NOTA DEL EDITOR: Estas ideas de inversión presentadas por el equipo de Horos Internacional y Horos Internacional PP, son obtenidas de la carta trimestral septiembre 2018 de Horos Asset Management.
* * *
Los valores que más han aportado a la cartera del fondo son Uranium Participation Corporation (UPC) [TSE: U], Yellow Cake [LON: YCA] y Ensco [ESV], beneficiadas por la importante apreciación del uranio y del petróleo en el periodo.
I thought the advice that Henry Kravis gave to young people in this talk is really applicable to investors of all ages: Be curious, get out of your comfort zone, and give back. One other takeaway: “Get off the computer and go talk to people.” $KKR https://t.co/lC7E8Jq1pE
— John Huber (@JohnHuber72) December 29, 2018
The cover story of the inaugural issue of CFA Magazine (Jan/Feb 2003) was a panel featuring Bernstein, Bogle, Brinson, Buffett, LeBaron, Neff, and Templeton. And, fittingly for today, Bogle got in the last word: https://t.co/HBMCzR4eJh
— Joe Koster (@jtkoster) January 17, 2019
Artem Fokin of Caro-Kann Capital presented his in-depth investment thesis on Burford Capital (UK: BUR) at Best Ideas 2019.
Read Artem’s preview.
The following transcript has been edited for space and clarity.
Caro-Kann Capital is named after the opening in chess, e2 e4 c7 c6. We invest in special situations and compounders. I generally look for securities that are mispriced due to lack of sell-side coverage and awareness among buyside peers. I typically focus on companies with a market cap of up to $2 billion, but there can be exceptions. My favorite investment patterns for special situations include spin-offs, a high-growth business segment hidden by a larger struggling segment, and sum-of-the-parts stories. My favorite business models for compounding machines are platform businesses with network effect and flywheel business models. We generally run a long bias fund, typically 80% to 100% net long.
Allow me to start this presentation by bringing up Stephen Schwarzman, who co-founded Blackstone with his partner and former boss in 1985. Blackstone’s current market cap is about $35 billion, and this is arguably the most successful private equity firm of all time. Imagine we had a time machine and went back to 1995, exactly 10 years after Blackstone launched its operations. We met 48-year-old Stephen Schwarzman, and he offered us to buy shares of a privately held Blackstone at roughly 15x last 12 months earnings. To be clear, I am talking here about investing in the management company, not in a PE firm. We can’t do the exact math because it was private back then, but there are enough informational tidbits to estimate that our return would be roughly 20x.
This presentation is not about Blackstone, but it still deals with a great investment opportunity. Led by two extraordinary founders, this company is called Burford Capital and is destined to dominate the litigation finance and legal claims investment industry in the same way Blackstone has dominated the global PE industry. The reason I picked 1995 as the destination for our time travel is that Burford launched its operations 10 years ago, in early 2009. I think it can compound its intrinsic value at 25% annually for many years to come.
Let’s start with the elevator pitch. Burford is a compounding machine, and the investment opportunity, in my opinion, can be best described as “growth at UNreasonably cheap price.” Burford is the leading and largest litigation finance provider in the world. It funds litigation and international arbitration claims by paying legal fees, and its average check size these days is somewhere around $20 million. In exchange, it gets for a share of the litigation award. Burford invests in legal claims from its own balance sheet and has capital of exactly $1.6 billion. It also manages hedge funds with external outside capital and charges a management fee of between 0% and 2%, as well as performance fees of between 20% and 42%. The company recently announced it would manage $667 million for a sovereign fund with a 42% incentive fee. Its AUM attributable to third parties are roughly $2.3 billion.
Burford offers a highly compelling customer value proposition. First, it is at the cutting edge of transforming the legal industry. Law firms now face growing resistance from clients reluctant to pay the extremely high legal fees. Burford’s customer value proposition is compelling because it allows the corporate clients to achieve several goals: better monetize their litigation assets, avoid unfavorable accounting treatment prescribed by either GAAP or IFRS, and make their in-house legal departments profit centers as opposed to cost centers. What general counsel of a big US or international company would not want to become a profit center after being viewed as a cost center for years? Importantly, law firms operating as a classic equity partnership are not well positioned to take large cases on a contingency basis. As a former practicing lawyer at a big New York firm, I can fully appreciate the challenges.
Burford has an extraordinary track record. It has generated 31% internal rate of returns on its capital over 10 years. These superb investment returns and earnings reinvestment have allowed the company to grow its earnings at a pace of about 50%. Burford’s return on equity has been about 30%. When someone sees such returns, they are likely to start immediately wondering about incoming competition. I think Burford’s returns are well protected by high barriers to entry. First, no sizeable player has entered the space since 2015, which shows it’s not that easy to do it. Number two, compared to existing players, Burford benefits from its scale, reputation, experience, and proprietary data, all of which allow it to run a better and superior underwriting process for its investments.
The legal industry is huge, and the penetration of litigation finance is not higher than 1% or 2%. Low penetration, compelling customer value proposition, and Burford’s undisputed industry leadership create, in my opinion, an extremely long growth runway, potentially lasting for decades. Importantly, we don’t need to wait for decades to see returns on our investment. Burford offers a compelling valuation today, trading at about 15.5x last 12 months earnings. I expect earnings to be going substantially higher over the next several years because the incentive fees which Burford is entitled to charge are not showing up on the balance sheet or income statement right now. In addition, the company can reinvest its own capital at very high IRR.
Management is well aligned with public shareholders. Each of the two co-founders owns more than 5%, or over $200 million worth of shares each. The next 20 executives collectively hold roughly $80 million worth of stock. Here is something remarkable: every single employee is a shareholder! This point, in my opinion, speaks volumes. Very few companies in the history of corporate America or the corporate world make every employee a shareholder, and those who do generally create tremendous shareholder value. Think how powerful it is when every single employee shows up at the office, and they know that they have a vested interest in this company succeeding beyond their selfish motivations. They want everybody to succeed, which creates totally different dynamics.
The leadership team has a long-term vision, and this is mostly due to aligned incentives. Interestingly, management refuses to give guidance despite most people asking them to do so. Their communication style is very candid and straight to the point. Their annual reports are wonderful documents, and whenever I read them, I have a genuine feeling that the management wrote those reports with a very strong desire to help people understand their business. They’re not fulfilling some compliance obligation or legal duty – they want us to appreciate and understand what they do.
Importantly, Burford is not a cyclical business. It doesn’t depend on the state of the economy or GDP. Companies litigate in good economies and in bad economies. I have a suspicion that litigation finance would actually go up, not down, in a recessionary environment because the number of disputes would probably go up, but companies would be even less willing to pay high legal fees. I see between 150% and 300% upside within the next three to four years.
Let’s explore these elements in detail. Speaking of Burford’s capital structure, the market cap is at $4.2 billion. The company has roughly $530 million of cash on its balance sheet. It also has debt, which is all publicly traded bonds. One quick note: Burford is listed on AIM, and its shares are quoted in British pounds, but all the financial reporting is done in US dollars.
Why does this opportunity exist? I see several reasons, one being that Burford is an AIM-listed company, and many people don’t follow AIM stocks. There’s low investor awareness mostly because of this, and there is also the fact that the industry where Burford operates is fairly new. Thirdly, there are misconceptions about litigation finance. When I talked to my buyside friends after we built the position, I had a number of those immediate reactions and misconceptions about the industry.
The most popular misconception is that if you invest in Burford, you need to have a view on the litigation outcomes of the cases Burford is investing in. Probably no buyside investor or sell-side analyst can develop these views. Those cases take teams of very expensive, highly qualified and experienced lawyers. There is a plaintiff, and there is a defendant, and one party loses unless they settle. Even those expensive and experienced lawyers get it wrong sometimes. This obviously would make Burford uninvestable for many investors. Here’s how we see things: by investing in Burford, you don’t make your own judgment about litigation outcomes but let management have their view on those litigation outcomes. They will inevitably make mistakes, as everybody does, but their track record is truly outstanding. You are betting that Burford’s investment process is repeatable and its prior returns have not been driven by pure luck. Burford has 10 years of returns, which I consider significant evidence that its investment is indeed repeatable and not luck. I’ve also heard concerns about personal injury and class actions, where litigation finance is very risky from a regulatory perspective. The good news is that Burford has nothing to do with personal injury lawsuits and class actions – it works only with corporate clients.
I want to introduce the concept that legal claims is a new and growing asset class, which is fairly counterintuitive. First of all, what exactly is litigation finance? It involves two parties. There is a litigation funder such as Burford and there is a claimant whose rights have been violated. A claimant either lacks money or doesn’t want to spend their own financial resources, and therefore asks a litigation funder to provide financing. In exchange, a claimant will share some of the litigation recoveries. The most conceptually accurate approach is to consider a litigation finance provider as an investor in the asset class of legal claims. Quite frankly, I don’t like the term litigation finance. What I prefer is legal claims investing. However, legal litigation finance as a term seems to be more widely accepted, so I will use both interchangeably.
Why is it so difficult conceptually to think of legal claims as an asset class? There are a few reasons, in my opinion. First, if you look at traditional investments, they would show up on your balance sheets, but legal claims never show up on the balance sheet of a party whose rights have been violated. Number two, the value of legal claims is extremely difficult to ascertain. Number three, if you lose in court, the value of legal claims ends up being zero.
Let’s reverse the question. Why can legal claims be an asset class? First, legal claims have payoffs, and those range from zero (if a party loses a case) to 100% if the plaintiff wins. Second, we can attach probabilities to various outcomes of litigation, and broadly speaking, there are only four: lost at trial, settled before trial, partial victory in court, and full victory in court. Third, if we combine those two points – payoffs plus probabilities – we can calculate the expected value of a legal claim. All other asset classes have expected values as well. Think about stock investing: when we invest in stocks, we construct various scenarios and payoffs, and we estimate the probabilities of those scenarios occurring, then we calculate expected value. Final point, buying an asset substantially below its expected value is what any investing is about, and investing in legal claims is no different. The spirit of investing in legal claims is identical to the spirit of investing in any other asset class, so I have a strong belief that legal claims constitute a new and rapidly growing asset class. Burford is an investor in this new asset class. Today, the legal investing industry is in the same place where private equity was in the early 1990s.
Allow me to read an excerpt from a Burford annual report which conveys the message: “A litigation claim is an asset. It sounds slightly strange to say that as litigation claim does not comport with our traditional concept of assets, but an asset it is nonetheless. Litigation claims can be bought, sold, hypothecated, securitized and otherwise treated like any other intangible asset. This is a crucial point as Burford’s business is not the funding of legal fees to bring a claim, as though we were a class or group action lawyer operating on a contingent or conditional fee arrangement. Rather, it is the financing of an asset. Sometimes, that financing takes the form of providing capital in support of the legal fees needed to develop the asset. That’s what we now call basic litigation funding. However, even that type of transaction is still asset financing; Burford’s capital is provided pursuant to a financing arrangement, often accompanied by a perfected security interest in the litigation claim asset. We are not equity partners with our clients but much more like mezzanine capital providers. We provide fixed-dollar investment arrangements, no open-ended commitments.”
Let’s consider the total addressable market (TAM) for litigation finance. It’s quite difficult to calculate its value exactly, which is due to a variety of factors. First, law firms are generally private. Many matters are confidential. While court decisions are public, their quanta are generally not aggregated. Many matters presented in front of arbitration panels are confidential. I will use two proxies for total addressable market. Proxy number one is legal fees. Nobody really knows what legal fees globally are. When you check out different expert and industry publications, they put those annually somewhere between $600 billion and $800 billion. Legal fees in the US alone are $400 billion. There are more than 40,000 law firms in the US, and 15 of them generate annual revenues in excess of $1 billion. These are massive businesses. The top 200 US law firms generate together roughly $100 billion in legal fees.
Not all of this $600 billion to $800 billion is related to litigation. When I browse the websites of several large US law firms, it’s my observation that approximately 20% of lawyers are litigators. This number is inherently imprecise because I didn’t browse 500 law firms, just half a dozen or maybe a dozen. It’s just my best guesstimate. If we assume that lawyers across practice group and departments bill the same number of hours at the same rate, which is roughly true for lawyers of the same seniority, then the litigation legal fees would account for $120 billion to $160 billion, which is still a massive number.
The other proxy is the quantum of litigation and arbitration awards. The exact number is unknown, but people think about it as a percent of GDP, which already speaks volumes about it. There is an arbitration institution in Paris called ICC, and it alone has a pending case load of $200 billion. In other words, parties in Paris are disputing matters potentially worth up to $200 billion. This is just one arbitration institution, and this estimate also completely ignores courts, which are different from arbitration panels.
One important point I didn’t realize at first but appreciated through my interview with lawyers is that litigation finance is very likely to expand and increase the total addressable market. Looking at the current TAM can be a mistake because there are many cases today that parties do not bring to court for it’s too expensive regardless of how strong the merits are. Burford is creating more of a level playing field for corporate America and the rest of the world. Thanks to it, even a small company can take on a Fortune 500 enterprise if the latter violated its rights. To put it another way, Burford helps David to fight Goliath.
Another important point is that litigation finance has very low penetration. The world’s top 10 industry players have been investing roughly $2 billion annually over the last few years. Thus, if we use this number against the litigation legal fees, the penetration rate is less than 2%. It is mostly low due to the novelty of the industry. In its current shape and form, it has existed for about 10 years. The law firm industry, on the other hand, is ripe for change. Law firms have very simple capital structures, and they don’t have access to capital. It’s partially due to laws and regulations and partially to law firm business models and the lack of tangible assets. Clients are increasingly resistant to high legal fees, which puts disruptive pressures on the legal industry and profession. The litigation finance industry is bringing solutions. We see all three components of a long growth runway: a massive total addressable market, very low penetration, and a compelling customer value proposition.
Let’s explore the customer value proposition and why clients want to work with Burford. Which pain points exactly does the company solve for its clients? Normally, when you say litigation finance, you think of a personal injury or car collision which involves an economically disadvantaged party that may not be able to pursue a legal claim to protect its rights. However, Burford doesn’t work for those. It invests in legal claims arising out of disputes between what I call “big boys” – one multi-billion corporation suing another multi-billion corporation or an investor filing an arbitration claim under an international investor treaty because a sovereign state violated investor rights. It can be Venezuela, Argentina, or another one. Those don’t strike me as parties that don’t have money, so why would they need Burford?
First, financial standards create an unfavorable and asymmetric treatment of legal claims and legal expenses. Any legal claims a company incurs are run through P&L right away. It’s an expense. Second, the company does not record any value on its balance sheet for those expenses even though it’s moving toward potentially winning a litigation case. Third, even if the company eventually wins, investors will treat it as a one-off extraordinary income. As investors, we view legal expenses as normal and ongoing, but we view litigation awards as extraordinary when we analyze publicly traded companies. This creates a massive asymmetry. Thus, a public company paying substantial litigation expenses out of pocket may hurt its share price. Using litigation finance solves this problem.
Companies also have an opportunity cost of pursuing litigation. Even if a company has financial resources, it can spend its money better. There’s a great story of a publicly traded company called Rurelec, which is an operator and developer of power generation capacity. It does lots of business internationally. Generally, Burford cannot talk about its client cases, but sometimes clients make information public for one reason or another. This case is one of those rare occurrences, and we benefit from their disclosure.
This is how Burford describes it: “Rurelec was pursuing an arbitration claim against Bolivia for the expropriation of one of Rurelec’s power plants. Rurelec did not need capital to pay lawyers – what is generally called “litigation funding.” Rather, it needed capital to continue to grow its own business, but lenders wanted very high interest rates because of the loss of its Bolivian assets.” It’s a Catch 22 if you think about it. “Unlike a traditional lender, Burford was able to evaluate the value of Rurelec’s pending arbitration claim, and thus was able to provide the following facility: 1) a fully recourse, secured $15 million senior loan at 12%, and 2) a contingent value right to receive a portion of the ultimate arbitration award, expressed on a sliding scale based on time and amount.” Rurelec eventually won the case against Bolivia. Burford put $15 million and generated $11 million of net profit. It had a 73% return and 34% IRR, which are great returns.
In my opinion, how to finance the pursuit of a litigation claim is a decision no different from any capital allocation decision. If a company buys PP&E, it would consider all options: pay with cash, pay with debt, lease, and other options. Litigation should be no different. The corporate world is embracing that. If Burford is involved in a case, it generally does not disclose it, but sometimes it does, which sends a powerful signal to the other party. This is how Burford puts it: “We believe that the disclosed presence of Burford in a case should make a defendant think twice about its position as it would then know that a dispassionate, highly skilled, profit-motivated entity had evaluated the plaintiff’s case and concluded that it had real merit.”
Also, there are structurally constrained claimants that don’t have other options. Think about investment fund managers who bought into a company which turned out to be fraudulent. A hedge fund or an investment fund suing it would not want to hit their limited partners with litigation expenses. Another example would be bankruptcy or liquidation trustee. I spoke with liquidation trustees, and they confirm that litigation finance is a hugely attractive option for them.
Law firm economics also encourage the use of litigation finance because these companies are structured as equity partnerships. Even if a more entrepreneurial law firm is willing to take a litigation case on a contingency, it will have two challenges, at the very least. Number one, it creates a working capital deficit. Number two, US tax treatment of litigation provides that law firms which advance client expenses are not permitted to deduct those expenses, and they must therefore fund them with after-tax dollars. This is obviously a very bad outcome for law firms.
