Collectors Universe: Framing an investment in July 2020
Diligence Report | 30 min read | How I framed this opportunity as a buy-and-hold investor
Originally published on midstoryventures.com in July 2020.
Before you read this segment in the Diligence Report series — please read the “Introduction: Diligence Report Series” post here.
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Will third-party graders still be around 10-20 years from now?
Will the company’s competitive position shrink or widen over the next 10-20 years?
Will the company grade more higher-value collectibles 10 to 20 years down the line?
Center of the Collectibles Universe
Three Pillars
The core business of Collectors Universe is a third-party grading system. Collectors send their items to third-party graders (TPG) for authentication, preservation, presentation, and marketability. Collectors from around the world submit sports cards, trading cards, and coins to their offices, trade shows, conventions, events, and authorized dealer network. Most items are sent to their offices in Los Angeles, Boston, Paris, Shanghai, and Tokyo.
Once the item is received, the company’s team of experts verify that the item is legitimate, then they grade it based on condition and appeal. Lastly, a team puts the item in cases, commonly called “slabs,” with a label that denotes the grade of the item for collectors to see.
The company operates two divisions: coins and cards. Professional Coin Grading Services (PCGS) focuses on coins and Professional Sports Authenticator (PSA) focuses on cards. Both divisions make money by charging a take rate of the item’s estimated value and the customer’s requested turnaround time. The higher the value and/or the shorter the request time, the higher take rate they charge. Their grading segment makes up 95% of total revenue.
The second part of their business creates markets for collectibles. They own Certified Coin Exchange (CCE), an exchange exclusively for high-end coin dealers. They also own Collectors Corner (CC), a marketplace designed for dealers registered on CCE to sell certified coins directly to consumers. To be a CCE registered dealer, a dealer must pay a fixed monthly subscription fee. Lastly, the company owns Collectors.com, a search engine that aggregates listings from eBay, Amazon, Google, Collectors Corner, and many other websites. It is far more collector-friendly than the general online marketplaces because it gives higher quality searches. Collectors.com makes money by selling advertisements to dealers / traders who want to be a featured seller on the platform. They pay anywhere $99 to $199 per month (on top of an initiation fee). This is included in other revenue, which makes up less than 5% of revenue.
Lastly, the company also serves as the information hub for the industry. Collecting is not very professionalized since it is made up of hobbyists, so Collectors Universe stepped into be a source of truth for the industry. The company provides free content to like price guides, rarity reports, and databases of every collectible imaginable. They also offer a $150 subscription program called Collectors Club. Subscribers have access to proprietary data sets and are exempt from grading fees for a set number of collectibles every year. This is also lumped into other revenue.
These three pillars make Collectors Universe arguably the center of the collecting universe: they serve as an “authoritative” source of information and facilitate the market through their grading services and exchanges.
The Economics of Grading
The third-party graders have strong unit economics thanks for their enormous bargaining power, capital-light system, and predictable operational model.
TPGs make customers pay for grading services up-front, even though some customers might not receive their cards 2-4 months later. This deferred revenue creates a significant negative net working capital balance every year. In any given year, debt-free cash-free net working capital (DFCFNWC) as a percentage of revenue is -10%. With this float, they have the opportunity to explore different strategies that create shareholder value. And despite the long turnaround time, demand continues to increase every year in their PSA division.
The TPG system relies on collectibles grading experts, so it doesn’t require much operating capital. On a normalized basis, the company invests about $2M in maintenance capex, which represents 3.0% of revenue. This capital-light system generates an average Return on Tangible Assets (ROTA) of 90%. In 2019, it was as high as 108%. In other words, the cost to grow the earnings by $1.00 was only $0.925. This puts Collectors Universe in the 99th percentile.
The operating model is really predictable. They hire about 70 experts who earn fixed salaries. The number of units graded per expert is pretty stable, though they can range from quarter to quarter. They grade about 75K items per year, or 300 items per business day. Once they’re graded, they are slabbed and sent back to the customer. That model has consistently generated 60% gross margins. The company doesn’t spend any money on advertising, only content. In total, the company consistently generates a 20% operating margin and a 20% free cash flow margin.
