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Macmahon: Mining Services Company in Successful Turnaround

May 29, 2018 in Asia, Asian Investing Summit, Asian Investing Summit 2018, Asian Investing Summit 2018 Featured, Audio, Deep Value, Equities, Materials, Micro Cap, Small Cap, Special Situations, Transcripts

Steve Johnson of Forager Funds Management presented his in-depth investment thesis on Macmahon Holdings (Australia: MAH) at Asian Investing Summit 2018.

Thesis summary:

Macmahon Holdings is an ASX-listed mining services company with a large and growing business in South East Asia. The stock has rightly been punished for the sins of the past, but the new management team and a solid order book are underappreciated by the market. Based on Steve’s estimates, the shares trade at an enterprise value multiple of 6x 2018E EBIT. Steve expects EBIT to continue growing in 2019 and beyond.

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About the instructor:

Steve Johnson serves Forager’s Chief Investment Officer. He has a Bachelor of Economics (Econometrics and Finance) from the University of New South Wales and is a CFA® charterholder. He enjoys marathon running in his spare time and lives with his wife in Sydney, Australia. Steve has a monthly column in the Australian Financial Review and regularly appears on Sky Business, the ABC and CNBC.

A Tougher Game, and Perhaps Even a New Game

May 24, 2018 in Commentary, Letters, Wide-Moat Investing Summit, Wide-Moat Investing Summit 2018, Wide-Moat Investing Summit 2018 Featured

This article is authored by MOI Global instructor Dan Sheehan, managing partner of Sheehan Associates and Credit River Value, LP.

Lengthy bull markets, especially when they have spread far and wide, tend to create challenges for our investing approach. For one, it usually becomes increasingly difficult to find new investments selling for prices that I find attractive. And while we may still get adequate returns—from sticking with investments that were bought when prices were more attractive—modest outperformance relative to the indexes, and perhaps keeping pace with Berkshire, is the best we can hope for. Let’s consider a few parameters to see why this is true:

I’d estimate that our current investments—in aggregate and on average—are likely to increase in value by about 8% annually over the next 10 years. And given that my estimate for the S&P 500 and TSX is closer to 6%, this would be no small achievement. Furthermore, an 8% return for the partnership means 7.5% net to you (or at best 7.75%, where the lower allocation applies), so any potential outperformance would be limited. And in the case of Berkshire, which I estimate will average about 9%, we would almost certainly underperform.

(FYI: Since SA’s inception on September 1st of 1999, the S&P 500 and Berkshire have returned 5.9% and 8.7% respectfully, compounded annually and as measured in U.S. dollars.)

The only way we can avoid that fate is to find more rewarding opportunities. The good news is that we tend to bet big, so we don’t need many. But we do need a few, and the last 5 years has been my longest dry spell, by far. Let’s look at how this could impact our results.

First imagine an investing environment where we could, on average, do the following: turn-over what we own every 3 years; buy at 50% of intrinsic value; have what we own increase in value by 8% annually; and then sell at 90% of value. The happy outcome of all those dreams coming true would be a Buffett like return of 31%.

Now let’s envision a world where Buffett groupies (takes one to know one) have spanned the globe, all doing their best to follow his lead. In that end-of-days scenario, opportunities are likely to be much harder to find; and turning our holdings over every 10 years, buying at 66% of value and selling for the same 90% may be the best we could hope for. The outcome, while not terrible, would be a much more pedestrian 11% annualized return, with most of the return (8 out of 11) coming from growth in the value of the businesses. As for my contribution, well, at least the mail wouldn’t pile up as much.

Interestingly, in both instances we are working with the same material (equities providing an 8% tailwind). And while maintaining either one of the two elements (buying at 50 vs 66% of value, or three vs ten year holding periods) increases the returns, the real magic happens when you are lucky enough to get both.

Sadly, today’s world feels a lot more like the latter than the former or when SA got started. Back then, the cohort making the trip to Omaha each year was smaller and for a short time, may have even been shrinking. And while we can always hope for some type of event that brings back the glory days, I fear the odds are no better than those of our Northern PM passing on a photo-op. So we should adjust our expectations to what is likely our new reality: a world where competition has increased, such that an 11% return may be just as much of an accomplishment, as 31% used to be. (Search: The Paradox of Skill by Michael Mauboussin for a better explanation).

This also explains why I have lowered my investment goal—but still, by no means promise—to beating the S&P 500 and TSX by 6% and Berkshire by 3%. If, and that is a big if, we are able to do so and my expectations for their returns are correct, then your net returns would come in at 10.5% and still manage to outperform all three. Wish us luck.

Perhaps a New Game

Value investing, as a discipline, got its start thanks to Ben Graham. His approach focused primarily on buying at large discounts to value, with less regard for the quality of the businesses themselves. Buffett spent several years following Graham’s lead but then, in part based on necessity, he evolved, with quality becoming a much more important factor.

It is this second version, call it value investing 2.0, that we have practiced over the last 18+ years. And unlike Buffett, we have never had to adapt in order to succeed. That may no longer be the case.

Hyped up industries (think pot stocks) or even activities that deserve a less flattering moniker (cryptocurrencies) are nothing new and all just seem a bit dopey to me. But an approach to both running and investing in companies that appears to be working and is growing in popularity, has me feeling, for the first time, out of touch.