Burford uses a wide range of deal structures in investing, the typical one being “capital back + preferred return + share of the award.” Here’s an example of how that works. Let’s say Burford has provided $10 million to a client that used those funds to pay for legal services. Burford and the client have agreed that if the client wins the case, Burford receives $10 million back plus a 12% return per year for the duration of the legal proceedings. Thus, Burford will get $10 million back plus $2.4 million. This is the capital back plus preferred return. However, Burford would then receive the portion of the remaining award. Based on my numbers, it would be entitled to 25% or another $4.4 million, so it would collect $16.8 million on its cost basis of $10 million.
I also want to address the issue of control. Burford does not control the litigation. It provides the money, but the decisions are made by the client, which is essential from a legal ethics perspective.
In terms of unit economics, the two most important metrics for any investment is return on capital and IRR. If, for example, Burford puts $10 million and receives its investment back plus $7.5 million of profit two years later, ROIC will be 75% and IRR will be roughly 32%. Burford has generated 60% ROIC and high 20% IRRs over several years, which I find amazing. These returns are calculated after losses, meaning that if the portfolio generates 75% ROIC after losses, winning cases generate 90% to 100% in order to make up for some cases Burford loses.
I’d also like to touch on the tension between ROIC and IRR. That tension is due to settled versus adjudicated cases. Think about it this way – if you go all the way to trial and the litigation lasts longer, you’d receive more money but slower, so it hurts your IRR. If you go and settle, you get less money, but your IRR is very high. A couple of years ago, Burford disclosed that it had never lost money on a settled case. According to data provided after the first half of 2018, its total portfolio has historical ROIC of 99% and IRR of 33%. However, on adjudicated cases, meaning cases that went to trial, ROIC was double the portfolio average and 27% IRR. Cases that settled fairly quickly, generally within a year, generated return on capital of 53% (half the portfolio average and 4x less than adjudicated cases) and IRR of 52%. That IRR is almost twice as large as the adjudicated cases IRR.
Burford prefers return on capital over IRR, which is consistent with corporate finance theory giving preference to NPV versus IRR, but everybody can pick their favorite metric. Asset duration is another important metric. In general, it dropped from roughly two years historically to 1.5 years in 2017. The average size of commitment increased 8x over five years, rising from $3 million in 2013 to more than $20 million.
If Burford is an investor in legal claims as an asset class (which it is, in my opinion), there is the issue of portfolio construction. Every investor will appreciate how important it is to have a diversified portfolio. This is what Burford said about it as early as 2011: “We have always maintained that the right way to invest in litigation risk is through a broadly diversified portfolio, and we have practiced that view assiduously. The Burford portfolio is diversified across a number of metrics, each of which is monitored by the board for compliance with internal portfolio policies. Those metrics include caps for investment by law firm, claimant, state, judge and area of law.”
Burford’s philosophy is quite similar to what Annie Duke writes in her wonderful book Thinking in Bets. The company recognizes that both skill and luck impact litigation outcomes. This is what Burford’s management said eight years before the book was published: “The very best trial lawyers will acknowledge that luck and circumstance play a role here, and that every lawyer win cases that should have been lost, and vice versa. If we shy away from risk for fear of loss, as some litigation investors do, we will not maximize the potential performance of the portfolio.” Burford’s portfolio is widely diversified. It had 82 separate investments with 877 underlying claims at the end of 2017. No defendant represents even 5% of commitments, and no single case’s capital loss would amount to more than 2%. It work with 70% of the top 100 US law firms.
Burford is extremely selective in its investment process. In 2017, it granted only 4%, or 59, of the requests for funding. In stage one of the process, Burford receives the inquiry (1,561 in 2017) and assesses whether the economics of the case work for it. If not, it kills the idea very quickly. About 32% of those proceeded to the next stage in 2017. This is where Burford analyzes the legal merits of the case. In 2017, only 151 cases remained after that review, and those went to the investment committee, which approved roughly 40% of them.
When discussing whether Burford’s returns are sustainable, consideration should be given to competition and barriers to entry. Will Burford’s success invite competition? Numerous significant barriers to entry in the litigation finance industry exist, which is why I think those returns will be sustainable for many years. First, scale is needed to build a diversified portfolio. Second, scale is needed to build a top-notch team. Third, relationships are critical in litigation finance. Fourth, Burford has superior underwriting. Fifth, it’s difficult to raise capital for new players if capital allocators can invest in Burford-managed funds. Finally, potential conflicts of interest prevent investment banks from entering the litigation finance industry.
An important thing to highlight is that Burford has always had competition. It’s not as if it is the only one doing this; it’s just the biggest, most successful, and smartest investor in the space. Burford was not even the first one – IMF Bentham was launched in 2001, and Jurdica and Harbour Litigation Funding started in 2007. Burford always had competition, but it currently manages 4x as much as its closest rival. There are no new entrants after 2015, which, in my opinion, shows how high the barriers to entry are.
One other thing to highlight is that price competition is not as fierce in litigation finance due to some structural constraints. Let’s compare how the investment process works for private equity and litigation finance. In private equity investing, the owner of a middle-market business wants to sell and gets in touch with an investment bank, which receives the sale mandate. The bankers get to work, conduct diligence, do research, and produce a deck that is blasted to everybody on the planet. This creates a highly competitive sales process with auction dynamics. The process could not be more different for investing in legal claims. Sending a deck or legal memoranda with confidential information to many parties can break the attorney-client privilege. The legal counsel will need to engage in conversations with potential litigation funders. Very often, a law firm will do this free of charge or on a deferred fee arrangement basis. As you can imagine, a law firm will not want to engage in the same conversation with multiple litigation finance providers as it is not billable. As a result, the competition is not similar to private equity. Based on my conversations with lawyers, reaching out to two or three finance providers is most common.
Importantly, the entire market is expanding, so players don’t feel the need to fight for market share because the entire pie is growing. That’s why I think the combination of high barriers to entry, lack of fierce price competition, and a growing market means Burford’s high returns should be sustainable.
Burford has two segments – litigation investments from its own balance sheet, which is the larger segment, and investment management, which is similar to managing any other hedge fund. In 2016, Burford acquired what is believed to have been the second-largest player at the time. It had $1.3 billion in AUM and managed only third-party capital.
How does Burford revenue recognition work for balance sheet investing? The revenue consists of realized gains and unrealized gains, which are fair value adjustments. Realized gains are simple – Burford put $100, the case is adjudicated by the judge, Burford is entitled to get $190, and it records a gain of $90. It’s the same with the loss. But how are the fair value adjustments recorded, and is fair value accounting appropriate? You may have all types of questions right now, such as doesn’t this sound horrible and potentially open to abuse and doesn’t it mean that management can come up with any amount of unrealized gains in any single reporting period? I had those questions as well, and they are totally legitimate. However, the company provides so much disclosure that shows its fair value adjustments are very reasonable and appropriate.
It must be noted that it’s not Burford making those adjustments, it’s IFRS that require of it to make them. Secondly, if you look at the balance sheet, only 36% of litigation investments constitute fair value adjustments. Burford is very conservative, and most importantly, it has almost never reversed an investment that it marked up first. It has happened only twice in Burford’s history, and those adjustments were 0.2% of all total write-ups by dollar value. To me, it’s minuscule and shows that the company is highly conservative in its accounting treatment of these gains. Another thing I would like to highlight is that Burford demonstrated very strong operating leverage as it was scaling, so its expense structure is very scalable.
The investment management business is straightforward – you’ve got other people’s capital and deploy that. Why did Burford enter into this space? The answer is mind-blowing, in my opinion. By 2013, the company had more great opportunities to invest in than it had capital. It had to figure out how to procure more capital, so getting into the third-party fund management business was logical. Burford has implemented a very clear allocation policy: 25% of every opportunity goes to its own balance sheet, 50% goes to the sovereign wealth fund, and 25% goes to the investment funds with third-party capital.
Investors take an extremely small foreign currency risk because even though the shares are denominated in British pounds, 85% of investment activity is in US dollars.
We model Burford by doing a sum-of-the-parts analysis because it has two quite different businesses. For the balance sheet investing business, I have my bear case IRR at 20%, base case at 25%, and bull case at 30%. Just as a reminder, most recent IRRs were in excess of 30%, so my base case feels quite reasonable. My assumptions lead me to an outcome which is very conservative, and I expect Burford to perform better than that. I am putting 17x P/E on my base case, which generates a 120% upside. I think this multiple is appropriate given the strong growth, superior return on equity, and consistent increases in dividends. In the bull case, the math is even more exciting – it’s 300% upside. My assumptions on the bull case are more difficult to execute, but they’re definitely achievable. In my bear case, I am getting 19% negative return by 2022.
The investment management business is fairly simple, with very few drivers – the most important ones are AUM and returns. You have fees but fees we know, so that’s easy to model. Even in my bear case with fairly draconian assumptions, I’m still getting to a small upside by 2022. I think there is a big margin of safety in this investment.
The following are excerpts of the Q&A session with Artem Fokin:
Q: What kind of CAGR do you expect for this industry over the medium to long term?
A: I think the industry can achieve 20% to 25% CAGR over the next 5,7, or 10 years. It is very difficult to predict whether it will be steady growth every year or whether we will hit an inflection point, with growth jumping to 40% or 50%. It may happen. It’s something worth watching. If you have lawyer friends, talk to them. Read legal industry publications. Sign up for Burford’s newsletter. To answer your question, I think 25% to 30% CAGR is reasonable to expect, in my opinion. Whether we will hit an inflection point where it accelerates, we will see.
Q: It sounds like the IRRs are somewhere around 20% or 30%. Is that right?
A: The most recent IRR has been 30%, and this is important to highlight – Burford gives those IRRs by year, and they are cumulative from inception. The company launched in 2009. When it says IRR was 24% in 2013, it means IRR on investments concluded between 2009 and 2013. The most recent IRR of 31% in 2017 covers all investments concluded from 2009 to 2017. I’m modeling 25% going forward, so I think my model in the base case is very conservative.
Q: Given the high IRRs, why wouldn’t a company like Burford, which is very good at this, keep it a secret and just compound its own capital? You’re making 30% IRR – take that and reinvest it in this thing. If the industry is growing at around 20% to 30%, you can just do it with your own capital. Why potentially put more pressure on returns by having more capital chasing these deals and it’s not your own capital?
A: Terrific question. Burford raised money in 2009 when it went public. From there on, it kept investing, and it started running into a problem – there were more great cases than it had capital to invest in. There were too many opportunities, and it started exploring how it could get more capital. Burford placed some public bonds into the market, which was one source of capital. However, the company is surrounded by lawyers, who are conservative people by nature and didn’t want to lever up too much. The other option to have capital for investment would be to raise money from someone else in a hedge fund structure. That’s what Burford did.
I would also point out that having third-party capital is amazing for Burford from a risk management perspective because it allows the company to take bigger cases. There are some giant legal cases in the industry, with legal bills running at $50 million to $80 million. If you take the entire case for $80 million or $100 million, that’s a huge ticket price. Litigation outcomes are binary. You can lose. If you lose $100 million, that’s painful. In other words, there are concentration limits on your positions. Now, Burford can take that $100 million case and spread it amongst several pools of capital based on its formula – 25% to its own balance sheet, 50% to the undisclosed sovereign wealth fund, and 25% to another hedge fund it manages. Burford can take a massive case without putting its concentration limits on positions in danger. That’s another beauty and benefit of running other peoples’ money.
About the instructor:
Artem Fokin is the founder and portfolio manager of Caro-Kann Capital LLC, a hedge fund based in San Francisco. Prior to founding Caro-Kann, he was a principal at Outrider Management LLC. Before entering the investing industry, Artem was an attorney with Greenberg Traurig LLP in New York City. Artem earned an MBA from the Stanford GSB (Arjay Miller Scholar), a Master of Laws degree from NYU School of Law (Newman Scholar) and a bachelor of law from the Higher School of Economics (Presidential Scholar) in Russia. Artem is admitted to the practice of law in the State of New York and is a dual citizen of the United States and Russia. Caro-Kann Capital LLC is the general partner of an investment partnership based on the principles of value investing that focuses primarily on special situations and compounders. Caro-Kann Capital is named after a chess defense that emphasizes building safety and defensible position before contemplating an offensive strategy. The Founder’s substantial legal experience brings a greater ability to analyze complex corporate documentation accompanying extraordinary corporate events. The Fund’s core investment principles include: (1) concentration when properly compensated, (2) risk is not equivalent to volatility, (3) non-economic selling can lead to attractive opportunities; (4) capital allocation is often underappreciated by the market, and (5) incentives and insider ownership are paramount.
James Davolos of Horizon Kinetics presented his in-depth investment thesis on Viper Energy Partners (US: VNOM) at Best Ideas 2019.
Thesis summary:
Viper Energy Partners was taken public in 2014 by Diamondback Energy (US: FANG) in order to monetize a royalty position in the Midland Basin on acreage owned and operated by Diamondback. The transaction facilitated an independent valuation for royalty acreage, which requires minimal working capital, as compared to capital-intensive operated acreage. Diamondback maintains a sizable stake in Viper Energy.
In contrast to most public energy “royalty” companies at the time, Viper was the first growth-oriented company, which has been facilitated by drop-down transactions with the parent. Viper has expanded beyond sponsored transactions from the parent and acquired assets from third parties. Royalty acreage has grown by 4.4x since the IPO.
Viper and its peers have limited acquisitions to cash flow accretive deals. This has resulted in an accretive acquisition mechanism, whereby the company can purchase acreage at a 50+% discount to the implied value of the acreage.
A critical variable to this compounding mechanism is capital structure; historically the company has only utilized short-term debt in the form of a revolving credit facility to close acquisitions. Subsequently, the company issued shares to pay down the revolver. To the extent that the company can issue shares at a material premium to the acquired acreage, the transactions are accretive on a cash flow and NAV basis.
Based on trailing distributions, Viper trades at a forward distribution yield of ~8%. While declines in oil prices will impact this rate in the short term, James expects organic production growth and hub basis differentials to mitigate the impact over the next year.
The following transcript has been edited for space and clarity.
At Horizon Kinetics, I would consider us to be contrarians, but not for the sake of being contrarian, more as a function of where the opportunities exist and where we can find strong opportunities mostly driven from a valuation standpoint. Viper Energy Partners is a company that is systemically and structurally undervalued for a variety of reasons, particularly for its sensitivity to commodities. Investor malaise through commodity companies is probably reaching an extreme where the energy operating companies, as evidenced by the iShares Energy Select ETF or index has underperformed the S&P 500 by almost 1,500 basis points annually over the past decade, while the VanEck Gold Miners index has underperformed the S&P by 800 basis points annually over 10 years. This is in spite of higher gold and silver prices compared to a decade ago and marginally higher oil prices. So, something doesn’t work with operating company investments, or it hasn’t, although there is a niche that is vastly underappreciated by investors within the commodity sphere.
Here’s an introduction to royalty companies. Most people are familiar with royalty companies through the lens of precious metals. The preeminent royalty company is Franco Nevada Corporation, which is a gold and precious metal focused royalty company that traces its roots back to 1983, when Pierre Lassonde founded the company in Canada as a financing mechanism for gold mines. The returns from 1983 through 2001 were staggering, although it’s not quantifiable as it was a private company. In 2001, it was acquired by Newmont Mining, which then grew the business but listed it through an IPO/spinoff in December of ’07 in order to fund a new royalty portfolio acquisition. Franco Nevada’s performance back to the spinoff out of Newmont Mining has been compared to the Gold Miners index, GDX, which has had a substantial capital loss over that period. Meanwhile, gold prices are up again, but not that strongly over a 10-year period on an annualized basis.
Gold and silver royalty companies are primarily a financing mechanism. They will provide upfront capital for a mine in the form of cash, which allows the mine to be developed. Rather than taking a cash interest payment, the company buys future production from that mine, usually in terms of ounces of gold, silver, potentially metals in the platinum metals group, at discounted rates. For example, you provide $100 million day one, and you expect production to start in year five. Spot gold prices at the time of financing are at $1,300 an ounce, but your forward purchase commitments are at $200 an ounce. That discount provides an inherent interest rate in that loan, and it’s proven to be very successful, but it makes sense for the mine and the mining company as well because they can’t take on large corporate level debt and cash interest obligations. Thus, it serves well both end markets- the financier and the miners.
Franco has historically been focused on gold, silver, and a little into the platinum metals group. However, recently they started to invest in energy royalties. Energy royalties, as opposed to gold and silver royalties, are a function of land ownership. Texas is used as a case for Viper Energy. With land ownership, you might sign an operating lease with a provider if you’re a rancher and you owned the mineral interest. For example, you can use precedent transactions where the oil and gas company might pay you an upfront payment of $50,000 to $70,000 for a premier acre in the Delaware Basin, but on top of that, they’re going to pay you 20% in a standard transaction of all oil and gas produced from these wells. This is a function of land ownership as opposed to a financing mechanism. Many public companies, “energy royalties” have fractional interests in liquidating operating leases. Certain examples are Permian Basin Trust, Sandridge Permian Trust, Prudhoe Bay Trust, and the San Juan Basin Royalty Trust, which are wells and fields that are in steep decline. There’s no new capital expenditure going in, and little new drilling. As a result, they’re valued on a current yield basis, and on a dividend-based rate.