Will third-party graders still be around 10-20 years from now?
A Short History Lesson
Third-party graders wouldn’t exist if collecting didn’t exist. The idea of seeking, locating, acquiring, organizing, cataloging, displaying, storing, and maintaining items is ingrained in our culture as a species. The activity dates all the way back to the 3rd millennium BCE in Mesopotamia.
A problem started to emerge in coin collecting during the 70’s and 80’s. Before third-party graders existed, sellers were authenticating and grading their own coins, and buyers simply had to trust that what the sellers were saying were true. These practices were flawed because there was the inherent conflict of interest: sellers had an incentive to say a coin was genuine, even if it was not, in order to close the deal. The situation was so bad that the Federal Trade Commission (FTC) had even investigated several coin telemarketing firms.
In 1972, American Numismatic Association (ANA), the world’s largest nonprofit coin-collecting organization, created the first third-party grading company, American Numismatic Association Certification Service (ANACS). However, there was a problem. ANACS only provided photo certificates with coins. It was inefficient. Nobody wanted to bring a photo certificate around. It was clunky, and if it was destroyed, you’d lose your credential.
In 1986, David Hall, a titan in the coin collecting industry, saw this problem and founded PCGS. PCGS invented the slab which quickly became the industry-standard.
The introduction of sealed cases opened the floodgates for people to enter the hobby. David Hall recounts that “many who wouldn't even consider buying coins... and several huge collectors have told me this... if it weren't for third-party grading.”
Nearly 35 years later, grading is the most discussed/debated topic in the hobby over the last 20 years. As one blog put it, “It’s been the center of casual conversations, debates, and even protests.” Some collectors see grading firms as evil and are on their way to purge every TPG. The hatred stems from a lack of consistency, and even scandals. A member of a forum best explains the widely-held feelings against TPGs in his signature:
However, “100% of collectors... felt that grading companies were a needed part of the hobby… [to] provide order and uniformity to grading and card pricing.”
Third-party graders create credibility in the market by verifying items as authentic and then grading them to denote the level of quality expected. Without third-party graders, there wouldn’t be a market for collecting, regardless of how collectors feel.
Technological Disruption
Third-party graders will still exist 10, 20, 30 years down the road. But what will they look like? Will humans be replaced by machines? What would that mean for the industry?
Thanks to grading and online transactions, collecting has moved from being “just a hobby” to “a potential investment vehicle.”
Right now, collectors have more financial risk than ever. The difference between a PSA 9 and PSA 10 can mean the difference of hundreds or thousands of dollars. With this financial risk, collectors are demanding that third-party graders become more consistent so that they can have more predictable investment vehicles.
Collectors are demanding consistency through technology not to replace experts, but to supplement them. As stated in this dissertation by a Department Chair at Western Connecticut State University written in 2003, a machine would be able to produce consistent outcomes at a technical grading standpoint and the expert would be able to produce an appropriate market grade of the collectible.
In reality, this technology will most likely not be adopted by any of the leading third-party graders. There’s two major reasons for this.
First, two of the most notably documented attempts at automated coin grading lacked commercial success. In 1990, the company’s very own PCGS announced the launch of PCGS Expert, which utilized robotics, image enhancement, image processing and an online image database for its integrated computer system. Around the same time, CompuGrade had introduced a system that generated a defect map for the graded coin based on the ideal version of the coin. Then an algorithm, which rated the marks contained in the defect map based on location and severity, came up with a technical grade. Both companies abandoned the systems after realizing the development of software could be a long and expensive process. These experiments occurred in the wake of rising development costs, missed deadlines, and ever increasingly complex rule sets. PCGS and CompuGrade abandoned their efforts when they lost hope of achieving profitability.
Second, the leading third-party graders coordinate together to maintain their positions. I suspect that there is some hesitation among these players to adopt technology. They most likely fear that technology would commoditize their services, allowing new entrants to steal their market share from reduced barriers to entry.
