND draws an additional $72m in debt does the math add up and the company not run out of money, as seen in the third table below.
In terms of valuation, including the additional debt (and assuming a lower multiple paid for M&A), we arrive at a fair value per share of ~$45.50, approximately 80% upside from today’s close at $25.19. Now lowering the average multiple paid by 2 turns is quite material, however I would argue that recent commentary from the company and other company’s executives’ points to valuation multiples lowering. In the public markets they have already come down considerably in some industries and private companies’ valuation multiples are beginning to follow. Additionally, the company’s net debt to EBITDA ratio was 1.8x as of the end of FY21 and would be 2.2x at the end of FY22 assuming it draws the remainder of debt capacity available to it. This isn’t an incredibly leveraged company, and it potentially could increase its debt capacity to lever up to 3.0-4.0x its net debt to EBITDA. I have opted to lower acquisition multiples vs increases debt capacity as 1) multiples are already heading there directionally, and 2) I did not want to make up debt agreements on the company’s behalf. In the end, what is likely to occur is a combination of both with reality falling somewhere in between for the company to execute on the upper targets of their M&A strategy (i.e. multiples contracting AND Cadre increasing their debt capacity). Finally, I would add that my 6.0x multiple paid is based on 1 transaction multiple where I already made an assumption on EBITDA margin, the reality of multiples being paid could be far higher or lower.
As promised earlier, below the WACC calculation can be found. I tried to use as accurate as resources as possible, and the result of 9.0% is relatively conservative in my view. For reference, FactSet has the company’s WACC at 6.8% as of June 1, 2022.
Conclusion
Cadre Holdings offers a compelling risk reward today, trading at ~12.0x EV/2023 EBITDA which is good value considering the quality of company and management team at the helm. In terms of base line organic growth, the company’s market leading position in several verticals, long standing relationships with its customers and inherent stickiness to its products should provide a floor of 3% organic growth at a minimum in the long run. That growth coupled with the management teams proven ability to grow through accretive acquisitions offers an attractive multi-bagger potential return if held for 5-10+ years.
Scenario 1 outlined the company’s potential return if organic growth is minimal and the company only executes at 25% pace of its intended M&A strategy. Even in this muted scenario, an investor would generate a very respectable IRR of ~15% over the 5-year holding period.
Scenario 2 outlines a more impressive 5% organic growth rate and assumes the company’s management fully executes on its intended M&A strategy. In this scenario an investor would generate an impressive ~25% IRR over the 5-year holding period.
In my opinion, the actual return in 5 years is likely to fall somewhere in between these two scenarios. I think organic growth of 3% as a floor is conservative, but to assume management will execute its M&A strategy perfectly is highly unlikely. There is a reason the company communicated 1-4 acquisitions per year and increasing revenues at a range of ~$50-100m, as not even they have a crystal ball. To sum it up, from where its trading at today Cadre offers limited downside risk but huge upside potential in the long run if management can execute. Looking at Warren Kanders’ track record back at Clarus Corp and Armour Holdings and considering he is highly aligned at ~50% ownership, I am happy to take a chance on Cadre and hopefully can recreate success for a third time.
Disclaimer: None of this is investment advice, please do your own due diligence before investing in any of your hard earned money!
Maran+Partners+Fund+LP+2021+4Q+Letter.pdf (squarespace.com)
Council on Criminal Justice (4Q21 Cadre Earnings Call Presentation)
FBI Releases 2020 Crime Statistics — FBI
Do recessions increase crime? | World Economic Forum (weforum.org)
Cadre Holdings - Prospectus
Care Holdings - 4Q21 Investor Presentation
Warren Kanders: The Most Successful Businessman You've Never Heard Of - (thetycoonist.com)
Cadre Holdings to Acquire Cyalume Technologies | Business Wire