Viper is amongst the new breed of about five or six publicly traded, energy royalty companies that are growth oriented. Viper was taken public in 2014. It was only a small patch of royalties owned by Diamondback Energy and was called the Spanish Trail formation in the Midland Basin. Since then, Diamondback has facilitated Viper being a highly accretive NAV growth entity where they have grown production, royalty acres and distributions above the underlying assets as a function of active management. There’s a need to differentiate between the old standard of a liquidating royalty trust versus an accretive growth-oriented royalty company.
An example of illustrative working interest is using a $40 barrel of energy pricing. That includes the BOE, the barrel of oil equivalent- a certain mix of gas and natural gas liquids, propane, butane, natural gasoline, and ethane. Pioneer has a working interest in a well. Upon paying $2.50 in production and ad valorem tax, $6.50 of operating cost, which is basically lease operating expenses and transportation for piping that oil or gas from a gathering system to a backbone pipeline, and to a hub, $14 for finding and development cost, which is exploratory drilling, the illustrative margin is the remaining $17, i.e. 43%. All of these expenses are necessary before one can even get that well and get that oil out of the ground. Compared to the royalty well where the standard royalty is the production and ad valorem tax of $2.50, 94% is netted back to the royalty owner. The economics are extremely compelling in terms of a PV10 – a standardized metric of a discounted 10% NPV. A well-level IRR in the 20% range, which is currently very low even at $45 oil, 70% of the economics go to the royalty owner. At a 50% well-level IRR, 40% go to the royalty owner.
There are different types of royalties, since not all royalties are created equal. The example of a rancher, who would lease out his or her land as a mineral ownership in the state of Texas, is just known as a mineral interest as opposed to a surface interest. It’s a perpetual interest to exploit the minerals in that land, and you can sign a lease with whoever you choose to exploit those minerals. The middle is a non-participating royalty interest, where you do not participate in any expenses, or any of the taxes. It’s 100% cost free. If the operator of that well realizes $70 a barrel and you have a 10% NPRI, you get $7. The third is an overriding royalty interest, which is a part of a working interest override, much more similar to the old standard of the liquidating, declining trusts.
When the minerals have yet to be leased in the case of KRP, Kimbell, which is a publicly traded company, they can carry all the expenses on themselves, and they’ll have all the revenue. Alternatively, they do the lease where they get the upfront cash payment. In return, they share the economics with the operator. Depending on the location, they might be spending $6 million to $8 million just to drill the hole, all the finding and development cost, tens of millions of dollars, transportation costs, etc. However, they’re spending zero capital by letting somebody take on that burden. In this case, the royalty owner might be taking 20% to 25% revenue of the economics for the trouble, while the operator takes 75% to 80% of the revenue. However, the cost is 0% to Kimbell, and 100% to the operator. These are not perpetual leases. In the case of the Delaware Basin, you might want to be exploiting a certain layer, and you can only do that within 10 years, that reverts to the royalty owner upon lease termination.
The benefit of royalty, relative to a working interest, is zero working capital requirements- simply cashing checks with minimal OPEX. In some cases, you might have a little share if it’s an NPRI, some production tax and ad valorem, but zero working capital or CAPEX. You use minimal or no debt funding since you don’t control the wellhead. Most companies have only used debt through a revolving credit facility to finance new acquisitions, and then they plug that through an equity raise. Finally, you have exposure to both production growth and commodity price growth as a free call option. If you place 30-year oil prices into a Black–Scholes model, it’s going to deliver a massive premium, not a discount where people are worried about energy prices exposure.
Viper Energy Partners was created in 2014 as a limited partnership. It has converted to a taxable entity effective May of 2018. It started in Midland County original acreage and since then, it has expanded into New Mexico, then parts of Western and even Central Texas, the Greater Permian Basin. They separated into the Delaware, which is newer, deeper and most robust resource, but it was more complex. Therefore, it’s been less explored than the Midland Basin, which has been explored for quite a while. Basic statistics is if you’ve got 124 million shares, or as they used to call them units, the market cap is pulling from 12/21. To put this into compliance with the current data, it’s 15% higher. Currently they have net debt of about $280 million, and liquidity on the revolver of $275 million. The enterprise value is $3.35 billion, relative to net royalty acres of 13,908. In Texas private markets, a net royalty acre nets out the royalty interest per acre. For instance, if you have a 20% royalty interest on one acre, five acres would be one net royalty acre.
In the Midland Basin, the part of the Greater Permian, there are eight layers of shale beds. In the geological zones carbon is decomposed into hydrocarbon-producing rock. That rock is very porous and brittle and it breaks up to create huge wells. Basic math from RSP Permian, one of the best operators in the basin, shows 46,700 net acres, 1,600 locations, a new location for every layer, and for every well. They might do 12 wells in Wolfcamp A, and they might do six or eight in Wolfcamp B. The important thing here is a billion barrels of resource through these acres. If we divide the billion barrels by 46,700 acres, that comes out to about 21,000 mboe nomenclature for a thousand barrels per acre. Since Delaware Basin is more robust, Reeves, Ward, Loving County is going up into Eddy and Lee County in New Mexico. There are over nine layers, but Wolfcamp A, which is the most robust part of the basin, is so large, that it breaks up into the Wolfcamp XY, and the Lower Wolfcamp A. Overall, 45,200 acres and 1.8 billion potential resources equates to nearly 40,000 barrels of oil equivalent per acre.
To shed light on the misinformation about these wells, we consider the cumulative production of the core Wolfcamp A and the months of production of this 1.5 million-barrel large robust well in the core of the Delaware basin. There is no need to have such robust wells, as you get out into the fringes, and more densely drilled. We model between 600,000 and 700,000 barrels per well, depending on the location. With around 15 months in, you can already be at about 450,000 barrels, so 30% of the well in the first year and a half of well life. It’s good that you’re getting a lot of oil very quickly, and you’re getting your capital return, so your IRRs benefit immensely from that. Negative press will say there’s a huge decline rate, and you have to keep on drilling to keep up. That’s true, but these are high-IRR wells. The companies out there are very efficient and fast with their drilling. For most of the basin, you’re getting about 60% liquid oil, 20% of NGLs, and 20% dry gas. Dry gas is methane. Henry Hub pricing was at about $3, then spiked to $5. Still most people’s long-term decks are below $3.
Simple math shows what the NPV of one of these wells would be if the acre was drilled immediately and started producing tomorrow. To consider the benchmark pricing, West Texas Intermediate Oil is at $46. It currently ranges between $45 and $50. NGLs, which are difficult to price properly, are generally at about 60% of liquid oil pricing. It depends on how much propane, butane and natural gasoline are in that stream, whereas ethane and the dryer stream are a little cheaper. Dry gas pricing is using a weighted average of 60% oil, 20% NGL, 20% gas. That gives a composite of $36.72, which is quite low. However, considering the Delaware Basin spot pricing, we assume that you are going to do each acre, it has 40,000 barrels for the Delaware and 20,000 barrels for the Midland. We then use a 17-year decline rate where it’s very heavily loaded to the front, and you’re getting 1/3 before you’re at the half year mark. Discounting that back at a 7% discount rate for the 40,000 barrels per acre, you get an NPV of $1.1 million per net royalty acre. For the 20,000 or 21,000 in the Midland, you’re getting about $580,000. To sum up, that’s a 17-year type curve, discounted back to present value at 7% using current spot pricing.
To get the answer where Viper Energy Partners implied acreage price, the enterprise value is divided by net royalty acres that gives you an imputed value of about $241,000 per acre, at $25 to $30, in the range of $250,000 to $280,000 or the implied price per net royalty acre. There’s a big mismatch between that and $1.1 million and $580,000. In the discounting future production, we’re still using the 7% NPV, but we’re assuming a weighted average of 10 years until production. Within the first 10-year window, some will produce at year 10, and others going out further about a 30-year resource to look at how the full lifecycle of drilling within the current inventory is. So, to use spot pricing the Delaware gets you to about $560,000, and the Midland gets you to $300,000. Based on the mix of acreage between Midland and Delaware, as well as a little of Eagle Ford, around $425,000 per net royalty acre using fair value method, that would equate to about a $50 stock relative to the high 20s today. That’s quite conservative because it assumes zero price recovery in hydrocarbon prices, and assumes no accretive growth, no dropdowns, no extended timeline to the resource base. It also assumes relatively slow development consistent with certain bottlenecks in getting oil and gas out of the basin. So you’re in a fair value of about $400,000 per net royalty acre using spot pricing.
Spot pricing is a huge point of misunderstanding for people, especially when it pertains to the Permian Basin. Viper data of the third quarter shows where production is at, the distribution per unit, and the DPU. Viper realized oil at the price of $54.51 in the third quarter of 2018. To take a simple average of the 90 days in the second quarter, West Teas for Cushing delivery averaged close to $70 a barrel during that quarter. This is a $15 spread where Viper was realizing this huge discount, and this is a result of a pricing differential because they were delivering mostly into the Midland hub. Since the growth rate in the Permian Basin exceeded even the wildest forecast, and there weren’t enough pipelines to get oil up to Cushing and realize that $70, so it stayed in Midland.
Plains All America has a lot of pipeline capacity and infrastructure in the region. A lot of the Midland hub capacity today goes up to the northeast of Cushing, which is right in the middle of the stream. Interestingly, all of the capacity is being built in the Delaware Basin. There’s also Cactus I, Cactus II, a joint venture and a couple of other pipelines, which are delivering into the Gulf. There’s a Magellan contract to regulate Gulf-based pricing, but Gulf is benchmarked to Brent. Brent Crude, which is a North Sea contract, has averaged about a $10 premium to West Texas Intermediate. West Texas is currently at $45 and Brent is at $55. As you get to the Gulf, you’re not going to realize full Brent pricing because you have to pay a seaborne transportation fee to get it to those hubs. There’re a lot of complex reasons why Brent trades at a premium to WTI- notably, the API gravity and refinery configurement, also the fact the US has a glut of oil and gas relative to infrastructure and refining capacity, as well as it relates to sulphur and European refineries having a much higher diesel and bunker oil mix.
Raymond James Financial shows a straight-line production estimate for the Permian. The backlog is easing up in the second quarter of ’19 and then really catching up in the third quarter with some new pipelines, the EPIC pipeline, a private company, Sunrise, which is Plains All America, Gray Oak, which is Phillips 66, and then Cactus II. You’re going to have overcapacity to get the oil and gas out of there by the end of ’19. Probably, there’ll be less congestion by the middle of the year. If they were getting $55 at a $15 discount to WTI, you’ll eliminate the Midland differential, but you’ll actually add $5 to that, as you start realizing Brent pricing as opposed to getting the Cushing WTI price.
The valuation comes from the MLP mind-set. New growth-oriented royalty companies have focused on yield and investors laser-focused on accretive acquisitions. This has created a massive mechanism of accretive unit growth and the acquisitions that Viper engaged in in 2018 ranging from about $20 million up to closer to $200 million. The operators were in Delaware Basin, Midland Basin, and BP/Devon/Conoco in Eagle Ford. If you’re trading at an implied value of about $250,000 an acre, but they’re buying from $100,000 to $200,000 an acre, that’s a function of the market. The market is not giving you any value for unproducing acreage. They’re valuing the current acreage to buy it at a 10% yield to make it accretive, otherwise, they’re not going to buy your property. At the end, they can buy the unproducing acreage at a massive discount, and the producing acreage at a slight discount to trading. If you’re buying it at $150,000 an acre, you’re using currency valuing it at $250,000 an acre, which is highly accretive in the long term. That mechanism where you use a revolver to close day one gives them a lot of operating leverage and a lot of scale since not many people can write a $175 million check day one. Fill in that revolver, plug it with an equity issuance, and issue shares. Hence, this is a very powerful accretive growth mechanism.
Besides, Diamondback continues to be a majority shareholder, and they have a very large equity interest in Viper. They don’t want to alienate this cash flow stream to the parent company, so they’ve continued to drop down mineral acreage and royalties as they’ve made acquisitions and had success in developing more resource. The drop-downs come through a mechanism of two things. 1) Acreage that was not previously producing goes into production. There’s a cash flow, so you can drop it down. 2) They’ve been aggressive with acquisition, Brigham Resources to name one. As that portfolio has royalty acreage, they can drop that down. At a steady state using $45 oil, NPV-ing the royalty stream and getting to $50, you should give some value to this growth mechanism on top of getting your current 8% dividend yield.
Regarding oil prices there’s a lot of misinformation about breakeven. You’ve seen several promotional CEOs talk about $20, even less breakevens in the Delaware Basin, which maybe possible if you take the very best acreage and you have extremely efficient pad drilling, you can then drill a well and make such breakeven. That’s assuming a 0% IRR or a profit margin at $20, but doesn’t include many economics. RS Energy published a chart in The Wall Street Journal, where they’re showing the breakeven that you might cite for the Delaware Basin at $35 at the low end. That’s just a well. So what’s my cost to sink a hole, get the oil up, transport it, and get my money back? What do I need to break even just looking at that? At $45 for the Delaware, other overhead costs are also included, not the least of which is corporate SG&A. You have debt service and many of these companies run at about 2x to 3x EBITDA of debt, so their cost of capital is not cheap. Further, you go up to $50 when the price of land is also included.
RS Energy study included a 10% profit margin. These are rational capital allocators and PV10 is a standard in the industry demanding a 10% rate of return. This gives a better idea of where the pain threshold is. At $50 for the Delaware, and given the fact that WTI is at $49, they’re still getting $10 haircut going to Midland. Also, the turnaround and differentials for Viper is about 20% of the barrel in gas this year. Gas in Henry Hub is about $3, but Waha, Texas, which is a small West Texas gas hub, got to the point where gas delivered there was getting virtually zero in the fourth quarter of this year because there’s too much gas and it costs money to store. So, as you get capacity to get that out of there, you’re going from zero up to $3 for that gas. The NGL mix has better economics. There’re a lot of ethylene crackers being put into Louisiana, Port Charles, Corpus Christi, Texas, so that’s a much stronger market.
Moving to OPEC and the large international oil providers, a fiscal breakeven balances their budget. Brent is at $58.24. Based on the budgets of Iraq, Russia, Kuwait, Qatar, they all are still balancing their budget at $58 Brent. However, very large producers, such as the UAE, Oman, Algeria, Angola, and most importantly, Saudi Arabia are at $88. The Saudis have an estimate of about $500 billion of reserves in their federal bank. If you’re $30 below, you’re breakeven and you start to bleed $5, $10, $15, $20. It might even be above that if these prices hold in your national coffers. Geopolitics aside, what’s going on over in Saudi Arabia, bleeding the reserves does not help anybody.
Putin and Russia have been resolute in saying they’re fine, but he’s not too far off either. Further up, you’ve seen a lot of supply disruptions in Libya, Nigeria with rebels and different factions taking supply offline there. The economic breakevens for oil are well above $45 at West Texas, and $55 at Brent. There is a lot going on in the fourth quarter- algorithms, trading patterns, short-termism, and manipulation for days, but, not to go down into the political spectrum, if Iran is not allowed to export, they don’t break even anywhere. If they are able to get some out in the black market, they’re not getting benchmark pricing, so a lot of pressure there. The plan for them was to go under sanctions where they would no longer be able to sell into international markets again in early November, and our administration decided to grant them a waiver for six months for about 75% of their oil.
OPEC doesn’t want a price spike. It’s bad for them if you get $100, $120, $130 oil because then you start getting the Norwegians, and the French, and the South Americans doing these massive offshore projects. A little well in the Permian giving you 2 million barrels is nothing compared to these deepwater 50-year resources, but those projects need $90, $100, $120 to make sense with a 10% IRR. Ahead of Iran coming offline, the Saudis, probably had some discussions with our government, began over producing, so there wasn’t a supply shock when Iran came offline. This lasted for months. Unilaterally, the United States decided to extend those waivers. So all of a sudden, you have a couple of million barrels of extra Saudi and Iranian oil on the market and the market was trying to balance and adjust for it. You see stockpiles showing up in the United States and abroad, and the market plummets in the short term because of the fundamentals.
In the fourth quarter, as oil’s deluge continued, the inventory data was really meaningless because none of the production cuts started until the beginning of the year. There were no pain points where certain non-core shale beds would curtail production. If you have your wells and your drilling crews up and running, you’re not going to take that well offline. The balancing act might take another three to four months until you see it in inventory numbers. Currently there’s a very odd situation. The last time Saudi’s actual resource base inspected and approved by international petroleum engineers was in the late 1970s. They’ve been producing heavily ever since, and they’ve revised their proven reserves, double what it was when the British and the Americans confirmed those resources 30 years ago. Probably the Crowned Prince is pulling the Aramco IPO. They probably aren’t perpetual marginal producer of oil. He realizes they need to get away from a purely petroleum-based economy. He wanted to take Aramco, the chemical business, and the refinery public. However, he wouldn’t allow international petroleum engineers to confirm the resource. So, the world views the Saudis swing production- switch on or switch off two million barrels a day at their behest as a balancing mechanism.