So we have this weird scenario. Like most duopolistic markets, there are competing interests between customers and vendors. Customers are demanding for technological improvements, but companies are incentivized to keep things the way they are. Between the two parties, the third-party graders have more bargaining power and face less functional obsolescence risk than investors might think.
Shifts in Profit Pools
The average investor thinks that the purpose of third-party graders is to verify and grade collectibles. This isn’t technically wrong, but I don’t think it’s a useful way to think about them. I believe the best way to think about it is through premiums: the purpose of third-party graders is to create premiums.
Redefining the purpose of third-party graders creates a significant implication. In order to create premiums, you need a track record. And in order to build a track record, you need to command a premium. Every leader in the grading space spent multiple decades building their network effect. This created huge barriers over the course of history. Today, new companies struggle to break in because they have to be willing to take years of losses or experience sluggishly slow growth. This explains why the number of third-party graders in the industry have steadily decreased every year. The competitive positions of third-party graders are durable, which means their unit economics are likely durable too.
Will the company’s competitive position shrink or widen over the next 10-20 years?
The Power of Early-Mover
Mohnish Pabrai defines the concept of a moat in a way that other investors often do not. He calls it the Dhandho Arbitrage. Arbitrage just describes an opportunity to take advantage of a spread with little to no risk. The Dhandho Arbitrage is all about the width of the spread and durability of the spread. Thinking with this framework is helpful when analyzing Collectors Universe’s moat.
David Hall, Founder of the Company, saw his opportunity to take advantage of this Dhando Arbitrage. While he wasn’t the first-mover, he was an early mover who created a permanent advantage through his reputation as a coin dealer and his idea of the slab. In the first month of PCGS operation, he had 32 authorized dealers and received 18,000 coins. In the second month, he received 32,000 coins. This far blew his initial expectations. He thought he would only receive 3,000 coins per month.
The Width of the Spread
PCGS was launched in 1986 and PSA in 1991. David rode the wave of unique market events to create a permanent advantage. By 1993, the company controlled 50% of the coin market and 90% of the sports card market. Thirty years later, their market shares stayed intact. You can confirm this by comparing the number of hits for each third-party grader on eBay.
Here’s how David describes those early years: “It was all pretty amazing. It was definitely an idea that appeared at exactly the right time.” Joe Orlando, who joined in 1999, said “It was sort of the perfect storm of events that really propelled grading to the next level. It has become very big.”
If PCGS and PSA entered the market three years later than they did, they would not have had the same market share that they have today. It’s hard to imagine a company who can overtake the positions that PCGS and PSA hold without having a perfect storm of events in their favor.
The width of the spread can also be measured by the premiums that their slabs command in the marketplace. Premiums are based on trust, and trust is built on strictness of grading standards and consistency of those standards.
The easiest way to evaluate premiums is by finding who grades the most expensive items. It’s reasonable to assume that a company who wins grading services for the most valuable items will have no trouble winning grading services for the less valuable items. In 2019, PCGS graded 21 of 25 of the most expensive US Coins. In 2017, they graded 19 out of 20 most expensive coins sold by Heritage Auctions. In 2016, they graded 20 out of 20 in the same auction.
Widening the Moat
Historically, there were only two reasons why a collector stuck with one slab. The first is trust in a slab’s premium. The second is the consistency of presentation within a set/collection. While these served as adequate switching costs, third-party graders were still looking for another way to garner customer loyalty.
Then Collectors Universe created the first-ever Set Registry. The Set Registry is the core of what collectors do. It’s a digital platform where collectors can upload a photo of their collectible to track their set progress, display their complete sets, and compete with others.
The Set Registry program is the company’s main strategy to widen their moat. In order for a customer to participate in the free Set Registry program, their item has to be certified by PSA or PCGS. Not only does this program increase loyalty and lock-in, but it actually spurs up demand. According to BBCJtv, the program created “PSA Set Registry Effect.” This is the phenomenon that describes how the Set Registry significantly increased demand for certain cards, especially the rookie cards. In the video, Nate and Eric described how cards that are easily attainable and have little to no collectibility appeal increased their value tenfold because of the increased demand caused by the Set Registry program.