Ironically, this approach has managers and investors focusing on building and investing in businesses over the long term—something I have often cheered and said we are trying to do ourselves. But when the hoped for profits are stretched out in to an indefinite future, well that is when my resolve is tested. Yet, some of today’s leading and most beloved companies are pursuing just such an approach. And success spreads, as a number of smaller, less well known firms are following their lead.

In terms of sales and market share many of these firms have been widely successful, as have their shareholders. And in some cases these firms may well establish sustainable, dominant and profitable positions. But as far as I can tell, even if they can, in most cases this is more than baked in to their current stock prices.

On the other hand, it could also be that my skills are outdated and some new way of evaluating companies is required (version 3.0?). For now I am still hopeful, but if it becomes clear the game has indeed passed me by, your money will be returned.

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Data, the “New Oil”, Hits an Oil Slick

May 24, 2018 in Commentary, Equities, Ideas, Wide-Moat Investing Summit, Wide-Moat Investing Summit 2018, Wide-Moat Investing Summit 2018 Featured

This article is authored by MOI Global instructor Elliot Turner, managing director of RGA Investment Advisors.

While news of Facebook’s shoddy data practices broke with respect to Cambridge Analytica and the 2016 election, we were patting ourselves on the back for having bought an under-the-radar data company playing an integral role in the online marketing ecosystem. Almost immediately after purchase, our shares in Acxiom were trading higher, until the last day of the quarter when Facebook decided to cut off Acxiom’s data broker as a third-party data provider on Facebook. The stock plummeted and at its worst was down over 40% from the prior week. Nonetheless, our conviction in Acxiom remained steadfast amidst the panic and we have since purchased more shares and dropped our average price accordingly.

This entire situation is one of the more unique and exciting ones we have seen in recent times. Before the Facebook news hit, Acxiom was lifting off on the heels of its intent to sell its legacy business—Acxiom Marketing Solutions—leaving its Connectivity segment (LiveRamp) as a standalone, pureplay growth company in an intriguing industry. Acxiom will surely lose some business from the Facebook change, but the vast majority of the value in this investment comes from the LiveRamp segment—a largely hidden jewel within the broader company. Acxiom acquired LiveRamp in 2014 and has scaled the business rapidly since.

LiveRamp is what is known as a data onboarder. Data onboarders help companies store, manage and use their data in constructive ways. A 2014 FTC report on data brokers defined “onboarding” as follows:

“Onboarding” refers to a process whereby a data broker adds offline data into a cookie (the process of onboarding offline data) to enable advertisers to target consumers virtually anywhere on the Internet. It allows advertisers to use consumers’ offline activities to determine what advertisements to serve them on the Internet.

Onboarding clients either (1) provide data about their customers to a data broker to facilitate the process of finding those consumers on the Internet to deliver targeted advertisements; or (2) use a data broker to identify an audience of consumers who are likely to share particular characteristics and find those consumers on the Internet to deliver advertisements. Three of the data brokers offer an onboarding product.

Onboarding typically includes three steps: (i) segmentation; (ii) matching; and (iii) targeting.[1]

There are elements of this definition that are not entirely accurate and nuances to how onboarding is deployed, but LiveRamp is essentially the only onboarder with robust offline to online capabilities. This being central to the FTC’s definition is demonstrative of how dominant LiveRamp is in the space. Importantly, it’s the kind of industry where network effects are key determinants of customer stickiness and growing value. The more data an onboarder has, the better its match rate will be (LiveRamp’s are the best) and the more use-cases that can be deployed on the platform. LiveRamp boasts a market share over 2x the next largest competitor and importantly, the key competitors including Oracle’s OnRamp (purchased in the $1.2b Datalogix acquisition in 2015) and Neustar are both heavily reliant on LiveRamp as key customers. Essentially, LiveRamp competitors cannot compete without access to LiveRamp itself and the role of competition has been relegated to either white labeling LIveRamp’s pipes or serving specific niches with unique, but not scalable value propositions.

LiveRamp makes money by charging its users subscription fees and tiered pricing depending on use. The majority of revenue comes from usage fees, and as such, the more use-cases LiveRamp can develop, the more it can grow its relevance and revenue base from customers new and old alike. Once the disposition of AMS is complete, LiveRamp will enjoy enhanced financial flexibility to deploy in developing and acquiring tuck-in applications that can expand the capabilities users will have on the platform. A recent example of such a move is the company’s acquisition of Pacific Data Partners to grow the B2B use-cases for LiveRamp.[2]

LiveRamp has been nurtured under smart, strong leadership. Scott Howe, Acxiom’s CEO, came to the company in 2011 from Microsoft, where he was the company’s top ad executive in charge of advertiser and publishing solutions, including Bing. As Howe explains, “The Axiom I walked into four years ago was really a legacy direct-mail database company but had developed some really great assets that could be extended to other channels and can be repurposed for the entire industry, and that’s the transition we’ve been making over time.”[3] Howe’s CFO, Warren Jenson, was an early CFO at Amazon where he is credited with helping lead the company to profitability in the wake of the dot com bust. The management team has been focused and determined in driving shareholder value and has held on to a material equity position in order to position for the upside they ultimately intend to achieve.