Energy securities are orphan securities. Energy was close to 15% of the S&P 500 a decade ago. Now it’s down to 6%. If you look at the S&P Energy Index, where 90% of allocators are investing, you’ve got 40% of the index in Exxon and Chevron. There’s also Schlumberger, an oil field service, three refinery-based companies, and Halliburton- a service provider. Not only is energy a pariah and an orphan security, there’s no passive fund flows and no investor demand.
To sum up, here is a risk disclosure for compliance. There are some interesting ways to pair along oil and gas royalty companies such as Viper where you’re getting 8% a year. You can short futures on oil prices as many times they’re in very steep contango. So, you can fund your short of the underlying spot commodity through your yield. To the extent, the historic economics of royalties are more attractive than underlying prices you’ll earn a decay of the contango. You can fund the short through a good amount of your yield. It makes a pairs trade or a hedge trade quite intriguing.
The following are excerpts of the Q&A session with James Davolos:
Q: How do you think about capital allocation in this space? What ought to be the priorities? Is there room for return of capital here? Is it about drilling and finding more resources?
A: That’s a good question. There was a mutiny amongst large oil investors halfway through this year where the old standard of the previous 30 years, when investors demanded to replace whatever you take out of the ground every year in new resource. If you’re going to pull up a million barrels, you better replace that and make sure that you’re not depleting your resource space. Whereas the institutional community came to the drillers this year and said, “You need to focus on free cash flow. You need to focus on economic returns to your shareholders and not only building an empire.” That is a new dynamic to create more discipline. You’re going to see stricter funding as people want to build resource.
As it applies to the royalty companies, they should prioritize growing their resource base and creating a larger and longer stream of resource as opposed to distributing 100% of the cash flow. It goes from the MLP mindset where you distribute everything and then grow through stock issuance and drop-downs. However, if you can buy a highly accretive acre that is not producing today, you’d rather buy that acre at an embedded rate of return that magnitudes higher than your current acreage and forego a dividend. It’s about aligning the investor base to a combined component of NAV growth with yield. That’s the happy median gold companies have reached over time, where Franco, even today, has about a 2% distribution, but they’ve grown NAV tremendously and investors appreciate that. Energy needs to evolve their royalties to have an NAV growth component with a yield component.
Q: Could you talk more about management incentives? Is high insider ownership the only way to align incentives? Are there other ways as well?
A: As a firm, we are highly skewed towards actual equity skin in the game, whether they are options, restrictive stock units, or incentive bonuses. They tend to be short term. We want you to be able to lose money, not only earn money in the case of a misstep. The Diamondback ownership is a very strong incentive for the parent company, which is quite large and one of the best in the basin. However, individual management at the Viper level is incentivized through direct stock ownership. That should be optimized as they’re primarily looking at distribution growth and total shareholder return, which is a large element, but they can be incentivized to grow NAV in addition to other metrics.
Q: There’s a lot of moving things here and data. What are the key data points to gauge value creation? You talked about a number of the metrics that can be tracked. Which do you think are critical?
A: The best metric to use, and this is at odds with how Wall Street likes to look at the world, is your net royalty acreage relative to your share count. That can be reconciled with your production growth and distribution growth. In terms of evaluating the industry, the well-level economics, how far they are drilling on a lateral basis. In some cases, it’s 5,000, 7,000, 10,000 feet. How many barrels of oil are coming out of that well?
Everything we’re seeing is showing a robust rate of return in the core Delaware and core Midland Basins, and this is the preeminent resource. It’s going to be interesting to see where the less robust resource is. You go into SCOOP and STACK in Oklahoma, which are phenomenal but not quite on the level of the Permian, same thing with the Eagle Ford. You have a much higher spread as you go up into the D-J Basin, Powder River Basin, and Williston Basin as you go further north. At a royalty level, it’s the acreage growth relative to units, combined with distributions, and you need to keep an eye on the industry itself and just continue to see how much the wells are producing, whether they’re realizing spot pricing, or they’re still getting haircuts. If all of that congeals well, it should all work out well for everybody in the industry.
Q: This sector obviously offers many interesting opportunities at this time. By sector, I mean companies tied to crude oil pricing. How do you think about going with an E&P company versus a service provider or even further away, some of the tanker companies and others that are leveraged to the energy cycle?
A: One of the reasons why we are so fond of royalties is the minimal or zero use of debt. You’ve seen through every cycle a lack of discipline in both gold markets and oil markets, where prices are high, budgets extend, capital markets are friendly, and you take on too much debt and expand capacity that requires high pricing. We are very fond of any E&P company or service provider that has the appropriate balance sheet, which will allow them to continue to weather a prolonged period of cyclical downturn and then have a commensurate capture of the upside. It’s dictated by the business model and the balance sheet. Certain E&Ps have wonderful assets, wonderful balance sheets, but they’re still very capital intensive, and a lot of cash flow is reinvested into future production and growing the resource base.
Service providers are going to have a tougher time, especially the offshore providers. Pressure pumping and frack spreads do not generate a lot of value adds. If there’re too many pressure pumps and frack spreads, it’s going to be hard for them to get pricing. The guys in the Permian have been able to exert pressure on them. I’m very fond of tankers, especially because there’s so much water-borne transport to get better pricing and better economics. A huge fan of Cheniere Energy, huge fan of Navigators. If you want to go esoteric, there’s an interesting player, American Shipping. They own Jones Act vessels subleased to day rate charters, generating a guaranteed minimum, mostly in the Gulf, and they transport oil and gas primarily to Florida because Florida doesn’t have pipelines. At the current base rate, they’re getting about 8% yield owning the stock, which includes debt amortization. However, if the market gets tighter, there’s much upside. In that case, they have the right asset in the right place. To sum up, business model, asset base and capital structure, and there are some phenomenal ways to play this cycle.
About the instructor:
James Davolos is a Portfolio Manager at Horizon Kinetics LLC. He serves as Co‐Portfolio Manager to the Kinetics Internet Fund, an equity fund with approximately $150 million in assets, and he is an investment team member of the Kinetics Paradigm Fund, Kinetics Alternative Income Fund, Kinetics Global Fund, Kinetics Small Cap Opportunities Fund, and Kinetics Market Opportunities Fund, all of which are a series of Kinetics Mutual Funds, Inc. James is also directly responsible for a variety of custom and concentrated equity managed account strategies, is a Co‐Portfolio Manager on certain private funds, and is on the investment team across the core managed account strategies. He is a member of the Firm’s Investment Committee and Research Team, and is actively involved in research, valuation and portfolio allocation for many of the Firm’s high conviction investments. James joined the Firm in 2005 as a research analyst. He earned his undergraduate degree (B.B.A.) from Loyola University of Maryland in 2005, and his Master’s in Business Administrator (M.B.A.) from New York University in 2016.
Mark Walker of Tollymore Investment Partners presented his in-depth investment thesis on ITE Group (UK: ITE) at Best Ideas 2019.
Thesis summary:
ITE Group is a UK-listed global exhibitions organizer. The investment merits can be summarized as “a very good, very cheap business”. ITE is a capital-light, founder-led business providing high-utility and enduring B2B services. A long track record of delivering ~30% returns on capital has been facilitated by a network effects-based defensible moat. The business model is characterized by double-digit revenue growth, high top-line visibility, strong cash conversion of earnings, and an appropriate capital structure. Non-fundamental selling pressures have contributed to a de-rating of the stock to a 19% FCF yield, leaving the business trading at a fraction if its private business value.
The following transcript has been edited for space and clarity.
It’s a pleasure to be presenting again at Best Ideas. I recently launched Tollymore. This is my first presentation to the MOI Global community in that capacity, so I will briefly outline Tollymore’s investment philosophy to provide the audience a context with which to judge the investment idea.
Tollymore Investment Partners is a private investment partnership investing in a small number of exceptional publicly listed businesses in order to compound partners’ capital over the long term. I have several years’ experience in investment research. Prior to forming Tollymore, I was five years on the buy side as a generalist long-term global investment manager and then five years on the sell side.
The first principle governing Tollymore’s investment philosophy is its long-term investment horizon. In the short-term, low correlations often prevail between stock and business, but over the long term, that correlation is high. Discipline and patience help us to exploit price-value discrepancies. Our efforts mainly focus on finding companies capable of both preserving and increasing their intrinsic values. We try, as long-term investors, to exploit a time arbitrage afforded to patient investors with patient capital.
Our approach is value-oriented. This community defines “value” in different ways; we tend to apply a private business owner mentality to listed equities. Our effort to focus on maximizing intrinsic value includes employing demanding price discipline and trying to identify companies capable of increasing their own values. The portfolios are concentrated. Excessive diversification prohibits the ability to carry out the due diligence required to think like business owners and, therefore, how to act when the quoted market price of the individual securities changes. Clearly, concentrated portfolios might be more volatile than the market or more diversified actively managed peers. However, we try to collect several investors who share our view that short-term performance is not relevant to long-term wealth accumulation.
We are benchmark agnostic. We don’t think a business owner mindset is necessarily consistent with taking a market view. Volatility can help us as public equity investors in providing opportunity to purchase assets at a discount. We don’t consider risk as volatility. Rather, risk is the capacity to lose capital permanently. For us, margin of safety is found primarily in the business and the management quality of the underlying holdings. We concentrate our research efforts on buying companies with strong balance sheets. These are companies capable of preserving and growing their private business value with hopes they trade at a large discount to that intrinsic value or to the capacity to grow that intrinsic value. That is, investment merits are typically accepted in the context of capital structure risk, business value impairment risk, and valuation risk.
What are the principles and the process consistent with our philosophy? A sensible long-term business owner investment philosophy is not useful if the investment ecosystem doesn’t allow us to successfully execute a consistent investment process. For us, the key aspect of that governs idea generation, investment research, and portfolio management. Overarching these pillars is that execution is everything. We’ve tried to construct a low-key physical working environment free from distraction and conducive to independent thinking. In the early days of Tollymore, we worked hard to make sure the investment philosophy and the investor base are matched to my temperament as an investment manager.
A systematic magic formula does not typically generate ideas. We have concentrated portfolios and a global investment arena. Therefore, our challenge concerns rejecting most mediocre investment opportunities crossing our path. The research process is bottom-up, one company at a time. We search for competitively priced, strong businesses which ideally have avenues for profitable redeployment of capital for a long time. These businesses have conservative capital structures, or which are at least appropriate for the business model. Their management teams are incentivized to make capital allocations capable of creating the most long-term value for owners.
With regards to portfolio management, by owning businesses which steadily compound their own per-share economic earnings, we tip the odds of earning a satisfactory equity return in our favor. One great advantage of being a public equity investor, as opposed to a private market investor, lies in our position to exploit stock market volatility and improve upon the underlying compounding business value.
We designed our work environment to help us make good decisions. The working environment must allow us to devote brain power to decisions and not to battling distractions. This environment is the source of a competitive advantage, which is behavioral. In the pursuit of a goal to create value for our investors, we do not take for granted the ability to make good decisions. Typically, that requires inaction. It requires solitude. It requires being epistemologically humble and patient. I have seen those qualities in my career, and they are not typically found within the constraints of large institutional money managers.
We move on to the idea. I encourage viewers to think about what they might be willing to pay to own a privately held company with the following economic characteristics: This company is a simple business. It’s a founder-led business. It’s a provider of enduring service, reflecting a business practice which is hundreds of years old. The business offers a a high utility to cost ratio for its customers. It is headquartered in the U.K., and it is geographically and industrially diversified. It is a capital-intensive business with typically 2% of revenues. Free cash flow conversion of earnings is strong, aided in part by deferred income balances which range between 50% and 70% of annual sales. The average through-cycle returns on capital would be around 30%. The business owns a defensible moat, which is predominantly provided by two-sided network effect barriers to entry. Revenue visibility is high. Around two-thirds of next year’s sales are typically forward-booked. The capital structure is conservative and appropriate for the business model. Organic revenue growth has recently been around 11%.
The company is London-listed ITE Group. What does ITE do? It’s involved in just one business activity: Organizing exhibitions and conferences globally. The nuts and bolts of the business concern hiring venues and gathering groups of exhibitors and visitors. It monetizes the exhibitor side of the network by charging companies for floorspace. ITE Group operates across several sectors including construction, food, energy, travel, and tourism in predominantly emerging market geographies. It is labor intensive but has a capital-light business model. Venue hire and staff are around 3/4 of the cost of organizing a typical event.
The end markets are cyclical but diversified. While multi-year agreements can be struck to secure venue capacity, these agreements typically have the flexibility to modify capacity commitment ahead of changes in demand. Forward bookings enable good visibility on revenues. Operating margins have been stable thanks to the moderate operating leverage used to organize an event. Operating profitability equals about 22%, and that is around 5 percentage points below mid-cycle levels. Some of that margin runoff comes from deferred revenue increases. Exhibitors secure their participation at a future event at a more competitive rate. What, therefore, might be surrendered in terms of income statement profitability is recovered via working capital inflows and free cash flow conversion. Despite that, the management team has a plan to restore the business to operating margins in the high 20s.
ITE Group is appropriately capitalized given its high revenue visibility, strong repeat business, and multi-year agreements with vendors. This is despite approximately £50 million of debt-funded M&A in FY ’18 and net debt around £80 million, which is around 1.4x EBITDA. The business has about two years of free cash flow and about 1/4 of ITE’s equity. Deferred revenue comes because revenue is recognized at the completion of an event, whereas ITE received the cash in advance from exhibitors. The deferred revenue characteristic converts to a costless source of finance for ITE, and it represents a working capital inflow when revenues grow. Of course, it can be a drag when free cash flow and revenues decline as they did a few years ago. This deferred income flow has typically been 40% to 50% of sales. The founder of the business left the business and has since returned as CEO. He has grown the deferred revenue float to two-thirds of annual sales, strengthening the cash conversion of the business.
The main evidence supporting existence of an economic moat lies in a long track record of super-normal profit which seems to emanate from two sources of competitive advantage. One source is network effects. Visitors are needed in order to attract exhibitors and vice versa, making it difficult for non-established players to gain traction. The second source is intangible assets in the form of trademarks and licenses to operate at venues, databases of consumers, and brand reputation. All elements render participants reluctant to move away from tried and tested events.
ITE facilitates pricing power by the fees charged to exhibitors, which represent low levels of the cost of the businesses. Pricing power factors also include venue homogeneity and ITE’s position as the anchor tenant with many venues.
ITE’s suppliers have continued to grow despite competition from the growth in lower cost VoIP and video conferencing. Some elements of ITE’s business model are clearly enduring.
ITE typically competes with small mom and pop individual tradeshows. In competition with larger global players, a niche geographic or sectoral focus characterizes the market. ITE focuses on construction, energy, food and tourism. Some of the larger competitors have their own niche sectors. Tarsus, for example, focuses on the medical sector. UBM is a large competitor but typically competes in the U.S. and China sectors of fashion and jewelry. Also, some competitors are geographically limited operators. For example, MCH is Swiss-only and Fiera Milano is Italy-only.
The key element to think about in this value chain is this competitive symbiosis within the value chain. Customers in this industry do not want more choice. They do not want competing tradeshows. They want to know their customers will attend the events that year or the events they attend once every two years. That characteristic creates an efficient scale with space for only a handful of profitable operators within each region and industry niche.
Concerning growth opportunity and avenues for profitable redeployment of capital, I’ve classified this business as a legacy moat business rather than a reinvestment moat or a capital-light compounder. The industry has a lack of greenfield and organic opportunities to build new exhibitions around the world. However, ITE enjoys a strong foothold in several emerging markets including India and China. ITE has established market-leading positions through fully-owned subsidiaries and has a controlling interest in locally dominant exhibitions brands including joint venture partners. It has a controlling stake in the market-leading conferences business; ABEC in India runs around 20 to 25 exhibitions across the country. ITE has offices in Beijing which it operates through JVs with Hong Kong-based Sinostar. It also runs conferences across Indonesia via JV partners and wholly owned subsidiaries.
The organic growth trajectory has inflected positively in the business partly because of economic stabilization and a business improvement program ITE put in place since the founder of the business returned to ITE in 2016.
A series of macroeconomic shocks beset ITE’s end markets and impeded business progress in the three or four years prior to 2017. These shocks included the Russia-Crimea crisis and resulting trade sanctions at a time when Russia was a larger part of ITE’s business. Also, the 70% collapse in the oil price harmed business in ITE’s energy-dependent central Asian market.
ITE’s improvement in top line organic growth should meaningfully increase underlying cash generation. Management has improved cash collection for conference pre-bookings, though the market implies the exact opposite will happen. That is, the sustainable tracks the business can generate will wither significantly, and the stock has continued to move in the opposite direction for the business to progress. Given our classification of the legacy moat business and its cash-generating capacity, an opportunistic M&A agenda presents itself. Opportunities for organic growth from building new shows are limited. M&A will always occupy a place on management’s capital allocation agenda. Therefore, it’s important to understand the management team, their track record, and their incentives for allocating capital.
The founder of the business, Mark Shashoua, returned to ITE with a plan to improve organic growth potential and profitability of the current portfolio. He has divested the least profitable sub-scale events. He executed this playbook when he ran i2i Events, his previous company. Under his five-year leadership period, i2i Events doubled revenues and profits before its acquisition by Ascential Events.