The PSA Set Registry was designed to spur demand. In order to win your prize, the collectors have to complete their entire set. There are anywhere from 50 to 200 items in one set. So, as a collector, you can’t just cherry pick your favorite cards in a set. You have to grade the common, in addition to the rare ones. As Joe Orlando points out, the Set Registry “drives the value of our products, which in turn drives submissions into our facility faster and faster because people need it certified to sell for that premium.” The Set Registry creates the momentum for their flywheel.
Over the past 10 years, there have been more than 1.8 million sets registered. The Set Registry grows by an average of 19% every year. The crazy thing is that this number doesn’t seem like it will slow down anytime soon. The success of the program will continue to increase the demand for PCGS or PSA slabs. Other competitors have tried to create their own Set Registry but have not done as well.
Content represents the second most important strategy for widening the moat.
The company doesn't spend money on advertising; it spends money on free content. As they flood the Internet with highly relevant content, they drive up most of the search engine results. By keeping customers within the Collectors Universe ecosystem, they have more conversion opportunities. The investment in content also cultivates the credibility of the brand.
You can observe the power of this strategy by studying the relationship between S&M growth and unit growth. Joe Orlando, current CEO, said this about their content strategy: “About 10 years ago on the PSA side of our business, we decided to take all of this content from behind the paid wall and make everything free. Since that time, we've had 10 consecutive years of growth, and I don't think that's a coincidence.”
Over the past 5 years, sales and marketing grew by 2.5% whereas the number of units graded grew by 8.7%. That's a 3.5x multiplier of S&M on unit growth. There are limitations with this analysis though. Unit growth does not convert directly into revenue growth. Over the same period, the multiplier on revenue growth was less significant because unit growth was offset by a decline in declared value per unit. Content remains an important strategy to widen the moat, but it is the most effective.
Durability of the Spread
Now that we’ve talked about the width of the spread, let’s examine the durability of that spread. For this industry, the durability is really built on the trust that the TPG has built with the collecting community. Third-party graders don’t really compete on price (although there is a point where a customer does become price elastic); they compete on trust.
Collectors trust a company based on (a) the reliability of the authenticity (b) the toughness of the grading, and (c) the consistency of the grading. As with other industries, these customers vote with their dollars on who they trust, which shows up in higher slab premiums or greater item submissions. There are two ways that this trust can break. The first is through scandals. The second is through crackouts and crossovers.
In 2019, PSA’s reputation was under attack due to an alleged trimming scandal. As stated in this article on the Washington Post, members of Blowout Forums started to find out that PWCC, one of largest trading card auction venues in the world, was selling a large number of trimmed modern cards graded by BGS and PSA. The scandal focused on 316 cards whose combined values were artificially inflated by almost $1,000,000. As of July 2020, the case is ongoing and neither third-party grading has been at fault, but there are good arguments that PSA and PWCC may have been knowing and willing participants in the scandal.
Interestingly enough, this is not the first time PSA has faced this type of accusation. In fact, trimming scandals are very prevalent within the hobby. Some even go as far to say that the card grading business was built on a scandal.
PSA’s first graded card was the controversial T206 Honus Wagner. It was owned and submitted by the famous Wayne Gretzky. Because of Gretzky’s popularity, this submission attracted mass attention and fueled PSA’s popularity. Many years later, Gretzky found out that the T206 Honus Wagner card that he submitted was actually trimmed. The person who graded Gretzky’s card, Bill Hughes, actually admitted that he was aware that the card was trimmed in a recent interview. Despite the testimony, David Hall still denies that the card was trimmed. To learn more, watch this 30 for 30 short documentary.
So the alleged scandal in 2019 infuriated collectors because they claim the hobby hasn’t improved since it began. Some headlines read:
“It’s Time for Collectors to Cancel PSA”
“Rigged System: The PWCC & PSA Fraud Scandal”
“PSA: Incompetent or Complicit?”
Many believe this scandal will not be enough to take down PSA’s crown. Let’s review the facts.
During the period in which the scandal took place, the number of submissions actually went up and the prices for PSA-certified items remained higher than its competitors.