While we have adjusted our expectations for the full brunt of the Facebook hit, we think there are very real mitigants to this loss. Companies like General Motors which advertise on Facebook by nature rely on third party data—dealers sell the cars, not GM, so as such, GM needs to stitch together a profile of its own end customers. In the past, Facebook enabled Acxiom’s data to be sold directly on the platform.That will stop in the second half of this calendar year; however,this revenue can be replaced in the following process, by way of example:

  • GM can now buy this data directly from Acxiom.
  • GM can then create its own custom audiences, in its own files
  • GM can upload those newly created customer audiences as “1st party data” for Facebook’s purposes
  • Advertisements can be targeted exactly as they had been on Facebook before

LiveRamp’s revenue run-rate has grown from $16m annualized in Q1 of 2015 (shortly after Acxiom acquired it) to $224m annualized in Q3 of 2018. The average customer spends over $1.7m per year on the platform and revenue retention is at 110%. At the shares’ worst price on Friday, March 30th, we think LiveRamp itself was worth more than the entire company even though the legacy company will do around $130m in EBIT after accounting for the Facebook hit.

If the AMS business fetches 4-5x EBITDA, the company will get between $1 and $1.4 billion in proceeds. Despite the Facebook news, the Acxiom remains intent on selling its AMS business and focusing purely on LiveRamp. Should a sale not materialize (though the company sounds confident it will) they can consider a spinoff instead. One way or another, LiveRamp will come to be independent in the near future. It’s large enough, self-sustainable on its own cash flow generation, and poised to benefit from strategic flexibility and customer relationships that were limited by its corporate parenthood. Assuming AMS fetches the low-end of our expected proceed range, that leaves half of the company’s value to be accounted for by a $224m run-rate business growing at rates upwards of 40%, likely to grow in the mid-30s for the upcoming year, with the potential to reaccelerate growth with the strategic flexibility afforded by being a standalone pure-play. Our bear case on a sum of the parts is that Acxiom is worth $27 per share, base case is $40 per share and bull case is $58 per share. Looking out further, standalone LiveRamp has the potential to capture a large and growing total addressable market and will very likely catch the eye of the well-capitalized behemoths who facilitate online advertising with their software solutions. It’s only a matter of time before this Facebook news is far in the rearview mirror.

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Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

Untapped Pricing Power in a Global Low-Cost Producer

May 24, 2018 in Diary, Letters, Wide-Moat Investing Summit, Wide-Moat Investing Summit 2018, Wide-Moat Investing Summit 2018 Featured

This article is authored by MOI Global instructor Gautam Baid, portfolio manager of Summit Global Investments.

“Within the growth stock model, there’s a sub-position: There are actually businesses that you will find a few times in a lifetime where any manager could raise the return enormously just by raising prices – and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer.” –Charlie Munger

A business that can increase prices at a rate that only offsets inflation is good, but not exceptional. While it is good to identify a business that has consistently raised its prices, it might actually be better to find a business that has not raised its prices in a long time for one reason or another, thus causing its product or service to become underpriced and undervalued to customers. This situation creates a sort of pent-up pricing power that can be released in the form of future real price increases for a certain period of time.

Real pricing power indicates an inefficiently priced product or service. This undervaluation is a source of great potential value as the business begins to price its product or service more efficiently, i.e. raise prices in real terms.

Just like we search for undervalued or mispriced stocks, we should also be on the lookout for undervalued or mispriced products or services which have “untapped” pricing power, as both situations eventually tend to correct themselves. Significant value can be unlocked for the owners in such situations.

Low-cost producers can sell their product or service at a lower margin than competitors and still operate profitably due to the large volume of customers. A good example of a low-cost producer is GEICO, the direct seller of automobile insurance to Americans. GEICO has the lowest operating costs in its industry primarily because it sells directly to its customers instead of hiring insurance agents. Buffett has often described GEICO’s cost advantage over its competitors as a strong moat – “Others may copy our model, but they will be unable to replicate our economics.” The more customers that buy from a low-cost producer, the more its cost advantage moat widens over time, creating a “flywheel” that accelerates as the business grows.

At Wide-Moat Investing Summit 2018, I will be presenting an investment opportunity which is a global low-cost producer with significant untapped pricing power.

I look forward to sharing my thoughts and insights and engaging in collaborative learning with our community.

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Bank of Baroda: Government-Owned Bank with Strong Management

May 22, 2018 in Asia, Asian Investing Summit, Asian Investing Summit 2018, Asian Investing Summit 2018 Featured, Audio, Deep Value, Equities, Financials, Macro, Mid Cap, Small Cap, Special Situations, Transcripts

Rahul Saraogi of Atyant Capital Advisors presented his in-depth investment thesis on Bank of Baroda (India: BOB) at Asian Investing Summit 2018. Rahul set the stage by providing a “big picture” and “small picture” perspective on India and discussing the sectors he finds particularly attractive.

Summary thesis:

Bank of Baroda is a top five government-owned bank in India, with 5,500 branches and a growing retail franchise. The bank has conservative accounting and is likely overprovisioned. It has strong management and culture. Pre-provision ROIC has consistently exceeded 18%. The bank is available at an attractive valuation despite strong growth ahead.

Rahul believes the risk of government interference is overblown and excessive dilution risk and uneconomic consolidation risk are now behind the bank. According to Rahul, the bank has a “bulletproof” liability franchise, with a cost of 5.3%. The bank is adequately capitalized and ready for the credit cycle.

The equity market cap recently amounted to $5.8 billion, as compared to book value of $6.6 billion. Rahul expects book value to double over the next three years. Assuming a price/book multiple of 1.75x, the shares could yield a 4x return over three years.

Read a related article by Rahul on investing in government-owned banks.