Mark founded ITE in 1991. He left the business and worked as CEO of several other companies then returned to ITE in 2016. In 2018, ITE announced the acquisition of Ascential Events based on an enterprise value of £300 million. The target assets comprise two global exhibition brands and several U.K. exhibition brands across a range of sectors. The CEO and the COO of ITE Group are familiar with these assets because they ran the companies together between 2011 and 2016. They describe their rationale in terms of both top line growth potential and some operating synergies.
Related to growth potential, ITE management believes the acquired assets had been mismanaged and produced suboptimal revenue growth. When the current ITE management ran these assets, performance was superior to its current state. They treat the essential assets as non-core, so the business performance as it relates to cash conversion, retention, and revenue growth deteriorated at the time.
As for operating synergies, ITE has an implementation plan seeking to eliminate obvious sources of cost duplication and to generate cost savings from economies of scale. The acquisition will also reduce Russian exposure. This is not a rationale explained by management for the deal, but the Russian exposure of the business will go down from around half of revenues to around a quarter.
Management incentives have improved mostly since the management change; they are reasonable but do not stand out. Base salaries for the CEO and CFO are low to mid six-figures. Bonuses are a function of pre-tax earnings, organic revenue growth, cash conversion, and qualitative targets. The LTIP is a function of earnings per share and relative TSR. Targets that are in place for the current LTIP to ITE’s earnings per share need to grow by 75% over the next two years for any of the LTIP to vest. For 100% of the LTIP to pay out, ITE needs to generate earnings per share of £14.4 by September 2020, which is almost treble their recently reported FY ’18 EPS. That indicates about a 25% yield of current share price. All measures were only introduced in 2017. While the cash conversion is a sensible target, some measure of returns on capital will be a welcome addition to the incentive program given the high cash generation of the business and the limited obvious long-term redeployment opportunities. Minimum shareholding requirements are based on 2x base salary, but insider ownership is given the short tenure of the management team.
To summarize the stewardship of the business, the track record of the new leadership and some of the incentive framework progression improve the stewardship of a demonstrably wide moat business. However, it is wide moat business which has suffered some macro headwinds. The headwinds have shown signs of dissipating. This is not a turnaround. Rather, this is already a fantastic, highly profitable business. It can benefit from macro mean reversion in the end market and from structural portfolio improvement driven by this positive management change. It can also potentially benefit from a re-rating of the shares to reflect those former drivers.
ITE completed its acquisition of Ascential. That was a $300 million enterprise value funded predominantly by a rights issue. It presents a feasible risk. The acquisition tapped shareholders to fund the empire building of this business. Management equity interest, unfortunately, is insufficient to act as any material safeguard against this risk. However, during the CEO’s tenure, he has performed asset rightsizing, which should mitigate the risks somewhat.
ITE’s share price collapsed since 2014 due to a series of geopolitical events including Russia and Crimea, the oil price collapse, and the Ruble depreciation. However, over the last year or so, the share price fell another 50% in part due to non-fundamental selling pressure as the portfolio has become less focused on emerging markets. Thus, the company’s stock price has moved in the opposite direction of the business’s performance as profit margins stabilized. This performance shows a sharp inflection in organic revenue growth and qualitative improvements to management and stewardship.
This company does not screen well. ITE’s cash flow and owner earnings are materially higher than reported earnings per share due to the large deferred revenue float, impairment of prior management capital allocation decisions, and amortization of quasi-permanent assets such as customer relationships and internally developed brands. It is important to keep these things in mind when in consideration of the normal free cash flow generation for the business. Adjusting for some of the one-off costs associated with the business improvement program and adjusting for biennial events – those events that don’t recur every year – the trailing 12-month free cash flow of the business is around £30 million. That’s around 25% of ITE’s equity and debt funding, and it’s almost 20% of the core group revenues. That excludes the small contribution of the Ascential acquisition.
The business generates double-digit organic revenue growth. How is the market pricing that growth? The current market cap is around £420 million. The market cap accounts for the rights issue-funded acquisition of Ascential completed in the summer. That rights issue was £265 million. Share prices are around £58 today. That price implies the market values ITE’s pre-acquisition cash flows at a 19% yield. It also implies material free cash erosion in the core business, or zero or even negative free cash margins in the newly acquired asset. It could also imply ITE management is under earnings, or perhaps that ITE massively overpaid for Ascential.
Does evidence or logic support any of these things? The core business recently recorded 11% organic revenue growth, and the acquired asset generates 31% EBITDA margin. Capital intensity is around 1%. It is unlikely ITE operates a free cash flow-negative business.
Did ITE overpay for the deal? Management believes it payed 11.5x EV/EBITDA for an ungeared business capable of double-digit revenue growth. That seems reasonable. In the case of zero revenue or cost synergies ITE referred to, it pays 12.5x EV/EBITDA. For a high-quality business with high entry barriers and capital intensity of about 1%, that was not expensive. It is possible ITE is a better owner of this business than the seller because it is a core asset versus non-core for the manager. That is not a contentious argument; rather, it is consistent with the comment Ascential made about the deal. It is consistent with Mark Shashoua’s comment to me before the acquisition when we talked about various competitors and how Ascential was not considered a strong competitor for ITE. Its non-events business is a data and analytics business.
I conclude the market is not paying attention. I’ve spoken with some of the large institutional owners of the shares, and they say ITE is a small part of a diversified portfolio. In certain cases, their understanding of the deal and appreciation of management’s prior history of the asset reflected that.
What is ITE worth? A conservative appraisal of a private business value would imply north of 70% upside to the current price. We would get there by capitalizing the trailing free cash generation of the core business at a 6% rate. That is a 4% growth rate. The global industry is growing revenue, so that’s 4% to 5% per year. You would assume ITE’s sustainable free cash flow growth is lower than the industry revenue growth. Assuming the Ascential acquisition was value neutral, the rights issue capital would be added to that number, which would lead to an owner’s value of around £750 million to £800 million.
The global industry is projected to grow at 5% a year. Many of ITE’s markets are expected to grow high single digit, which is conservative. It would also imply management missed its own goals and LTIP targets substantially. Management targets and has overachieved high single-digit revenue growth. They target market expansion and putting in place measures to ensure large working capital inflows. Those drivers would then result in free cash flow compounding around 1.5x revenue growth.
In conclusion, as it relates to the deal, several senior ITE people ran these assets for years. They paid a no-growth multiple for a high-quality asset, yet they have a track record of growing the same asset double digit. They have a track record, albeit short, of turning ITE from negative organic growth to plus 11% since they arrived. That empire risk is mitigated by reasonable management incentives, a history of less profitable asset disposal, and the familiarity of the asset they intend to incorporate into the core business. From an economic value-added perspective, the idea that the EVA that can be created in this business after the deal needs to be larger than before the deal because the asset to which the returns improvement from the business improvement program can be applied have increased meaningfully. Additionally, there may be other non-fundamental benefits to the share price in the form of better liquidity, better shareholder communication, and a larger market cap leading to broader analyst coverage. But mainly, the investment merits of this business can be summarized by saying ITE is a good and cheap company.
The following are excerpts of the Q&A session with Mark Walker:
Q: As a follow-up on the management incentives, you mentioned the founder no longer owns a significant amount of stock.
A: Yes, he sold his equity when he left the business. Since his return he has not been a material owner, though he has been acquiring shares.
Q: Oh, but he has been a buyer of the stock in the open market?
A: Yes, he’s been buying the stock in the open market, but I wouldn’t say at a considerable level. He will easily surpass the 2x base salary holding requirement, but he won’t appear on the register for quite some time.
Q: Let’s talk more about the Russia portion of revenue. Do we know the profitability of that piece? Do you see hidden risks?
A: Yes, profitably recently exceeded the overall growth level of profitability. A vast majority of the Russian business is in Moscow, and that business has fully rebounded to a profitable level. Some of the other Russian exhibitions they run outside of Moscow still lag. However, the prospect for markets with a history of depressed conditions is not based on any macro forecasting other than the observation that they are currently below pre-cycle levels. ITE’s Russian exposure is about 25% of the business. I would consider that a directional positive, whereas it triggered a lot of selling because the emerging market fund is no longer in stock.
Q: And Mark, going forward, what would be the key data points to keep an eye on to either validate or challenge your thesis?
A: Capital allocation is one key data point. So far, evidence suggests empire building was mitigated. The biggest ITE acquisition is Ascential Events, and it paid a reasonable price. It was a unique circumstance, and they know these assets inside out. Evidence exists supporting the idea that underearning assets can improve from an already decently performing level. ITE divested several events without affecting EBITDA much. If management uses most of the cash-generation business to support inorganic revenue, it would be a capital allocation red flag.
In terms of the businesses, I’d like to see management continue building their equity interest in the company. I’d also like them improve their incentive framework by introducing incremental cash returns and capital metrics into their incentive framework.
In terms of the business’s progress, management operates with clear targets for the organic revenue growth potential of the business. That growth rate is high single digit, and it recently generated double-digit organic revenue growth. If the organic growth suddenly deteriorates meaningfully, that would be inconsistent with the view that this is a business with a high level of revenue visibility.
Margins have stabilized. I would expect to see several costs taken out of the normalized free cash flow number as relating to the business improvement program; I would expect them to disappear in a couple of years, not right away.
If we see recurring non-recurring items, then that would cause me to reevaluate my view of the sustainable free cash flow generation of the business as well.
The valuation of the business assumes a level which implies free cash flow erosion. Margins provided by the entry price are quite significant here. In this business, high barriers to entry mitigate business risk. A 19% free cash flow yield mitigates valuation. Higher levels of revenue visibility and a net debt level mitigate the balance sheet. The net debt level is consumed by free cash flow in a couple of years.
Q: To clarify, does the 19% free cash flow yield apply to the entire enterprise, or does it exclude the acquired piece?
A: It excludes the acquired piece. That free cash flow yield takes the normal free cash flow of the core business and divides it by the current market cap adjusted for the rights issue. Ascential has been in ITE’s financials for 2.5 months of FY ’18, the year ending in September 2018. I removed an estimated free cash flow contribution from the Ascential Events. That is why I say the valuation core free cash flow, which is a 19% yield to the rightly adjusted market cap, will materially erode, or Ascential Events will negatively contribute to free cash flow. The combined free cash flow of the business will decline, or ITE will have materially overpaid for Ascential assets. I’ve discussed why I don’t think of that as an obvious conclusion.
Q: And Mark, how cyclical is this business?
A: The end markets are cyclical, but ITE’s sector and geography diversification dampen revenue volatility. The low operating leverage of the business and the large financial leverage of the business render stable profit margins. Operating margins range from low to high 20s; recently they fell in the low end of the range. Free cash flow volatility will then be higher than operating volatility because of significant negative working capital influence attributed to whether organic revenue is growing or declining.
About the instructor:
Mark Walker serves as managing partner of Tollymore Investment Partners, a private investment partnership for long term investors. Previously, he was a global equity investor at Seven Pillars Capital Management, a long term value-oriented investment firm based in London. Mark has fifteen years of investment research and financial analysis experience. He joined Seven Pillars from RWC Partners, where he was part of a two-person team managing a long term global equity fund. Prior to that Mark worked as an investment research analyst on the sell-side for Goldman Sachs and Redburn Partners.
Elliot Turner of RGA Investment Advisors presented his in-depth investment theses on PayPal Holdings (US: PYPL) and Roku (US: ROKU) at Best Ideas 2019.
Thesis Summaries:
PayPal Holdings and Roku both benefit from improving unit economics and large, growing total addressable markets. Each company benefits from an open-ecosystem that favors customer choice and smooth user experience.
PayPal suffers from an over-emphasis on take rate and too little appreciation for the virtuous cycle flowing around increasing user engagement. Improving unit economics at PayPal will drive higher out-year margins supporting a DCF-driven price target upwards of $120 per share.
Since Roku’s IPO, too many analysts have viewed the company as a hardware company and have failed to appreciate the business model evolution to an advertising platform. At a price around 3x 2020 platform sales and 2020 expected growth upwards of 40% y/y with a long runway of operating leverage, the company offers investors rapid growth at a reasonable price.
The following transcript has been edited for space and clarity.
I have learned so much from the community. I like trying to do my part to give a little back, but I get so much more out than I put in. Thank you again for all the hard work you put into making this happen.
Let me start by trying to give a sense of our long-term orientation. PayPal and Roku, which are the focus of this presentation, bring to seven the number of ideas I have shared at Manual of Ideas conferences since 2015. Collectively, these seven ideas add up to just shy of half of our portfolio, and we haven’t sold a single share of those companies. In fact, we own more of most of them than at the time of the respective presentations. We have a GARP bias and low turnover.
I first presented PayPal at Wide-Moat Investing Summit in 2015. While I’ve always tried to present new ideas, I felt a strong impulse to go back to the well on this one. This is the Best Ideas Conference, after all, and this is my very best idea, as well as our largest position. Roku was a stock I followed with interest, but it became a best idea during the month of December.
In 2015, I used a quote by Kant to preface the PayPal section of my eBay presentation, and I’d like to use it again as it works well for both PayPal and Roku. Kant said the following: “Act in such a way that you treat humanity, whether in your own person or in the person of any other, never merely as a means to an end, but always at the same time as an end.” PayPal was formerly a means to an end within eBay, namely driving volume. It wasn’t about PayPal itself as a payments platform. Today, it’s finally treated as an end, and it has a core mission and a mandate to fulfill it. As for Roku, it is competing against a bunch of players whose TV strategy is secondary to their own essence, Amazon being a key example. Meanwhile, at Roku, connected TV is its DNA, and that fact alone I find advantageous.
I think it makes some sense having PayPal and Roku in the same presentation. Even though both ideas were inspired independently of one another, they share some traits that support their growth and differentiate their offerings from the competition’s. They each have improving unit economics driven by accelerating engagement. One of the things I really like is that both have a huge addressable market to sell into. They have secular tailwinds driving both growth in their actual addressable markets and share they’re capturing there. Something that differentiates them from competitors is that each is an open ecosystem, so they partner with many players on both sides of their respective industries. Customers have a choice when they engage with these brands, and there’s a really smooth user experience. There’s also a virtuous cycle connecting all of the above.
After more than three years of independence, PayPal has forged a unique identity. CEO Dan Schulman, who started just before the separation, has been the visionary at the wheel. He has a unique background in both mobile and payments, so he was the perfect choice to run the company. The Economist recently called him a “re-founder” for having uniquely reformulated and repositioned PayPal as a fresh new company, almost as if it was founded again from scratch, starting at the point of split from eBay. Schulman recognized early on that what really differentiates PayPal from the other payment competitors is its being a two-sided network with a direct relationship on both sides. PayPal owns the customer relationship in a way that makes even Visa and Mastercard envious.
Central to Schulman’s strategy has been empowering consumer choices and emphasizing partnership with the many players in the payments ecosystem. As part of eBay, PayPal had a major problem it had to attack – the user experience had been really clunky. It was hardly a platform, it wasn’t scalable, and it wasn’t open. The tech reformation started with the acquisition of Braintree, and current PayPal COO Bill Ready has been instrumental in driving this initiative. Without the technological improvement, the many partnerships would have been much tougher to forge. Besides having tech stack issues, PayPal had taken an antagonistic stance toward the credit card networks by steering payments to ACH, which are higher margin for PayPal but problematic in the eyes of the networks. Charlie Scharf, then CEO of Visa, called PayPal a frenemy and threatened to go nuclear. Scharf recognized the risk to Visa itself by PayPal owning the customer relationship and having a degree of power in influencing how consumers behave. PayPal was effectively making some volume that could have gone to Visa and Mastercard go elsewhere. It wasn’t easy, but Schulman plowed ahead with his vision in an attempt to change this. Visa opened the floodgates for partnership throughout the payment landscape once it was done.
Partnership was something Schulman hung his hat on, but it wasn’t always perceived well by the investment community. As soon as he was able to turn Visa from frenemy to partner, the stock suffered its worst day as a public company. The investment community had quickly pivoted their concern from viewing Visa as the foremost threat to fearing what take rate would look like. It became an obsession. It also happened to result in my first-time quote in The Wall Street Journal. While everyone was getting bearish on PayPal, I was counting on the Visa relationship becoming an important driver of improving engagement down the line and engagement itself being more deterministic to the company’s future worth than take rate. The article appeared in July 2016, so this fear about take rate is not new; we still hear about it all the time today.
The foremost concern arising out the Visa deal was the high margin ACH volume on PayPal would shift to a lower margin credit card transaction, and in the process, this would squeeze PayPal’s transaction level margin. After the fact, it became really clear in PayPal’s communication that ahead of pursuing this partnership path and forging the deal with Visa, the company tested out what choice would look like on the consumer side to analyze and project exactly how funding selections would change and to get a good idea of what its margin would look like. As a result, the company had a clear thesis on what the future funding mix would look like and a thesis on engagement.
Importantly, the obsession with take rate ignores the history of the payment industry, which has been about shrinking take rate. If we look at American Express’s and Visa’s historical take rate equivalent, the trend is obvious – tit trends lower over time. If this is true, how do the platforms make up for it? The answer is that as take rates decline, these platforms are able to increase scale on both the merchant and consumer side, and consumers engage with the platform with ever greater frequency. This is a compounding force on the economics of the business. These are two-sided networks, after all. One might ask if could you invest in American Express in the 1960s knowing what take rate would do from then on. Even though Visa wasn’t public, would you theoretically invest in the company in 1980 knowing what would happen with take rate? Knowing what these companies have done and what their valuations are today, the answer is obvious.