PSA still has 2x the market share of its biggest rival and 10x the market share of the third player. Its competitors would need the infrastructure to match PSA’s capacity, the management team to build a better brand, and the money to develop technology that catches trimmed cards. None of these scenarios are realistic for many obvious reasons known to collectors.
A survey created by All Vintage Cards indicated that while “100% of respondents said they have some concerns with PSA… [and] SGC is viewed at the most trustworthy, PSA is [still] viewed as the most accurate.”
The company will not come out of this scandal without battle scars though. Collectors Universe has a warranty agreement such that a collector whose item receives a lower grade or is deemed inauthentic upon resubmittal will be compensated in a way that the collector receives no loss from the devaluing of the item.
Historically, these warranty payments have represented about 1.5% of revenue. Warranty payments and expenses are a component of cost of sales. In 2008, warranty payments reached the highest it has ever been, representing 3.6% of revenue, or $1.4M. This made gross margins drop from 53% to 43%. In addition to warranty payments, the company would most likely have major expenses related to litigation.
Besides scandals, the other way that Collectors Universe can lose its reputation is through crackouts and crossovers. Similar to how customers compare speed between carriers in the telecom industry, collectors can test their grading through crackouts and crossovers.
If we compare a Gem Mints of a MJ Rookie Card in a PSA holder and a Beckett holder, you’ll find that the difference is about $55K. As of July 2020, the PSA 10 went for $90K and BGS 9.5 went for $55K. If collectors crackout or crossover the rookie card from PSA 10, only to find out it was re-appraised as a BGS 9, then as a collector, you realize that the PSA card was over-graded and therefore overvalued. With enough experiments, crackouts and crossovers can make the market “efficient” and correctly price the premiums.
While crackouts and crossovers serve as a way to test the company’s position and even disrupt a company’s moat, there are significant barriers that hold a collector back from doing it.
Cracking out an item is the physical process of taking it out of its slab through use of force. Like any arbitrage game, it represents risk. There’s the physical risk of damaging the item during the crackout process. There’s also the financial risk of receiving a lower grade or even receiving no grade if deemed counterfeit. Even if you receive the same grade, you’ve lost money because you had to pay the fee -- this is just like paying the premium on an option that you can’t/don’t exercise. So most collectors do not crackout every item that they submit for grading.
Crossing over your item is a legal way to re-appraise your items. It also hedges your risk. Let’s say you have a BGS 9.5 and want to cross it over. You would keep it in the BGS slab and send it to PSA for a crossover fee. Let’s say you have a requested grade of a PSA 10. If a grader determines that it is actually a PSA 9, then your only loss is the crossover fee. You have not lost any value below BGS 9.5. But if it is determined to be PSA 10, then you get the upside of the PSA premium.
Collectors say that the likelihood of a success crackout is 50%. For crossovers, PCGS says that the success rate is about 35%. The toughness and consistency of each third-party grader will continue to be tested through crackouts and crossovers. As long as Collectors Universe sticks with strict grading standards, their slabs should continue to command premiums in the marketplace.
Will the company grade more higher-value collectibles 10 to 20 years down the line?
The biggest concern from investors about Collectors Universe is their growth prospects. We break up these concerns into three categories (a) drivers of growth (b) constraints of growth (b) opportunities for growth.
Drivers of Growth
Growth is extremely valuable for Collectors Universe because the tangible ROIC is so high. The best way to understand growth is on a per unit basis. Revenue per unit is driven by two factors:
Take Rate
Declared Value Per Unit
The take rate represents the company’s pricing power. The long-term average take rate is approximately 2% for coins and 9% for cards. This is because the average coin is worth 8x as much as the average card. They have to compensate for less expensive items with higher take rates in order to cover their costs.
The take rate, which is an important driver of growth, has room to grow for a few reasons.
The take rate has not moved significantly over the past 10 years.