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About the instructor:

Rahul Saraogi is the founder and managing director of Atyant Capital Advisors, advisor to the Atyant Capital family of funds. In the last 18 years he has focused on the Indian markets. His mission is to consistently identify the best 10-15 investment ideas from among the thousands of publicly-traded Indian corporations. Rahul’s value-based investment philosophy stands apart due to his belief in the paramount importance of corporate governance, specifically how management operates with its minority shareholders in mind. Rahul is the author of Investing in India: A Value Investor’s Guide to the Biggest Untapped Opportunity in the World, a definitive guide on navigating the Indian markets published by John Wiley & Sons. Rahul graduated from the Wharton School of the University of Pennsylvania with a degree in Economics. Outside of Atyant, he practices Vipassana, a 2,500 year-old meditation technique that helps people see things as they really are. Rahul splits time between Chennai, India and Miami.

Alex Kinmont on the Macro Backdrop for Value Investing in Japan

May 22, 2018 in Asia, Asian Investing Summit, Asian Investing Summit 2018, Audio, Communication Services, Equities, Macro, Transcripts

Alexander Kinmont of Milestone Asset Management discussed the macro backdrop for value investing in Japan at Asian Investing Summit 2018.

Alex argues that Japan’s economy is slowly pulling out of a two-decade slump. Growth appears likely because Japan is (at last) a competitive locus for capital investment: The Yen is fairly valued for the first time in a generation, and Japanese labor is cheap in an international context.

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About the instructor:

Alexander Kinmont is the CEO of Milestone Asset Management, a Tokyo-based independent asset manager. Milestone offers both long-only and long-short value strategies to institutional investors. It does not employ leverage. Milestone is focused on valuation discrepancies, not just statistically inexpensive stocks. It is guided by a value philosophy which emphasizes minimising the risk of permanent loss of capital. Prior to starting Milestone, Alex headed Japan equity strategy at Morgan Stanley MUFG in Tokyo. He began his career at Daiichi Securities in 1985. Alex graduated from the University of Oxford with a Masters Degree in Literae Humaniores (Latin and Greek Literature and Ancient History) and is fluent in Japanese.

Jammu & Kashmir Bank: Leadership in J&K Provides Cheap Deposit Base

May 22, 2018 in Asia, Asian Investing Summit, Asian Investing Summit 2018, Asian Investing Summit 2018 Featured, Audio, Equities, Financials, GARP, Small Cap, Transcripts

Rajeev Agrawal of DoorDarshi Value Advisors presented his investment thesis on Jammu & Kashmir Bank (NSE: J&KBANK) at Asian Investing Summit 2018.

Thesis summary:

Jammu & Kashmir Bank has 60+% market share in the geography in which it operates, Jammu & Kashmir (J&K) state in India. The bank lost its way over many years by venturing into areas in which it had no competitive advantage. The bank appointed a new CEO one-and-a-half years ago. The CEO has cleaned up the books and re-focused operations on areas in which the bank possesses competitive advantage. This, along with improvement in economy, resolution of stressed assets, and government support, positions the bank well going forward. As provisions subside and earnings show through in the coming years, the shares may be revalued by investors. According to Rajeev’s fair value analysis, which is based on 9% asset growth and 0.9% ROA assumptions, the bank may trade at more than twice the recent stock price (after dilution of 25%) by the end of fiscal year 2021.

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About the instructor:

Rajeev Agrawal is the Founder and Managing Partner at DoorDarshi Value Advisors. Rajeev has been investing in the US and Indian equity markets for 15+ years. Rajeev follows Value Investing principles and finds that Indian equity market provides wonderful opportunities for his style of investing. Prior to starting DoorDarshi, Rajeev was a Technology executive focusing on the Financial Industry. He retired from IHS Markit as MD and CTO. Prior to that he has worked in US in various senior positions at Goldman Sachs, Bank of America, JP Morgan and Dresdner Bank. Rajeev completed his B.Tech from IIT Bombay and MBA from IIM Calcutta. He is also a CFA charterholder.

How to Lose Money: Top Five Mistakes of a Value Investor

May 21, 2018 in Commentary, Wide-Moat Investing Summit, Wide-Moat Investing Summit 2018

This article is authored by MOI Global instructor Gary Mishuris, managing partner and chief investment officer of Silver Ring Value Partners.

Gary is an instructor at Wide-Moat Investing Summit 2018.

In my article How to Lose Money in the Stock Market: The Top 5 Mistakes, I sought to teach you what not to do when investing by answering the following question: What is the most certain way to lose the most money investing in stocks?

As a refresher, the five most certain ways to lose money in the stock market that I identified were:

1. Invest in Bad Businesses
2. Invest with Bad Management Teams
3. Invest in Companies with Too Much Debt
4. Pay Too High a Price
5. Focus Only on the Short-Term

Now, I want to share with you my own mistakes in each of these categories from my 15+ years of professional investing experience that have taught me valuable lessons. My hope in sharing these with you is to help you avoid making these mistakes yourself.

Avoid Investing in Bad Businesses

About fifteen years ago, as a young equity analyst, I recommended that the large investment firm that I worked for invest in a company’s stock. It was a cyclical business, and I carefully analyzed the past financial statements and made what I thought was a well-reasoned estimate of the future mid-cycle earnings power of the company. Over a decade hence and with the full benefit of hindsight, I realized that I had been off… by a factor of 10x!