There are certain specific beneficiaries of the shift towards choice and partnership, account growth being one of the obvious early beneficiaries. It is influenced both by bringing in new users and making sure that new and existing users don’t churn off once they start. PayPal had been on the receiving end of considerable frustration from customers who found it too hard to select their preferred credit card as a default option. These people often gave up on the platform, becoming a headwind to net user growth. With choice enabled by partnership, it all changed. Account growth, which was trending down into the split in 2015, jumped in 2016. This jump happened alongside choice and accelerated with it.
I think this is the beginning of a period of higher sustained growth in active users. The experience has gotten so much better from a consumer perspective, and there are new partnerships, including with issuers offering their own, self-funded customers incentives to add credit cards to their PayPal wallet. There’s also an emerging push to give liquidity to credit card rewards. PayPal is uniquely positioned to make this happen. For example, JPMorgan Chase (through its Chase cards) and American Express will be letting their own users spend their reward points through the PayPal platform. This is helpful to Chase and American Express because these rewards are building up as a liability on their balance sheets, and they want to increase their velocity. PayPal is the one able to make it happen.
The other beneficiary of choice is engagement. Its growth appeared to slow in 2015, but this is also a reflection of the rapid increase in new accounts – it takes time for the new accounts to rise to the level of engagement of existing users. It’s habit-forming but not instantly so. Engagement has been growing swiftly, all things considered, and growth and engagement re-accelerated this year. Since 2012, the typical user has gone from engaging with PayPal less than twice a month to more than three times a month now, and you can expect this trend to continue.
In some ways, you can simplify the entire thesis to the idea that so long as engagement is growing, the stock should go up. It’s really that simple, and I’ve been thinking about it along those lines. Engagement is the reflection of the mindshare PayPal has with its users. It’s a direct reflection of the network effects in the business. When engagement is rising, users are expressing the fact that PayPal’s service is more valuable and useful to them. The more engaged the userbase is, the more merchants want to accept PayPal on their sites, and the more sites that accept PayPal, the more users can engage in a virtuous cycle. This is a crucial feedback loop within the two-sided network. User engagement also exposes the platform to peers who don’t yet have accounts. Peer-to-peer payments and transfers are a critical component in this strategy. When friends want to send money to one another and don’t have cash or the change necessary, they’ll ask if you have a PayPal account. If the one owed money wants to get it, they have no choice but to download the app, so this has been a good driver of new users.
Besides choice as a driver of engagement, another one was the big improvement in PayPal’s tech stack, which was empowered by the acquisition of Braintree. In addition, PayPal’s fraud detection prowess was a crucial enabler of this technological advancement. What we’re talking about here is the PayPal button and One Touch. One Touch, as the name suggests, makes it possible for users to log in once on a device and check out with just one touch forever after. One Touch combined with the PayPal Checkout Button has become central to the company’s ethos. The leadership has literally started defining itself as selling conversion to merchants. PayPal can seize this high ground because its conversion rate is nearly 90% compared to 50% or less for competitors. As a result, One Touch and the PayPal Button have been a big success in the merchant community for how it levels the playing field with Amazon’s one-click checkout. The Checkout Button itself is the value PayPal delivers to merchants and supports a good chunk of the margin they earn. These one-touch checkouts earn a much higher margin than the typical checkout over any other kind of PayPal transaction.
Regarding the unit economics of the business, customer acquisition costs have fallen two years in a row and should continue to do so as the network effects take hold. With all the obsession with take rate, there hasn’t been enough creativity thinking about what PayPal looks like down the line, for example, what the lifetime value of customers would look like if engagement were to double from here. This is important in a few ways. First, there are already extremely engaged cohorts that are valuable to PayPal right now, and they represent large chunks of the user base. Second, when you double the engagement, lifetime values go up 3.5x, so there’s a multiplier at work here. That’s some nice margin leverage. When I look through analyst reports, I see some of these assumptions supporting topline growth, but what I don’t see is the analyst community buying into any operating leverage coming with it. Meanwhile, the company has been increasingly confident in the past year in forecasting operating margin leverage down the line. It has earned some trust with the funding mix results since the Visa acquisition, yet analysts are still a little reluctant to buy into the operating leverage thesis.
In 2015, I was told by many PayPal skeptics that my estimates were a little too aggressive, but in reality, they weren’t aggressive enough. This is not to say the future will be as kind as the past, but it does show that when companies are executing well, they tend to outdo what most of us expect. Importantly, PayPal has three revenue levers and one delever. The levers are new customer accounts, engagement (viewed as transaction per customer account), and the dollars per transaction. The last one is interesting for how it protects us, investors, against inflation. When the cost of goods and services rises in the economy, PayPal generates more revenue, and its cost base doesn’t go up accordingly. I assumed dollars per transaction would rise at about the Fed’s inflation target. The one revenue delever is the take rate. Adding it all up, the three levers minus the one delever result in a revenue growth rate around 20% annualized for the next few years.
If PayPal meets our expectations or even falls a little short, we think the stock can easily compound in the upper teens for years to come. One of the more exciting opportunities to mention is pay with Venmo going commercial, but I’d rather think of that as gravy on top and not embed any expectations. eBay is also perceived as a big risk considering it opted to ditch PayPal for Adyen, but we are increasingly comfortable knowing that eBay growth has slowed dramatically in the last year, and merchants on eBay are clamoring for the PayPal button to remain a checkout option. Both eBay’s and PayPal’s management teams have acknowledged this reality. eBay has no choice but to oblige, and word is it will keep PayPal central to the checkout experience and a big part for the foreseeable future. Clearly, One Touch has been a big part of that. One key driver of upside will come in the form of margin leverage. The analyst community is yet to buy into it. We view that similarly to how the Visa pact was greeted at the time, but eventually, they’ll come around.
One other thing is the sale of the consumer credit portfolio to Synchrony. This resulted in cash proceeds of nearly $7 billion and an ongoing relationship where PayPal gets a little piece of the revenue from every bit of consumer credit sold to Synchrony. This equipped the company with a cash stash to make acquisitions which fill strategic holes. One such acquisition is iZettle for in-store payments and to fill a need in Europe, and this puts PayPal in competition with Square for in-store payments. Another one I really like was Hyperwallet for marketplace payouts to merchants with a specialty in cross border, which fits nicely with the push to help marketplaces in all elements of payments, so both payments from consumers to merchants and from platforms to the merchants themselves.
With our more ambitious margin assumptions, the DCF supports price targets at around $150, which compares to analyst consensus estimates of $100. Obviously, we’re looking for a good degree of upside here. At the very least, we view PayPal as a compounder and think its shares should compound at the rate of free cash flow growth at around 20% annualized or more for the next five years.
Let’s now shift gears to Roku. This one is for those who subscribe to the idea that volatility is not risk – so far in 2019, the stock is yet to have a range of less than 10% in any one day, which makes it somewhat challenging to nail down any market cap or enterprise value-based metrics. That said, I think the volatility is the market’s way of reflecting just how wide the range of potential outcomes is here.
I have a weird infatuation with companies which have a great product that resonates with consumers but don’t necessarily have a profitable approach to it from day one. It takes them a long time to figure out how to make money along the way. When they do, that’s when I like thinking about them as an investment. A little history here might be helpful. Anthony Wood, the founder of Roku, is a serial entrepreneur. The name Roku translates to six in Japanese in honor of this being the sixth company Wood has founded. Roku itself is also an appealing, unique sounding name, already synonymous in some circles with streaming web-based content on a TV.
The money Wood used to bootstrap Roku was earned from the sale of a TV-attached box which was an early TiVo competitor called Replay TV. He learned a lot in the process of building a TV box. Since he bootstrapped much of early Roku before having to take venture capital or strategic investors (including the likes of Fox and Sky), Wood was able to maintain a high degree of ownership – just shy of 25% of the outstanding shares today and over 40% of the voting control.
Roku’s ties to streaming run deep. Think how synonymous Netflix is with streaming itself. Interestingly, Wood was working at Netflix when he was getting into developing what we now know as Roku. In fact, its first name was The Netflix Player by Roku, and it was effectively owned as part of Netflix. Within Netflix, it was called Project Griffin, and Reed Hastings squashed the idea of launching a hardware box at the last minute because he feared the company would be put in conflict with some of its licensing partners, like Apple (whose Apple TV was used for streaming Netflix), Sony (whose PlayStation was one of the early distribution channels for Netflix), and Microsoft (which used Xbox similarly in early distribution for Netflix). Just before launch, Roku and the team were told the box wouldn’t be going live, and they were spun out into Wood’s corporate Roku entity. The rest, as they say, is history, both for Netflix and Roku.
Many people still think of Roku as a hardware company because, after all, it does sell hardware, and that hardware has the Roku name on it. In reality, hardware sales are a means to drive placement of the platform. When new users create Roku accounts, they add things like their telephone number and payment information, which are data that enhance ROI for advertisers.
Roku monetizes the platform in several ways. One is by taking a royalty on subscriptions commenced through the platform. Since Roku has payment credentials, someone who wants to subscribe to Netflix can do so fairly simply via Roku itself. Roku gets a cut of that user’s monthly payment to Netflix so long as that subscription remains active. It also takes royalty on purchases through apps on the Roku platform. For example, if you buy Frozen on Amazon over your Roku device, Roku takes a cut at Amazon’s expense.
The second and more important way the platform is monetized is through ads. Roku has two main kinds of ads. The first are audience-building ads where, for example, a channel like Showtime can buy space on the home screen to try and get a viewer to watch a show like Homeland. Second, on a variety of apps within the platform, including the Roku channel, Roku places ads within the viewable content, much like you see on linear TV although at a much lower ad load. Once a household has an active account, the platform side has several levers to drive revenue growth. Every day, there’s more content available to stream on the platform, and this makes the average household more and more likely to consume video on Roku. The ad side is still pretty new, both technologically and with big advertisers. As a result, some inventory continues to go unfulfilled. Between better tech and advertisers committing more budget, this will no longer be the case in time. Heading into 2019, Roku first sold inventory in industry upfronts, which are quite a big deal. It’s standing up there with pretty much every channel (CBS, Fox, ABC, etc.) and selling some of its inventory in advance, which should have a strong effect in 2019. Also, Roku has some unique inventory, and it is able to add a layer of data that’s just not possible on linear TV. This has already resulted in average CPMs around $30. In moments of scarcity, for example, with more live TV being streamed over Roku devices, there could be great room for even better rates down the line.
The platform has been driving growth on every KPI. Active accounts are growing swiftly with no deceleration, though we assume some in our forecast for 2019. ARPU is growing quickly, with some recent deceleration though the base is still very low. We’re only talking about $17 on a trailing 12-month basis per active user as of the third quarter of 2018. It should be seasonally higher in the fourth quarter, but this is pretty low compared to the other ad platforms. It’s especially low when you consider the level of engagement and completion rate. We don’t include hours streamed in our forecast for 2019, because the number is growing very fast, and it’s too challenging to do so. But similarly to engagement with PayPal, hours streamed is growing at over 1.5x the rate of active accounts. In other words, every single day, people are using their Roku devices to watch video content more than they were the day before. This has a powerful compounding effect on the demand for Roku devices and the topline the company can generate.
Connected TV led by Roku boasts industry-leading completion rates. Viewers on Roku immerse in content more than they do on other video platforms. Connected TV completion rates are clocking in at around 95% compared to 80% for tablets and around 70% for desktops. Targeting helps completion in digital media compared to linear, but there’s clearly something special about CTV beyond targeting that gets meaningfully better completion rates.
Why is completion so good? In my opinion, a big driver is how tasteful the Roku ad load is. Ads are 15- to 30-second spots with no pre-rolls – those annoying things that lock you in before you get to watch the content – and at 1/4 the frequency of linear TV. They’re also uniquely tailored, which helps. Roku has a big lead moving in this direction. When the rest of the industry was focused on selling subscriptions for streaming, Roku was focused on building an advertising platform. It’s estimated that 87% of requests for CTV ads happen on Roku devices. Recognizing its lead and seeing its thesis play out, the company took steps to put in place a data overlay to make it better for advertisers and provided them with all the key metrics to judge attribution and know their ROI. When I talk to people in the industry, they say that Roku is as good, if not better, than everyone out there at sharing some of this data. One of the biggest critiques you hear about Facebook and Google is that while they boast great ROIs, they don’t necessarily give the right metrics for attribution. They also don’t enable third parties to attribute, while Roku has signed on both Nielsen and Comscore and has worked with many partners to facilitate good attribution. As a result, large advertisers’ test budgets are turning into real budgets that are always on. This is becoming a recurring expense at advertisers and a recurring revenue stream at Roku.
Everyone online is obsessed with walled gardens, and for Facebook and Google, being a walled garden has enabled them to hold firm and not give some attribution despite the pressure. Roku is trying to be a little different on that front though it aims to be a walled garden. It prioritizes the user experience first and foremost. Because of its targeting capabilities, Roku brings into video some advertisers that otherwise might not be able to do so. The long tail can figure out what they want to target and go for it on this platform. That’s quite an effective way to grow the TAM compared to the linear share capture alone. The best evidence of advertisers getting ROI is that spending budgets on Roku keep surging.
One more recent development is Roku’s shift towards building a moat around its walled garden. Some publishers sell their own inventory on apps, like Hulu, so Roku hasn’t monetized those ads other than unfilled inventory Hulu itself couldn’t sell. Recently, Roku changed its terms to no longer let publishers access the IP address of the viewer. Without the IP address, a lot of crucial data, such as geolocation, can’t be accessed. In order to access this data for a publisher, Roku now must get paid even on inventory it doesn’t control. The publishers have to go along with this because Roku is how many people watch their content today.
The addressable market on the ad side is pretty big – around $70 billion is spent on TV in the US alone. Digital advertising is growing much quicker than advertising on linear TV, which isn’t growing at all, maybe even shrinking a bit these days as much of that share moves to CTV. Ads on Roku have been growing much quicker than digital itself. While this sounds great, budgets have been slower to move to connected TV than hours viewed although they inevitably will. It begs the question why all TV won’t eventually be watched through a connected device. It’s better both for advertisers and users. This opens up the potential for TV ad spend addressable market to go up because, when you think about it, the move from linear to CTV, the data overlay, and the opportunity to target should greatly improve ROIs while also bringing more long tail advertisers into the playing field. Those things aren’t captured by thinking about TAM in this way.
Currently, two clear leaders are emerging in CTV in the operating system market: Roku and Amazon. Google and Apple are also around. Google’s Chromecast capabilities are built into a lot of TVs, but its offering is really different. Roku has a big lead in advertising, but it was reported recently that Amazon is going to push ahead with an ad-supported offering of its own. While 87% of CTV ads today are on Roku, it doesn’t necessarily mean this share will be as high going forward though it will continue to grow nicely.
The second key addressable market to think about is the household side. Today, 1/3 of adults in the US are reachable on internet-connected devices for TV type viewing, according to Nielsen. There are 126 million households in the US, and 27 million households already had Roku in 2018, just a fraction of those being international accounts. It’s important to stress that Roku speaks in terms of households – its active accounts is not the number of unique users, nor is it the number of devices sold because more and more households are buying more than one Roku. This has been one pillar supporting the growth in stream per account, and it also serves to keep churn low and increase the value of the existing customer base.
One interesting aside about the Roku stick and something it’s done to change what a household means for video viewing is that people who love their Roku devices have started traveling with them when they go on vacation. Every hotel or Airbnb place now has Wi-Fi capabilities, so you could bring your Roku, connect it to the Wi-Fi, and have all your channels available to watch exactly as you would at home. This is something new, interesting, and really easy because the stick is the size of the USB dongle.
Competition is always a concern. Amazon is a major competitor to just about everyone these days in just about every industry. Alongside Amazon, Google and Apple are also playing in this area. I think Roku has a few advantages. It’s the first mover here, so the existing scale is ahead of the competition, both in terms of the number of households and the number of ads they serve. I also think the technology is superior. I’ve tried both Firestick and the Roku side by side, and the Roku offers a far better user experience.
Getting back to my quote from Kant, CTV is not a means to an end for Roku. It’s literally its essence and its very existence. For the competition, CTV is one of many strategic initiatives competing for resources with other areas. While they do have considerable resources to dedicate, it’s one pillar in a multi-pronged strategy. For Roku, it’s everything. If you think back to Facebook in its very early days, everyone was worried that something like Google Plus could kill it. It’s very different to have something be your end all-be all versus something being one other strategy. When it’s your end all-be all, you tend to be more creative and more attune to what developments could actually make a difference.
One of the most important differentiators is that Roku is an open platform. Its competitors also compete with one another. YouTube has been off the Amazon Fire TV, and Amazon Prime has been off of Google’s Chromecast offerings. Roku is the only platform where you could get everything, and it lets you access all the content you want. Quite recently, fears arose when Apple stated that its movies would be available for viewing on Samsung devices, much as the Roku channel is. People were worried this might be another prong of competition for Roku. The next day, Antony Wood suggested that perhaps Apple would eventually appear on Roku devices as well. I think that’s inevitably going to happen. If you want to have the maximum choice from a user’s perspective, much like in the case of PayPal, then Roku is the obvious one for you.