They don’t really compete on price. Most companies disclose that they “compete on price” in their Annual Reports, but Collectors Universe does not make such a statement. Instead, the company says that they compete on brand recognition, reputation for integrity, and responsiveness of service. They also say that “price is much less of a factor in the case of vintage collectibles” because high-end collectors and dealers would rather pay the highest fee than get the lowest grade and lowest for their collectible. A poor grade can mean thousands or tens of thousands of dollars in lost money. In fact, they don’t even have to compete for those high-end items; it just comes to them. “If people have vintage coins to grade, we will receive them. It's much like on the PSA side of our business... we don't have to go out and ask for those types of submissions. They sort of naturally come to us.” They do hedge these statements by saying that they have to be more price conscious for modern collectibles because that’s where the bulk of the volume is coming from.
Their PSA division has increased prices every year for the past 10 years, but the number of items submitted each year continues to grow at an even faster pace. The laws of price elasticity of demand tells us that the price has not reached its highest possible point if demand continues to grow.
The CEO tells us that the PCGS division has not fully leveraged its pricing power. “I guess the way I would sum it up is as long as you're doing everything else well… I think you can ask for a little bit more. I think in the past, we've been a little bit reluctant to utilize that leverage [that brand power]. And so looking forward, I think it's time for [PCGS to learn from PSA].”
For both divisions, the take rate has the strongest effect on RPU growth. Between the two divisions, PCGS benefits the most from an increase in take rate. All else equal, RPU would grow by 40% if the PCGS take rate rose from 2% to 3%. RPU would grow by 12% if the PSA take rate rose from 9% to 10%.
The Declared Value Per Unit (“DVPU”) represents the estimated price that a collectible is worth in the marketplace. Technology investors can think about DVPU like GMV. The take rate is exclusively controlled by management, but DVPU is mostly controlled by market trends. The only way they can control this lever is through positioning and incentives.
For example, PSA has one of the best competitive positions for vintage baseball cards. Vintage baseball cards are worth more than modern baseball cards because of their collectibility factors, rarity in population, and longer life spans (wherein values of the card increase every year). By finding other positions like this, they can increase their DVPU.
DVPU has the second strongest effect on RPU growth. Unlike the take rate, the DVPU input fluctuates greatly from year to year. One way to calculate trends in DVPU growth is from period to period. This is what I call a medium-term calculation. The table below shows the growth of DVPU in each 5-year period.
A medium-term calculation shows that coins have generally gone up in value from period to period. If we expand our time horizon, a long-term calculation indicates that DVPU for coins actually remained flat over the 2005 to 2018 period. And lastly, if we shrink our time horizon, a short-term calculation indicates that the DVPU decreased from its all time high in 2015, dropping from $1,000 to $700.
Some investors might only consider the medium-term view. Others will consider only one of the other views. And everyone else will choose some combination of the three. It’s all about knowing your own time horizon as an investor. Regardless of your time horizon, this question must be addressed, even if the answer is “I don’t know,” because PCGS makes up the majority of revenue -- about 60%.
Opportunities for Growth
We’ve looked at RPU growth. Now let’s turn our focus to unit growth. The market can be broken up into classic (also called vintage for the cards segment) and modern.
Coins made before 1965 are generally considered to be classic. Baseball, basketball, and football cards made before 1985 are generally considered to be vintage. Trading cards from games like Pokemon and Yu-Gi-Oh! that were made in its first five years are generally considered to be vintage.
Classic / vintage items represent the most attractive opportunities for Collectors Universe. The price of these are in the thousands, tens of thousands, or even hundreds of thousands dollars due to their scarcity. The problem is that demand for grading those items is unpredictable.
The company believes only 10% of US classic coins and US vintage cards have been graded by third-party graders. These figures imply that there are at least 1.5B high-end, vintage coins and 1B high-end vintage cards in the market. The reality is that these items don’t make up the majority of submissions; modern ones do.
There are two commonly held beliefs why vintage items are not the most popular submissions. Your investment decision hinges on the perspective that you hold.
First, there actually might not be 1B+ items. The company’s estimated TAM for those vintage items assumes that every item is worthy of grading. Most vintage items do not make economic sense to grade. After decades of wear and tear, they become in such poor condition that the value of the item becomes nearly worthless. There’s a big disparity in price if you receive a PSA 6 versus a PSA 7. Let’s assume that only 30% of all of those will be worthy of grading. That’s 300M vintage coins and 450M vintage cards. While this number is still large, it’s much smaller than the 1B+ implied market.