How is it possible to be off by so much? Well, it turned out that the future was quite different from the past that I was relying on in my analysis. While this is always a risk, the magnitude of the deviation from past financial results was driven by the low quality of the business – its operations were in tough industries in which it had only very marginal, if any, competitive advantages. This made it unable to cope with the negative changes that the industry experienced after my investment recommendation, and caused the earnings of the business to permanently collapse.

The lesson learned? A business with no competitive advantage can have future economic characteristics that are drastically different from those it had in the past. What is worse, the direction of any unexpected changes in profitability is likely to be negative. This can make estimating the value of such unpredictable businesses an exercise in overconfidence and futility, and is thus better avoided barring extremely unusual circumstances.

Avoid Investing with Bad Management Teams

While managing the Focused Value strategy at my last firm prior to founding Silver Ring Value Partners, I came across a small consumer goods company. The stock was very inexpensive relative to historical earnings and cash flow, and the business seemed to be good enough, with decent niche brands that had high market share within their categories. As I studied management’s communication and actions over the years, I became somewhat concerned by the lack of focus on maximizing value per share, and instead a focus on growing the business. I put aside that concern, in part because I saw that the two brothers who were the main executives at the firm owned a very large amount of stock. This gave them a fair amount of control over the company, and I thought it would also align their incentives to act rationally. Unfortunately, I was wrong. Management kept underperforming operationally, and what’s worse, it started deploying capital into large acquisitions. Management openly admitted after the last of these deals that they didn’t have any idea what the return on the investment would be. I was forced to reassess the value of the company, and this caused me to sell the stock. Fortunately, the low initial purchase price resulted in this being essentially a break-even investment as opposed to a big loss, but that was still a poor outcome.

The increase in profits that I anticipated never materialized. Looking back on this investment today, the earnings of the company are far lower than I originally thought they would be when I made the purchase, and also lower than the company’s historical profit levels despite a healthy economic environment. The stock is currently ~ 15% lower than when I sold it, despite the overall market increasing substantially during the intervening two years.

The lesson learned? The best predictor of management’s future behavior is its past behavior. When a management team shows lackluster capital allocation skills in the past, it is unlikely to become good at capital allocation in the future. What’s more worrying is that if the business encounters any challenges, the management’s lack of acumen can cause substantial value destruction for the company. While large stock ownership is an important means of aligning incentives with the shareholders, it alone is insufficient to guarantee a management team capable of and interested in maximizing long-term intrinsic value.

Avoid Investing in Companies with Too Much Debt

Also at the beginning of my investing career, I was recommending purchase of another stock. This company had a somewhat stretched balance sheet, but not so much so that I thought it was going to be a problem given that the then current credit metrics were OK. Right before Christmas, the company pre-announced a major earnings disappointment due to weakening demand trends, suspended its dividend, and announced that its expectations for next year’s results were now substantially below last year’s profit levels. With this revised view, the credit metrics were no longer OK at all.

That night, I woke up in the middle of the night very agitated, and I kept repeating just one word: “EBITDA! EBITDA!” (Earnings before Interest, Taxes, Depreciation and Amortization.) As I fully woke up, I remembered the dream that I was having – the bank group which had lent this company money was considering forcing it into bankruptcy due to non-compliance with the loan covenants, and I had been arguing with them for forbearance based on the company’s future levels of profitability.

The lesson learned? When the balance sheet of a business with no competitive advantage carries what seems like an appropriate amount of debt in a benign business environment, it leave no margin of safety for adversity which can quickly impair the company’s profitability and cause the balance sheet to become unhealthy quite rapidly.

Avoid Paying Too High a Price

Three years ago, while managing the Focused Value strategy at my last employer, I came across a company with a very strong brand in the apparel space. The stock had already declined by a meaningful amount, and was now trading at a low ratio relative to its historical profits. As I did additional work, it became apparent that some of the reasons for the decline in profits were not temporary and were the result of structural industry changes and company-specific brand challenges. Management was trying to implement a plan to turn the business around to restore past profitability, and was well incentivized to maximize long-term value. That stock was not yet cheap on the then-current earnings, but I judged it to be substantially undervalued if the turnaround materialized.

I made a small investment in the stock, as the combination of business quality, management quality and a strong balance sheet led me to believe that it was undervalued relative to my range of intrinsic values for the company. Unfortunately, fundamentals continued to deteriorate, and the turnaround has failed to materialize thus far. When I left my prior employer to start Silver Ring Value Partners in 2016, I reassessed all of the investments with a fresh perspective, and this led me to not include this stock in my new portfolio. So far, this has been a good decision as the company has fired its CEO, fundamentals continue to track below expectations, and the stock is down substantially despite the overall market being up.

The lesson learned? Had I been more patient initially and waited for a stock price that was low not just relative to an outcome that I thought was likely, but also low relative to the current trajectory of the business without a turnaround, I would have had a higher margin of safety. This would have allowed me to lose less money even in the scenario where the likely turnaround that I was expecting failed to materialize. Price is the only variable a passive outside investor can fully control, and it is very important to be extremely patient to wait for one that offers a large margin of safety relative to the company’s intrinsic value.

Focus on the Long-Term, not on the Short-Term

When I started investing in my own account while studying at MIT, I came across a brokerage report about a company of a then well-known branded apparel manufacturer. The report highlighted the short-term prospects for sales growth, and the likely upward direction this was going to result in for the stock price. This was shortly before I had the opportunity to listen to Warren Buffett speak on campus and became a value investing convert. Back then, I didn’t really know what I was doing, and I quickly became excited about the company and bought a small number of shares.