Roku’s user experience is much better than all the others. It’s faster, higher quality, and simpler to use. Another thing which helps is that large retailers love selling Roku-powered TVs because they move well, they’re high quality, and selling Roku helps beat Amazon in a key area. If you’re Walmart or Costco, which sell a whole lot of TVs, why would you ever want to help Amazon in this area? You’re going to do what you can to empower Roku here. They’re putting their money where their mouth is. Walmart had special promotions for Roku, so much so that BTIG media analyst Rich Greenfield thinks Roku will inevitably be bought by Walmart.
TV manufacturers deserve special mention for how they strengthen Roku’s hand against the competition. They’re a key part of its edge, and Roku plays a key role in empowering TV manufacturers. Its software is built to run on low-cost TVs, so the manufacturers themselves can get the same picture quality with cheaper hardware components. This is a big driver of Roku’s appeal to manufacturers and retailers, and something customers love because they get a cheaper TV with the same quality. Roku’s hardware is increasingly the TV itself, though the company also sells streaming sticks. One in four TVs sold today are powered by Roku. The advantage it also offers manufacturers is made most clear by the example of TCL, which rose from 24th in the US TV market just a few years ago to number three in 2018. A Washington Post hardware reviewer recently called the Roku-powered TCL “the best deal on a premium TV I’ve ever seen.” It was able to win these accolades despite costing half as much – $600 for TCL Roku TV versus $1,299 for a Samsung of the same size. Why wouldn’t a customer opt for the Roku?
Something Wood has mused about is that, theoretically, Roku could lower the price of its hardware to have about a 6% gross margin on the hardware side of things, which could go to zero or even negative given the platform value. However, it has found market resonance with its price today. It is already cheaper than the competition, so there’s no price pressure, and the purchase price serves as a form of commitment from the purchaser. This commitment is similar to someone becoming a Costco or Amazon Prime member. The psychological force behind commitment is a real phenomenon, and it’s very strong. If this is a platform company, why all the talks about the hardware? I think it’s because we’re looking at a SaaS-like company, but you don’t need to subscribe or think about canceling. Switching costs are high. With a TV, you’re putting screws into your wall and placing a heavy piece of equipment on it. As a result, Roku should have much lower churn than any comparable streaming company. I know people who subscribe to Netflix, binge-watch their favorite show and cancel within a month. You can’t do that with Roku, and the likelihood of churn goes down even more because of it. Many houses are adding a second, even a third Roku device.
This brings us to The Roku Channel (TRC), which was first launched in October 2017 and has come a long way since. It’s already a top five viewed channel on Roku. At first, TRC was only available on Roku, but the company reached an agreement with Samsung to offer it on Samsung smart TVs. Roku then enabled web-based login to stream from a computer or tablet. Soon, you’ll be able to stream TRC from the Roku mobile app. What’s interesting is that these moves have untethered TRC from the hardware itself. In doing so, Roku has created a way for people without the device to engage with what the company has to offer. It has also made it possible for those who already enjoy TRC on Roku to take it with them wherever they go. TRC has been a great platform for the company to experiment with ad formats and apply machine learning for content suggestions to users. It’s becoming increasingly a central hub to the entire Roku experience, and I’ve heard suggestions it will be the home screen soon, maybe by the end of the year. It’s also potentially becoming a modern aggregator and bundler of content. Roku has just said it would make subscription channels like Showtime subscribable and payable through TRC. Users will get one simple monthly bill. Remember, billing information already is stored in every Roku account. Amazon has something similar, and it has done it with great success. Considering Roku has already done well driving subs for content providers, this has a good chance of succeeding too. The better TRC does in all of its initiatives, the better content Roku is able to get on the platform, and the better content on the platform, the more people will want to watch TRC, so it’s another virtuous cycle at work here.
In terms of the unit economics, the hard part to figure out is where ARPU will go over the coming years. We expect decent growth in this number. The main driver will come from more hours watched, a larger share of those hours going to TRC, which is monetized at higher rates than other channels, better CPMs, and more subscriptions sold through the platform. The platform itself is very capital-lean, with most of the investment flowing through OpEx, R&D in particular. For the purposes of this study, I take half of R&D to be growth investment. In doing this, I’m looking to figure out two things. First, what’s the actual cash flow the platform could generate per user were it not aggressively investing in growth? Just as an aside on this investment in growth, when the company announced its intent to be EBITDA-breakeven next year despite about $15 million of EBITDA this year, the stock took a pummeling in the fourth quarter of 2018. It was one of those times when investors were looking for companies not necessarily to drive as much topline but to give growth. The second thing I’m looking for here is to get an idea of when incremental margins will inflect to become positive. It’s likely that Roku will be EBITDA-positive this year. The company suggested as much, though it wants to be conservative in how it approaches its financial guidance.
In year 0, we have a negative number in our model. That’s customer acquisition cost, which is offset with the gross margin on the player sales. This is how the company views it, as a form of negative customer acquisition cost, and it’s the way we approach valuing the business. We ascribe no value to the hardware revenue stream; we don’t view it as the sum of the parts, as some analysts do, and focus instead on valuing just the platform. This is where the hardware value comes into play, and the IRRs here are really attractive. If you take our expectation for 37 million households by the end of 2019 and multiply it by the LTV for each user, you get $1.7 billion of expected value off of next year’s user base. That’s a nice baseline to think about because it presumes no growth and no retention of any users beyond year 5. We don’t have enough history to make clean assumptions about churn and customer lifespan, but thinking about how long the average TV lasts, you can get a ballpark sense. Many think the average TV lasts five to seven years at its first placement and often gets moved to the next, so using five years as a baseline for customer lifespan seems fair in this situation.
What’s the path to $1 billion in platform revenues? It will take 40 million active accounts and an ARPU of $25. Remember, $17-plus was the number at the end of the third quarter in 2018, and it’ll be decently higher in the fourth quarter. Both these numbers – 40 million active accounts and $25 ARPU – are 50% growth from today’s levels on each respective KPI. The question to me is not if but when the company reach these numbers, and it looks increasingly likely this will happen in 2020.
What does $1 billion in platform sales look like for Roku? We can use 10% for the WACC and 4% or 5% for growth to figure out what net margin the market is implying. At the beginning of 2019, the company was trading at 3x the 2020 expected platform sales. The math’s a little different right now but not that far off. Using that 3x number, we can then think about the embedded expectations the stock price is handicapping against. For Roku to work well from here, you need any one of the following to happen: greater than 40 million households, ARPU of over $25, a net margin above 20%, or terminal growth beyond 2020. For context on margins, even a company like Twitter, which everyone looks at as struggling and is a stock we own, has given the Street a long-term EBITDA margin target of 40% to 45%. If you translate that to net at a 25% tax rate, you’re looking at 30% net margins longer term. Now, the margin number is the one least likely to happen in the near term, so the company maintains its insistence on investing in growth, but we think it’s highly likely it hits the numbers put out on households and ARPU by 2020. Meanwhile, the stock is suggesting that if any one of these numbers is checked off, we’ll have a good investment on our hands.
Since player sales don’t really go towards the bottom line, the most relevant comparison between Roku and its peers is enterprise value to gross profit. Looking at the peer group, which includes large and small platforms, all with pretty good growth, it’s clear that Roku stacks up favorably. According to consensus estimates from Bloomberg, Roku has the highest expected growth rate but below average EV/gross profit every year from 2018 through to 2020. The discount gets steeper the farther out you go. Notably, while many growth stocks had a rough fourth quarter in 2018, the declines were met with lowered analyst expectations. That’s what you’d expect to happen, but Roku’s pummeling came alongside rising estimates. The extent of the decline was something I haven’t seen while expectations were moving upwards, but that just plays into our hands and is exactly why the opportunity exists today.
The strategic value is pretty big too. There are many potentially interested acquirers in diverse related industries, from Comcast to Walmart, Google, and Disney. I’d never premise a thesis on acquisition alone, but it’s important to consider what this asset means for the ecosystem. If you think about Disney launching its own streaming platform, viewing Netflix as its ultimate competitor, something like Roku would be quite the strategic asset on several fronts. The obvious one is that Roku could enhance Disney’s ability to distribute and generate subscriptions on its own services, but the less obvious is how Disney would be able to get data on users’ Netflix viewing habits. Roku would be a Trojan horse of sorts, which Is an interesting scenario to think about. Comcast already has an existing relationship whereby customers could forego a set-top box and access its channels through Roku instead. It does charge a little for this, but it’s less than half the price of a set-top box. Sky, which Comcast is acquiring, already has an ownership stake in Roku and a relationship for the digital distribution of its content in Europe.
I think it’s interesting to contrast Hulu with Roku. Disney recently pegged Hulu’s valuation at $9.25 billion. Hulu apparently ended 2018 with 25 million users, so we’re in the same ballpark here. We don’t know ARPU or churn at Hulu, though it’s likely both are higher than at Roku. Hulu is burning money rather swiftly, spending over $2.5 billion on content alone per year. That’s before R&D necessary to build a modern streaming service. It is clearly far more expensive to run than something like Roku, which is capital-lean. Hulu does compare favorably in that it earns almost 5x the advertising revenue of Roku today, but in some ways, I’d like to view this more as helpful in how it provides a nice idea of where Roku can be.
Looking ahead, it’s hard forecasting a company that is growing so fast in such a dynamic industry, but it’s interesting to think about where it can be in 2022. In the worst case, with a meaningful deceleration in ARPU and net new active growth, I think it should be able to hit pretty soon, especially on the ARPU side. Roku could end up with over $2 billion in platform revenues. This is going to be a high-margin, capital-lean, highly recurring revenue base. The question is how much you would pay for it. At 5x the lowest revenue estimate in one scenario, this will be a $10 billion market cap, which will be a 23% annualized return over the four years heading to 2022. Time will tell, but there’s room to fall short and end up with great results, just as there’s room to excel and turn it into something truly special. I lean heavily toward something truly special happening with Roku.
The following are excerpts of the Q&A session with Elliot Turner:
Q: A question on Roku, tying back to your comment that there hasn’t been a day where the stock hasn’t moved around 10% or more. To some extent, it’s understandable why because this really does have a very interesting future. I’m just wondering if there’s any kind of a short thesis on it out there or any vocal investors who disagree with the story.
A: One recent move was inspired by Citron Research, which has played both sides of Roku. It has put out short hit pieces when the stock was in the 60s and called it the future of streaming when the stock was in the mid-30s. I think Citron’s sentiment changes with the wind – it just put out a tweet suggestive that it was short the stock, then rescinded it and said it was actually not short it, just not long it anymore. But the short thesis I’ve seen out there on Roku is that at the end of the day, it can’t escape being a hardware company. The platform is going to have a hard time monetizing. Most of the hours viewed happened on Netflix, where Roku doesn’t have any right to sell ads, and that the competition is going to come on pretty heavy from the likes of Amazon, Google, and Apple, and everyone aiming to get into this area.
One of the points I’d emphasize is that these devices are in people’s homes already, and the clearest evidence of it is both the sales of the players themselves on the hardware side and the hours viewed. Many of these homes have more than one or two. My home has four Roku devices between two sticks and two TCL TVs powered by Roku. You’re not going to replace every single TV at once, and even if you replace one, you’re not going to turn off Roku, so I think there are some things that really keep Roku sticky with its existing user base. The competition for these devices will happen more around the margin.
About the instructor:
Elliot Turner is a co-founder and managing director at RGA Investment Advisors, LLC. RGA Investment Advisors runs a long-term, low turnover, growth at a reasonable price investment strategy seeking out global opportunities. Elliot focuses on discovering and analyzing long-term, high quality investment opportunities and strategic portfolio management. Prior to joining RGA, Elliot managed portfolios at at AustinWeston Asset Management LLC, Chimera Securities and T3 Capital. Elliot holds the Chartered Financial Analyst (CFA) designation as well as a Juris Doctor from Brooklyn Law School.. He also holds a Bachelor of Arts degree from Emory University where he double majored in Political Science and Philosophy.
Glenn Surowiec of GDS Investments reflected on long-term investing and current opportunities at Best Ideas 2019.
During the conversation with John Mihaljevic, Glenn discussed his thesis on General Electric (US: GE), among other ideas and case studies.
Listen to this session:
No slide presentation accompanies this session.
The following transcript has been edited for space and clarity.
John Mihaljevic: Instead of a formal presentation, we’ll have a Q&A. Perhaps we could start with an assessment of your portfolio and outlook going forward.
Glenn Surowiec: Yes, let’s start talking about investment philosophy. I am a value investor. I believe price is what you pay, and value is what you get.
I favor higher quality companies, companies capable of compounding an acceptable rate of return over a long period of time. That approach leads me to industry leaders with high return on invested capital and wise stewards of leadership to manage the capital allocation process. Also, my preference is a low turnover portfolio. My approach seeks cheap companies, maybe misunderstood companies, and I might have a different perspective over the long term than the market’s perspective.
A cornerstone of value investing favors emotional discipline focused on long-term potential in a world increasingly devoted to the short-term. That approach renders my focus to an inch wide and a mile deep. I prefer to own a handful of companies I understand and that meet all of my valuation criteria.
Mihaljevic: Glenn, maybe we can go to an example. GE is a company you know quite well. It’s in the crosshairs, but how do you look at something like that in terms of taking a longer-term view?
Surowiec: GE is probably a deeper turnaround. I still own it, and I own it at higher prices. Sometimes, when you endure large unrealizable losses, it’s not so apparent whether you’re wrong or early. In a situation like GE’s, it makes sense to recheck facts and make sure the logic is still in place. Volatility should not guide long-term decisions.
John Flannery did a decent job taking over from Jeff Immelt. He redirected the company down a different path. Jeff Immelt made overpriced acquisitions, whether it was around stock or whether it was Alstom within GE Energy and Power, or Baker Hughes. Jeff Immelt spread the company wide, and he did so in an undisciplined way. John Flannery simplified the organization, restructured power, and built the next generation of GE around aviation. Healthcare was the right move. In October, John Flannery was let go, and the board brought in Larry Culp.
When I say “brought in,” he was already a member of the board. He came in February. Larry Culp has an exceptional track record. He ran Danaher for 14 years, from 2000 to 2014. Danaher’s market cap and revenue grew fivefold over that period.
Danaher is one of those companies most investors and most laypeople have never heard about. But, in some ways, it was almost the antithesis of how to run a conglomerate; contrast that with the way the GE conglomerate had been run. Danaher employs 60,000 people, and less than 200 work in the corporate headquarters in Washington, D.C. He brought a change in culture. Culp believes leadership should be out in the field, and he has a phenomenal track record; he will continue to do what John Flannery started.
Culp needs to accelerate changes, and he needs to bring additional liquidity quicker than John Flannery was able to. More importantly, GE needs to send a cultural signal that Culp is an outsider, and this outsider offers perspective capable of helping create value for shareholders and employees.
For a company like GE to bring in an outsider, it tells stakeholders that GE endures a serious problem. GE presents the good and the bad. GE Capital continues to unwind and is essentially in runoff mode. Legacy liabilities need to be addressed, and it is trying to address them by building reserve. A reinsurance transaction could potentially help resolve these risks.
GE is trying to do something with Baker Hughes, the publicly traded BHGE it telegraphed to the market. GE is trying to do something with GE Healthcare via an IPO or spinoff or some other corporate transaction. Power is still a work in process, and GE is addressing it, not unlike what Bank of America (BAC) tried to do by separating the bad stuff and restructuring around the good stuff.
BAC is one of my more successful investments. I originally invested at $10 per share after 2008 or 2009. It wasn’t at the height of the crisis, but issues lingered. I thought Brian Moynihan was doing great things, and the market was still concerned about legacy mortgage operations. BAC’S management failed to realize two things. A lot of progress had been made with the core long-term businesses. Also, BAC understated profitability because it supported this legacy mortgage business. Overhead was higher than it should have been.
I first bought it at $10 and averaged down, and it ultimately bottomed at around $5. I had large unrealizable losses there, but I felt the company was putting the business on the right track. Its recent price is near $26.
GE, with the right execution – I’m a big fan of Larry Cup – GE can carve out a trajectory similar to Bank of America’s.
Mihaljevic: It seems GE’s valuation has come down so much, if it can get through this period without dilution, the upside will be intact. What’s your level of confidence in terms of GE weathering this period without issuing equity?
Surowiec: That’s a good question. The market already discounts some dilution. GE recently cut the dividend, and management aims to reallocate capital with different priorities. GE’s success enduring this time depends on whether deterioration in power persists. If some of these contingent liabilities turn out to be greater than expected and/or if GE can’t offload risk to a reinsurance company, it might not be able to avoid issuing equity. GE announced a $92 million share offering in BHGE and a secondary offering. This addresses near-term liquidity short of issuing equity. I don’t know that anything is off the table. Larry Culp will certainly do what’s in the best interest of long-term shareholders.
BAC did the same thing when it issued convertible preferred stock to Warren Buffett. The market endured a near-term reaction. In the long term, it probably made sense.