Second, the total market penetration of vintage items might actually be higher than 10%. There is not a compelling reason to keep a perfect Morgan Silver dollar in its raw form. There are very compelling reasons to grade your Morgan Silver dollar as soon as possible if you have a good looking coin. It’s true that some collectors prefer raw items, but most people wouldn’t take that financial risk with a perfect vintage item. There is the chance that your item will get scuffed up and/or drop in value due to market trends. Collectibles do not always go up in value. If we believe that the penetration of vintage items is higher than 10%, then we can reasonably conclude that the most vintage items being graded come from collectors who are re-slabbing, not grading from raw.
If you hold the first perspective, you believe Collectors Universe has great prospects to grade more higher-value units. If you hold the second perspective, you believe the only possible way the company can grade more higher-value units is through the modern market.
Modern items make up the majority of submissions. 80% of PSA’s backlog are modern cards.
Between the two, the modern coin market is more spotty than the modern card market. There is only one manufacturer for coins in the US: the US Mint. If the US Mint doesn’t make coins that are attractive to speculative coin collectors, then third-party graders will see less demand
Success as a third-party grader in the coin industry relies solely on the success of the US Mint. If the US Mint doesn’t make coins that are attractive to speculative coin collectors, third-party graders will process less coins. The US Mint sells about six million coins every year.
In the card market, Collectors Universe has at least seven channels to grade modern cards: MLB, NBA, NFL, NHL, Pokemon, Yu-Gi-Oh!, and Magic the Gathering. The modern card market is also booming thanks to pack rippers. The prices of modern cards have grown at a much faster rate than modern coins. Combined, these companies sell many, many more items than the US Mint.
Another way to think about market opportunities is domestic and international. The company’s first international move was through PCGS when they set up offices in Paris and Hong Kong. The most promising opportunities exist in Shanghai, China for PCGS and Tokyo, Japan for PSA. Experts say that these markets alone could be bigger than its respective domestic markets. Fortunately, consumer behavior in international markets is pretty similar to consumer behavior in the United States so the company does not have to make any drastic changes to their strategy.
Constraints on Growth
Collectors Universe has a huge throughput problem, which has hindered their ability to grow. The problem is caused by hiring struggles, training challenges, and operational inefficiencies.
The company currently employs 71 collectibles experts who grade and authenticate items. 39 work for PCGS and 27 work for PSA -- the remainder work in the PSA/DNA division.
The average expert grades about 75,000 items per year, or 300 per business day. That means an expert has to be able to grade an item in about 70 seconds. Finding specialized professionals who can accurately grade an item under 70 seconds is challenging.
Grading is an extremely niche career path only suited for certain types of people. First, they need to be interested in collectibles markets. That’s already a small starting point. They also need to be interested in grading, which reduces that size even more.
There are many collectors who have outspokenly said they would never want to be a grader, even though they enjoy grading their own cards for their collections. Most collectors don’t think it’s all that is cracked up to be. The general perception is that graders are treated like slaves and earn poor salaries. My back-of-the-envelope math indicates that a grader’s starting salary begins around $70K and can be as high as $250K. The drastic difference from perception and reality means that third-party grading companies have an uphill battle to climb.
There’s also another reason why experts are hard to find. The best graders are usually successful collectors or traders. These people are making much more than $250K. So the most qualified people for the job have very little financial incentive to become a grader.
The company has tried to combat this by building a “Minor League” system. The CEO believes that an internal recruiting system that funnels employees from other departments into their grading department will serve as a competitive advantage as they look to grow.
Getting employees in the door isn’t the only issue though. It’s also training. Historically, the average expert has about 25 years of grading experience. Since 2016, that number has dropped to 12. Collectors Universe has tried to keep up with demand by hiring less qualified experts.
The company has also been slow to maximize the efficiency of their operations. It took the company nearly 30 years to realize that they could increase operational efficiency by bringing the two divisions under one roof and cross-training receivers and sealers. While the upgrade was really overdue, it has shown promising signs. In May of 2020, PSA had three consecutive weeks in which it took in more than 100,000 units at its Southern California facility. That’s 32,000 more than where capacity stood last fall.