The short-term sales growth that the brokerage report touted never materialized, and the business continued to weaken. Its brand became less relevant with customers, and it lost market share and retail shelf space. As a result, its profits declined, and the stock declined as well.

 Lesson learned? Thinking about where the business is heading long-term is more helpful when investing in the stock market than trying to anticipate short-term trends. Additionally, I learned never to rely on the work of others, and always do my own research to validate the attractiveness of an investment

One of my favorite sayings is: “When a man with money meets a man with experience, the man with money leaves with experience and the man with experience leaves with the money.” My hope in sharing some of my mistakes and the lessons that I learned from them with you is that these insights will help you be a better investor and avoid making some of the same errors that I had to learn how to avoid through painful experience. Value investing can be very rewarding when implemented properly, but it is far from easy to do so. Hopefully reading this will help you improve as an investor.

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The information contained herein is provided solely for informational and discussion purposes only and is not, and may not be relied on in any manner as legal, tax or investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any fund or vehicle managed or advised by Silver Ring Value Partners Limited Partnership (“SRVP”) or its affiliates. It is not to be reproduced, used, distributed or disclosed, in whole or in part, to third parties without the prior written consent of SRVP. The information contained herein is not investment advice or a recommendation to buy or sell any specific security. The views expressed herein are the opinions and projections of SRVP as of May 29th, 2017 unless otherwise noted, and are subject to change based on market and other conditions. SRVP does not represent that any opinion or projection will be realized. The information presented herein, including, but not limited to, SRVP’s investment views, returns or performance, investment strategies, market opportunity, portfolio construction, expectations and positions may involve SRVP’s views, estimates, assumptions, facts and information from other sources that are believed to be accurate and reliable as of the date this information is presented—any of which may change without notice. SRVP has no obligation (express or implied) to update any or all of the information contained herein or to advise you of any changes; nor does SRVP make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. The information presented is for illustrative purposes only and does not constitute an exhaustive explanation of the investment process, investment strategies or risk management. The analyses and conclusions of SRVP contained in this information include certain statements, assumptions, estimates and projections that reflect various assumptions by SRVP and anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and contingencies and have been included solely for illustrative purposes. As with any investment strategy, there is potential for profit as well as the possibility of loss. SRVP does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk and investment recommendations will not always be profitable. Past performance is no guarantee of future results. Investment returns and principal values of an investment will fluctuate so that an investor’s investment may be worth more or less than its original value.

Media/Telecom: Usual Suspects Still Hated… But CHTR Now a Special Guest

May 19, 2018 in Equities, Letters

This article is authored by MOI Global instructor Patrick Brennan, portfolio manager of Brennan Asset Management.

Investment banking and real estate are the proverbial “cool kids” compared with this ostracized loser in the minds of investors. While we sound like a broken record, we think the following discussion is warranted, given our substantial exposure to this most hated of areas. To quickly recap, Liberty LILAK trades roughly 15-20% below the levels where John Malone purchased $37 million worth of stock last summer and ~7.3x 2018E EBITDA assuming Puerto Rican EBITDA 55% below 2016 levels. Prior to LILAK’s acquisition, Cable & Wireless disposed of a large number of subscale systems far worse than existing holdings at higher multiples…and obviously Chile is worth far more. While periodic blackout announcements suggest that Puerto Rico’s electrical grid is still fragile, substantial progress has been made since the start of the year. LILAK’s commentary regarding its anticipated year-end Puerto Rican run rate was well ahead of our estimates.

Meanwhile, across the pond, press reports confirmed Liberty Global is in talks with Vodafone over certain continental assets (Germany and Central/Europe and maybe 50% of Netherlands JV), yet investors keep selling. Adjusted for its minority interests/tax assets, LGI trades at roughly 7.8x 2018E EBITDA despite the asset sale discussions (and soaring pound and euro). The valuation is more incredible, given that the company sold its smaller Austrian operations for 11x EBITDA and likely will not sell its German operations for less than 11-12x. If LGI manages to sell Germany/CEE/Netherlands and if the share price does not move, the implied “stub” would trade at 5.8-6.2x, depending on assumed multiples. This metric is relevant as LGI will not be bashful in repurchasing shares. And then there is the ever loved DISCA. DISCA’s 2048 bonds still trade at par but somehow this investment grade company trades at ~5x our 2019E free cash flow per share. Meanwhile, formerly popular Charter reported strong fourth quarter results, including adding 15,000 video subscribers, but it has somehow fallen roughly 10% since the start of the year. By purchasing shares through GLIBA (formerly LVNTA), we estimate that we are buying CHTR shares near at an implied value of roughly $245. Please keep that number in mind when we discuss free cash flow per share a couple of years out.

Clearly, a new generation of video consumers watches far less linear television (i.e., a television set) and instead chooses to watch online video, Netflix, YouTube and other programming outside the traditional video cable package. It is also true that above-inflation increases for programming have driven video packages above the threshold of what certain users can afford or are willing to pay. While there is considerable debate on the speed with which these trends progress, there is little doubt they will accelerate over time and put additional pressure on the traditional cable video business. We do not dispute this fact set.

Instead, we simply dispute the degree of exposure to these risks. As discussed in past letters, video costs are vastly different outside the United States. Netflix’s positioning, while formidable, is not nearly as dominant as it is in the United States. Both LGI and LILAK can also drive growth through their broadband offering. Of the owned names, DISCA is the only content company and clearly the name most exposed to the cord cutting risks, but it has several offsets (library/synergies/international exposure, etc.) that we discussed in detail last quarter. We would also note that the tax reform provided a bigger benefit than many realize.

5G vs. Wireless Subscriber Gains: Which Sounds More Threatening?

The recent weakness in CHTR’s stock has been surprising to us. While cord cutting concerns are still present, many investors have previously been willing to accept that CHTR’s vastly higher-margin broadband growth story offers a substantial hedge in case video losses come faster than anticipated. We suspect that the more recent concerns generally center around threats to its broadband business from mobile broadband (5G1) and from some concerns about valuation levels, as CHTR is not as statistically cheap by cable investors’ preferred enterprise value/EBITDA metric.

In our 2017 Q1 letter, we discussed the multiple uncertainties surrounding setting the 5G standard, let alone the cost of any large scale rollout. CHTR executives have noted that the technology works well…when there is little rain, limited tree interference and clear visibility…a back-handed way of describing a fantastic in -the-lab product but perhaps a more difficult real-world application. CHTR CEO Tom Rutledge also noted that a full blown nationwide 5G rollout involving multiple small antenna would likely be as costly as a full fiber rollout. This is quite expensive considering the large dividends that Verizon (VZ) and AT&T (T) maintain, not to mention VZ’s less favorable experience with a fiber rollout (Fios). We also previously noted that it is tougher to interpret T’s planned acquisition of Time Warner or VZ’s reported interest in bidding for CHTR, as strong acts of confidence in the two companies’ standalone ability to compete with cable. Why issue shares if a new product will soon be able to take meaningful share in a ~90% gross margin business? And if this is not enough, Chinese telecom provider Huawei, a 5G pioneer whose supposed dominance in the new technology was cited as one of the justifications for blocking Broadcom’s acquisition of Qualcomm, recently noted at an industry conference that most consumers would not see any material difference between 5G and existing LTE service. Nevertheless, we suspect that Verizon’s rollout of 5G service in Sacramento later this year (quite a convenient location for us!) likely planted some doubt into certain cable investors’ minds. This may prove to be ironic, as it is conceivable that the required fiber backhaul needed for 5G services ends up being a substantial opportunity for the very cable names that the service is supposed to displace. And what if we are completely wrong and Verizon can successfully hit its 30 million home rollout target by 2022? Well, a recent report from Morgan Stanley suggested that roughly 0.5 million subscribers (representing 1% of CHTR’s cable EBITDA) would be threatened…in over 4 years.

Interestingly, the fear over 5G has likely diverted investor attention away from the substantial competition coming in the wireless space as CMCSA (currently) and CHTR (later this year) execute mobile virtual network operator (MVNO) agreements with Verizon to essentially rent their network and offer mobile services to subscribers.2 As we have previously noted, the mobile offering can substantially reduce churn and thus can be priced more aggressively versus a company trying to maintain 40%+ margins in order to protect its sacrosanct dividend. While one can read about pricing in analyst reports and stare at Excel models, we find it helpful to experiment with the underlying product. We recently became Comcast mobile subscribers after spending several hours on the phone with the company and its various competitors. We show the cost of unlimited versus shared plans for two people in the chart below:

All plans are pre-tax unless otherwise noted and are quoted for 2 lines and assume auto pay; per GB based upon data offering available (i.e., some offer 4GB, others 5G, others 8G).
1 Per GB=$100 for 5G
2 Per GB=$85 for 4G or $105 for 8G
3 Receive $10.99 Netflix subscription per month taking unlimited down to $109 – taxes are included. Including the value of each, the price would be approximately $100
4 Tmobile would not initially sell per gig; when we asked on CMCSA pricing, they offered us two lines for $100 at 2G per line or $25 per G
5 The “unlimited” plan covers 23G of data
6 Per GB=$65 for 4G; If a customer goes beyond 4G, he/she can purchase 1G for $15. Sprint fiscal year ends 03/31
7 CMCSA margins are for its cable business

As one might imagine, there are hurdles3 for the initial rollout, and CMCSA does not have its “A” marketing game together currently. There are separate bills for mobile versus cable, and CMCSA representatives were often less knowledgeable about their own product and even sent us to Xfinity stores that couldn’t handle mobile. That said, CMCSA’s offering is 31% cheaper than Verizon’s price on an unlimited basis and 9-44% on a per GB basis with the CMCSA plan having more flexibility to swap offerings. Again, CMCSA is using Verizon’s network for its service, so the two products are identical4. These marketing kinks strike us as far easier to work out versus a time consuming 5G rollout, especially when there are still concerns about whether the technology actually works. It is true that wholesale revenue will offset some of these customer losses, but not every carrier will have this revenue stream. If mobile prices decline industry-wide, it seems reasonable to believe that valuations will follow. If the cable companies can build any scale in mobile, perhaps they will have an opportunity to eventually snag wireless assets on the cheap. In Europe, LGI has achieved enormous savings in the markets (Belgium and Netherlands) where it replaces MVNO wholesale arrangements with an owned network.