A Metaphorical Valuation Method
Collectors Universe is a very unique company. It operates in an extremely small niche and its competitors are privately-held, so the valuation process will look a little different than, say, a large cap restaurant with many peers.
When we don’t have perfect peers, we can create “metaphorical” peers to create upper and/or lower limits of valuation. This is an exercise that I first learned in Venture Capital and studied more in-depth when I learned about Warren Buffett’s investment in See’s Candy and Joel Greenblatt’s investment in Moody’s.
What is a business that is needed for markets to function, operates in a duopoly structure, adds a premium with their brand, and requires very little capital to grow? That smells like a credit rating agency.
The Upper Limit
The most popular credit rating agencies are Moody’s and S&P Global. The essential purpose of these credit rating agencies is to put their stamp of approval on debt so that the debt can be marketed more easily (liquidity premium) and at a higher price (marketability premium). They serve the same purpose as third-party graders in the collectibles market.
Credit rating agencies are similar in other ways too. They rely on highly-trained, well-paid experts to grade their client’s securities. MCO and SPGI have a combined average ROTA of 95%, which is nearly equivalent to Collectors Universe. Their growth is also directly linked to the vitality of the market.
Credit rating agencies serve as the upper threshold for the valuation of Collectors Universe. There are many ways that credit rating agencies are superior to third party graders.
Their position is more durable. They have support from regulation which helps them maintain their competitive position. They are also not consumer-facing, so any headline-worthy mistakes on grading will not impair their customer relationships.
Their unit economics are stronger. They generate 70% gross margins, 40% EBIT margins, and 30% FCF margins.
Their growth is also a little more predictable. The debt market is driven by sophisticated clients/banks who have a financial incentive to issue as much debt as they can. The collectibles market is mainly driven by casual collectors whose decisions waver between appeal and trade. Credit rating agency revenue has historically grown around 12% every year.
To summarize, credit rating agencies are high-quality businesses: they generate nearly free growth, offer strong growth prospects, and command permanent competitive positions in their core business. Third party graders are above-average quality businesses: they generate nearly free growth, but their growth prospects have more hurdles and their competitive position is durable but not permanent.
An average quality business typically trades at 10x EV/EBIT. Both credit rating agencies currently trade at 27x EV/EBIT. Their long-term multiple has floated around 18-20x.
A Caveat in Valuation
In the month of June 2020, Connor Haley, Managing Partner at Alta Fox Capital published an Open Letter to Shareholders regarding Collectors Universe. As a 5% shareholder in the business, he believes significant opportunities exist within the control of management, and mainly the Board of Directors, to unlock substantial value for all shareholders.
He identifies the board’s lack of interest and ownership in the company as reasons why the company has failed to improve its margins through technological capabilities, capture non-core growth opportunities, and allocate capital towards the right initiatives.
At the upcoming Shareholder Meeting, Connor is offering to replace the board with his own slate of directors. Connor, along with potential board member Nate Turner, major position took place between April through June.
Before Connor’s announcement, Collectors Universe was trading at 11x EV/EBIT. The company currently trades at 22x EV/EBIT. The long-term multiple has floated around 14x.
Key Questions
I’ve spoken both to Joe Orlando and Connor Haley. Objectively, it seems like Connor’s views on the business do not differ greatly with Joe’s. Joe is already pursuing many of the things that Connor has proposed. The difference is the rate of the execution. With the proposed board slate, Connor believes he can surround Joe with the people he needs to create more value at a faster rate. So here’s three last questions to consider before calculating your own value and making your own investment decisions:
Before Alta Fox’s letter, was Collectors Universe worth the price of an average business, the price of a credit agency, or somewhere in between?
How much more would those post-letter future cash flows be worth? 1.5x, 2x, 3x?
What is the probability that Alta Fox succeeds in replacing the board?
Thank you for reading. I hope to sharpen my skills every month and develop meaningful relationships along the way. What points do you agree with? What points would you like to share your own perspective?