The mobile companies are certainly not blind and will discount to protect their core business. VZ will offer content with its mobile product, while T will meaningfully discount DirectTV or HBO (the latter, assuming the TWX deal goes through). Both companies will lay some fiber and package their products in overlapping areas, but both need to keep substantial powder in order to continue funding the large dividends. Additionally, unlike Europe, US cell phone companies do not have nationwide fixed networks and generally have less densely populated coverage areas. If consumers are primarily interested in receiving higher-speed broadband offerings, it could prove challenging to attract and maintain customers no matter how much one discounts the copper. As just one example (often repeated across the country), we currently have download speeds of over 400 Mbps with our standard triple-play CMCSA package versus a comparable offering of 30 Mbps through AT&T. The offerings are simply incomparable, and therefore it makes a switch challenging, even at 50+ percent discount levels.

While it is far from clear that VZ could actually acquire CHTR (or that CHTR would have any interest in accepting…or that VZ could trump possible other bids for CHTR), it is worth considering which of the following is a worse outcome from VZ’s standpoint:

  • Making a wildly overvalued bid for CHTR, but securing a differentiated product offering (and longer-term dividend coverage)?
  • Facing questions from a coupon clipping shareholder base about dividend security if cable companies secure meaningful wireless market share?

We encourage readers to give some thought to the above when viewing cell phone bills.

How to Value an Unregulated Utility?

But what about valuation? CHTR currently trades at ~9.5x 2018E EBITDA, a level at the high end of historical trading ranges and above that of other cable companies. When CHTR first announced the acquisition of TWC in 2015, one could see a path towards substantial free cash flow as synergies were realized and capex declined over time. Given the owners, this cash flow stream was likely going to be used for share repurchases and therefore the per share metrics would skyrocket. Since that time, tax reform was passed, which not only lowered the underlying corporate tax rate to 21%, but also allowed the immediate expensing for tax purposes of the substantial capital investments. Or said differently, not only would the domestic cable companies pay a lower rate, but the actual amount of income subject to taxes was less because of the capex shield.

To go deeper into the weeds, say CHTR can generate something close to $18-$19 billion in EBITDA by 2020. CHTR had roughly $10.5 billion in depreciation last year, including $3-4 billion of non-deductible merger-related amortization that runs off at a declining rate. We show capex dropping to roughly $6-$ 6.5 billion by that time. This might imply that roughly 60-70% of income is shielded from taxes before applying the interest deduction, let alone the significantly lower tax rate. One caveat to this analysis is that there are differences between the tax and GAAP depreciation schedules and investors do not have access to this level of detail. But, our quick analysis suggests that the tax assets might shield the company from most cash taxes beyond the preliminary 2021 guidance. This reform has occurred while CHTR has refinanced debt at lower levels and while the stock has now declined over the past year. To be intellectually honest, we assume that CHTR would be forced to repurchase shares at substantially higher share prices to roughly match our anticipated ~20-25% IRR. After recalibrating the starting repurchase price and after adjusting for the tax law changes, we think it is possible that CHTR ultimately earns closer to $40 per share in free cash flow by 2021 versus an original assumption of $30-$33.

How should this be valued? If we assume that CHTR should never trade above 9x EBITDA, this would imply that shares would ultimately trade at 8-10% free cash flow yields (and “only” mid-teen IRRs). Does this make sense? Some investors would argue yes, citing the company’s debt levels. Others (ourselves included) would question how an unregulated utility could trade so far below the broader market (~20x) on a price/free cash flow basis. Thought of another way, we project that CHTR will grow EBITDA at least 7% on a CAGR basis over the next 4 years versus a current cash interest expense (with a weighted average tenor of over 9 years) of just 5.7%. These two numbers are interesting when thinking about Dr. Malone’s quip that “if you grow faster than your interest cost, your value is infinite.” At the very least, it is tougher to see how this capital structure is irrational. Depressingly, we must concede that while cable faces far fewer risks than content companies, if investment grade DISCA can trade at 20% free cash flow yields, then 10% levels are possible for cable companies. That said, no pep talk is required for this team to repurchase stock. Finally, investors should remember that four different parties expressed interest in acquiring CHTR.

In summary, we remain frustrated with the stock prices of some of our holdings, but we do believe value is being created and that discounts to intrinsic value will not last forever. We do not have sentimental attachments to any of the names mentioned above and we will change our opinion if the facts change. We would like to conclude the letter by thanking Larry Cunningham for letting us participate in his latest in his last project The Warren Buffett Shareholder: Stories from Inside the Berkshire Hathaway Annual Meeting. Larry is an astute financial observer and fantastic writer. We got to know him through The Creighton Value Investing Panel during Omaha’s Berkshire weekend. We’ve been fortunate to work with Larry on a couple of Liberty Media themed articles and we hope to continue our collaboration on a larger project. We believe value investing aficionados will surely enjoy the book’s collection of essays.

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1 5G is the term used to describe the next generation of mobile networks beyond the 4G LTE mobile networks of today.
2 On April 20, 2018, CMCSA and CHTR announced a partnership agreement to develop back-end software to support services for their Xfinity and Spectrum mobile offerings.
3 Up until the start of this year, CMCSA mobile customers would have to purchase a new phone to be eligible for a mobile offering. This policy changed earlier this year as customers could swap carriers on certain phones. For AT&T customers, old iPhones (6) worked but newer iPhones already on the T network did not, nor did Android devices. These restrictions were not a problem for VZ customers looking to swap to CMCSA mobile.
4 While our sample size is small, it is less clear that VZ representatives we spoke with were clear that CMCSA was using the VZ network for its service.

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