Was it dilutive? Possibly. It depends on how you look at it. Was it necessary? Maybe. Hindsight’s 20/20. Maybe BAC could have gotten by without the preferred issue. But it de-risked the company so it could move and focus on things outside of liquidity and capital structure. The preferred issue allowed BAC to take a different path and know it enjoyed the comfort of having Warren Buffett as a major shareholder.
In the near term, dilution creates a negative impact. In the long term, not all dilution is created equal. If you can bring in a partner and take a risk off the table such as liquidity, then it can have a positive impact. Putting the dilution thing aside, GE has other levers to pull. I don’t know if an equity issue serves its first option, but I don’t know if it’s off the table either. But the fact it effectively eliminated the dividend reveals how GE considers many choices. GE senses its assets have value, and it is not locked into any particular path. I can tell you that Larry Culp, at least based on what he did for Danaher, locked into long-term shareholder value. If that means pursuing one strategy or a different one or a hybrid of the two, then he’ll probably do what’s financially responsible.
Mihaljevic: Are his incentives aligned with the long-term shareholder gains?
Surowiec: Yes. Not only has Larry Culp been a buyer in the open market, the vast majority of how he’s paid directly aligns with equity owners’ interests.
Mihaljevic: That’s helpful. Glenn, maybe stepping back a little, you talked about philosophy in the beginning. I know you are on the lookout not just for deep and undervalued, but also for quality. What do you look for when you say quality? Is it more the business or the management team?
Surowiec: That’s a good question. First, I look introspectively. I think these questions of quality come up in a lot of your conferences. You have a lot of different value investors who operate differently. They have an investment committee, and some operate with a single person making decisions. I’m more of the latter. I network with a group of people, and that’s healthy. But in terms of having final say over a decision, you have to understand what companies you need to own in order to win long term. Lots of people that can do the whole “I’ll buy a dollar and pay $0.60,” a la Ben Graham. They look for those kinds of cigar butts and they can be highly successful.
My philosophy is this: I don’t want to say trial and error because directionally, I started down this approach, but my winning formula is pretty simple. Price is what you pay. Value is what you get. I seek value.
I need a denominator and that equation to go up, which means I look for businesses creating more value every year. How they go up is different. Some create value with measured acquisitions. Some do it through opportunistic share repurchases. Some apply their pricing power. Some try to broaden the scope of what they do. Some enjoy economies of scale. I mean, there’s a variety of ways you can increase the value of a company. I’ve owned companies where you have John Malone, who does his thing, and maybe he uses more leverage. His might be more maybe tax driven, and he’s dealing with a certain industry. I’ve owned companies that Vernon Hill has been part of. He is more de novo organic expansion where, literally, he’s taking a model that works and he’s building another store and yet another store, a la Home Depot or McDonald’s. I am indifferent; I only want to make sure value rise.
The companies I look for, the companies I feel most secure about for my clients are number one or number two in their industries. I don’t like to deviate. Typically, if the industry operates in a duopoly, then all the better. A number one with 9% market share where it’s highly fragmented…that is different than a number one with 35% market share and the next closest competitor might be at 20% and 15 competitors make up the remaining 45%.
I prefer the latter. Capital structure we talked about with GE, and GE falls outside of this a little. But most of my companies are extremely conservatively financed.
I’m not interested in companies trying to maximize economic theory when it comes to leverage because sometimes you’re not building the capital structure around the most likely event. You’re building it around the hundred-year flood. I prefer companies operating with that mindset.
To introduce a Will Thorndike reference, I look for outsider CEOs. There’s a huge tailwind to being in a good to great business and having a management team that is a tailwind and not a headwind. Management teams can come in and destroy a great business because they’re essentially renting their jobs. They know they have five years to make a difference. They try to hit home run after home run when maybe singles and doubles are more suitable for what they’re trying to accomplish.
I am definitely looking for outsider CEOs, and the way you identify that is, you look at how they allocated capital in the past. You want to talk to them if possible. You want to listen to what they say and what they do. You want to read 10-Ks.
Through that process, you discover a lot of CEOs came through the organization through the sales channel. Without generalizing, I found a lot of those CEOs to be dangerous. I would prefer a less charismatic CEO and someone who is more operationally savvy, someone who understands the manufacturing process. I would rather a CEO who understands the finance piece of the business as opposed to someone who constantly needs to defer to the CFO. Because, at the end of the day, if you have a CEO who takes ownership over every aspect of the organization and you have a CEO who understands the significance of capital reallocation processes, they are in a better position to make decisions in shareholders’ best interests. We’ll be agnostic whether it comes to paying dividends, buying back stock, pursuing M&A, or maybe investing in our own business; they will choose the most appropriate path. Those are CEOs that I want to align myself with.
Whenever I hear CEOs say, “Yes, we bought back stock because we wanted to offset dilution and equity compensation,” I say, “That doesn’t make any sense.” If your stock is overvalued, then why are you buying back stock? Maybe dilution isn’t such a bad idea. Or, if you have companies issuing debt when the stock is overvalued, it doesn’t make any sense.
Mihaljevic: I’m curious about your take on the accepted wisdom that brands are not necessarily what they used to be. How do you look at the pace of innovation and the pace of destruction of some types of moats historically viewed as wide? Have these developments pushed you toward expanding the circle of competence, maybe looking at companies in the technology space?
Surowiec: I do own quite a few companies in the technology space. There’s no question the lifecycle of companies has shortened. Disruption cuts both ways. It presents opportunity, and it also means companies will be on the other side of that force. For decades, certain industries enjoyed a reputation for moats and pricing power; the reputations might not be true.
Traditional thinking targets newspaper and consumer product companies, like Colgate, as suitable positions during recessions. I’m not sure that thinking is true. They are vulnerable and I have stayed away from them. Other companies present a real moat. I look at metrics like net promoter score to determine which brands consumers value. Net promoter score is just one data point, but other data points can corroborate. Investors must be mindful of an environment. Because of the pace of technology and the pace of that change, moats are not what they used to be. I don’t know about expanding the circle, but maybe rerolling it is the right way to think about it. The irony is that companies with moats today might be vulnerable. For example, Apple has a moat and operates in a huge ecosystem. If you consider what’s happening in the Valley, many companies open up second, third, and fourth lines of business. In the past, a clear separation seemed to distinguish Apple’s business from Google’s, Amazon’s, and maybe Alibaba’s. Those lines are getting blurrier.
Investors must be mindful of changing moats and a company’s competitive situation. Certainly, some companies today enjoy wide moats. Jeff Bezos made reference to this either in his last shareholder letter or I read it somewhere, but he said, “Listen, at the end of the day, we will get disrupted. You need to build an organization with an edge preventing it from getting stuck in the mud.” That’s the world we live in. It’s not universally good, and it’s not universally bad. It’s something investors need to evaluate.
Mihaljevic: To the extent you’re willing to talk about it, I’d be curious in what kinds of technology-related companies you found have value.
Surowiec: I’ve owned Qualcomm for a while. While it is not a traditional technology company the way a lot of people think about technology, but it has a long-term earnings growth story. I like what Qualcomm is doing after the NXPI acquisition failed because they didn’t get Chinese regulatory approval, and they engaged in a massive buyback at accretive prices. Some overhang exists because of the licensing dispute with Apple. That’s a company I like. It has a rich pipeline. It spends an enormous amount of money on R&D. I’m comfortable owning Qualcomm partly because it is shrinking the denominator in the earnings per share calculation and it is on the wave of many emerging technologies.
Many emerging market companies’ stock prices have declined. For example, prices for some of the biggest companies in China have come down to interesting levels. These companies are entrenched, similar to the way Google is with domestic search and Amazon with domestic e-commerce and the cloud. Prices for these emerging market names, because of some of the trade angst, have come down quite a bit. Those are in my portfolio, and they are interesting to me.
I have owned the FANG names at one point or another over the life of GDS Investments. I do not own them now. They’ve all done quite well. I was early in getting them out of the portfolio, but I was right in my entry price. If you look at Apple, investors were uncertain about its ability to reinvent things after Steve Jobs. However, I was comfortable with what Tim Cook was doing, initiated positions then, and it performed well. My concern is not that Apple has come full circle. Certainly, it’s off a lot from the last month or two. But when you’re dealing with trillion-dollar companies, the next leg of growth gets difficult, and it’s not a bet I want to make. If you look at the upgrade cycle we’ve seen with the core smartphone product, you see it gets longer and longer. With each new innovation, customers will be less inclined to upgrade. The industry is starting to see that now. The ecosystem will be there, but I’m not sure people will pay $1,200 for the next generation phone when they see maybe a 5% improvement. When you have the price continuing to go up with the rate of improvements coming down, that’s an uncomfortable intersection. That’s what I’ve been doing lately in technology.
Mihaljevic: Great, that’s helpful. I’d be curious also, Glenn, to know what you think about holding cash both in general as well as in this market environment that might be a late stage bull market. We’re getting some jitters now. What do you think about cash in the portfolio?
Surowiec: I think about cash not necessarily in a top-down way but more in a bottom-up way. If I have ideas and if I have more great ideas than cash, then I would like to be close to fully invested. On the other hand, if I have more cash than great ideas, I’d like to build up cash.
If you look at my history, I’ve been anywhere from 0 to 30% cash, depending on the opportunity set. Today the economy is slowing, and people are nervous. If you look at individual names, the Caterpillars, the DowDuPonts, and look at traditionally economically sensitive names, the stocks are pricing in some of the slowing economy. DowDuPont has a great CEO in Ed Breen who did wonderful things at Tyco. They’ll break up the company. Value will increase as they do that in 2019 and 2020. The price is at multi-year lows. Bellwethers whose prices have dropped imply some recognition the economy is slowing down. I don’t own Caterpillar, but I do own DowDuPont.
Directionally, our market is more similar to the late ’90s when we had the huge concentration of capital misallocation into some of the growthier names. If you look at the disparity between Russell 1000 growth and the Russell 1000 value, a slowing economy will act as a catalyst for a rotation of the value. That’s the missing ingredient. People will become more price conscious when the growth isn’t there. I am less than 10% in cash. I’ve used volatility in September, October, and November to do two things: Increase my cash position and upgrade the portfolio. I have rerouted away from positions that have gained value and from companies carrying too much business risk. I have added to positions in cheap, bulletproof companies with structural tailwinds over the next 5 to 10 years. I’m encouraged by how a slowing economy might force investors to reprice certain growthier assets; that presents an advantage for value-oriented managers.
Mihaljevic: You’ve talked about Commerce Bancorp in the past. Will you update us? Has it developed the way you expected? Do you consider it one of those solid pillars?
Surowiec: I owned Commerce for a long time. It was a 15-year holding up until it was sold in 2007 to Citibank. I have since participated in Vernon Hill ventures. The first is Republic Bank, which is a small bank in Philadelphia involved in de novo expansion Commerce was so famous for. It’s around $7 or $8, and my basis in that is about $1.50. Its venture in the UK is also interesting. It is involved with a bank called Metro Bank. I own Metro Bank. I like Metro Bank for more than the obvious reasons. You have Vernon Hill’s involvement and you have a formula that was highly successful in the States. The model in the UK will work better than it did in the States. I say that only because the UK banking system has not witnessed a single new bank charter since 1840. This industry is ripe for disruption.
You have this maverick in Vernon Hill. You have competitors incapable of dealing with this new way of bringing in deposits because the HSBCs and the Barclays and a lot of these four or five banks that control 98% of market share haven’t reinvested in a retail banking business. Their culture isn’t suited to bringing in deposits. These six legacy banks are out of step and bureaucratic. If you talk to customers of these legacy banks, they do not do business with the banks because of any underlying goodwill. They do business with them because of a lack of alternatives.
I bring it back to other models. Did people go to Hechinger, Builders Square, and Grossman because they absolutely loved the experience, or did they go there because there wasn’t a Home Depot? It was the latter. They were there temporarily.
I’ve always been fascinated by models on the verge of disruption. Management thinks their customers have more loyalty than they have. You see a model that’s coming around, and you see the distinction between, in this case, deposits that are there for all the right reasons.
Commerce brought in deposits for all the right reasons. It didn’t have customers. It had fans, and it had people who felt they could not do without Commerce. It was because of friendly service. It was because Commerce was open seven days a week. It was because depositors could visit before and after work and know the bank would be open. Commerce’s lenders were known to work with businesses throughout the economic cycle, where other lenders were known to cut off lending during recessions and business slow-downs.
Metro is in a good position because it is scratching the surface for what will be a decade- or two-decade-long runway. I own Metro. I own Republic Bank. Studying Commerce’s model, working at Commerce, and having relationships with people at Commerce, give an advantage about understanding what’s happening and how powerful the model is. I am bullish on both of these businesses.
Mihaljevic: Metro Bank’s price has dropped, probably because of Brexit and related concerns. These concerns have nothing to do with the long-term economics of the business. It seems now might be a good time to look at Metro Bank.
Surowiec: It would be a great time.
Mihaljevic: Glenn, thank you. It’s always a pleasure. When we do these Q&As, we never quite know where it’s headed, but I always learn a lot. I’m sure those listening have picked up some things to follow up on, as well. Thank you for taking the time to do this.
About the instructor:
Glenn Surowiec started GDS Investments in 2012. From 2001 to 2012, he worked for Alsin Capital Management, Inc. as an equity research analyst (2001-2003), co-portfolio manager (2003-2008), and portfolio manager (2008-2012). Glenn has a BA in Management (Accounting concentration) from Gettysburg College and an MBA (Finance concentration) from Southern Methodist University. His interests include running, cycling, golfing and youth coaching.
Phil Ordway of Anabatic Investment Partners discussed companies that “do capital allocation right” at Best Ideas 2019.
Here is Phil’s session preview:
Investors place a lot of emphasis on capital allocation when considering businesses as potential investments, and rightfully so — over multi-year periods there are few things more important to a company success. So why do companies pay so little attention to it?
Is it because of managerial inexperience? Most CEOs get the top job because of operational excellence or other skills that have nothing to do with allocating capital. At least in the first few years of such cases it’s not even fair to expect capital allocation success from new CEOs.
But what about the board? Isn’t the board supposed to choose and oversee the executives? Yes, but most boards are similarly inexperienced when it comes to capital allocation.
So what about shareholders? They supposedly own the company; can they do something constructive in this regard?
Whatever the reason, I will argue that there are mutually beneficial solutions.
We’ll look at several examples of companies who “do it right” when allocating capital and interacting with their investors. A smart capital allocation framework, communicated through a thoughtful investor relations function, can attract patient, long-term, rational shareholders that will be an asset to the company. It is possible to create a positive feedback loop in this regard, but precious few companies even bother to try. Studying the companies who get it right should yield a fruitful list of potential investment ideas.
The following transcript has been edited for space and clarity.
I thought I’d do something a little different this year, which is pick a topic and a group of companies as opposed to one specific industry, as I’ve done in the past.
Today’s topic is one near and dear to my heart – capital allocation and the role it plays with investor relations and overall corporate governance. This came up recently when a company that’s one of our biggest holdings hosted a meeting for some of its investors. Later, I was having a nice conversation with the CEO, and he asked for my impressions about some things, so I gave him my usual sermon on the topic of capital allocation, investor relations, and overall governance in that regard. To my great surprise, he was so receptive to it that he asked me to come present to the board. I regard this as a great sign because most investors probably know from experience it’s not a topic that seems to get as much attention as it should at the CEO and board level. That’s often through no fault of theirs – it’s simply not their background, interest, or area of expertise. Still, it is a mistake, in my opinion, and companies do need to pay attention to it.
When I make presentations, I always advise against people blindly taking the information and acting on it. I believe they should study it and learn on their own. The companies I’ve picked here are not businesses I have particularly deep knowledge about; they are just particularly good or vivid examples of certain ideas and practices relating to capital allocation, investor relations, or overall corporate governance. This is not investment advice by any stretch of the imagination.
The basic idea is that all would agree there are three things all companies need, Firstly, they need to take their capital and allocate it effectively. They also need to have good shareholders, meaning the right kind of shareholders who are aligned with what the company is trying to do so that there is a helpful, productive, symbiotic relationship. To get that, companies need meaningful communication with their shareholders and all of their stakeholders. These three things often seem to be viewed in isolation, but maybe they’re all related. If we study companies which do it right, we should get potential investment ideas over time.
Anyone who’s been in investing for some time has seen how important these topics are. I mean, the best use of cash is the number one thing any investor is doing, and it’s the same with any corporation. The CEO and board will certainly have a massive influence on the company over any amount of time. If they stay for more than a few years, they will end up allocating a lot of the capital deployed in the company. No matter how cheap the security, a bad capital allocation decision or regime, a bad acquisition, buybacks at the wrong price, or just a poor overall governance environment can ruin any business, and I’m sure we have all seen examples of it.
When we talk about capital allocation, it boils down to how we use our cash. This is a fundamental question, whether you’re an investor or a company executive. It’s amazing to me how adept many businesses have become at using their cash intelligently. They’re incredibly smart in how they allocate their cash when it comes to managing their suppliers and vendors, running their internal accounts receivable, overseeing the day-to-day operations, or investing in their PP&E. When it comes to the financial aspects of their business, their capital structure, it tends to be a totally different conversation. That seems very strange to me because we’re all just talking about tradeoffs. If you go out and talk to companies about this, you have to be able to argue that this will define them over time, separate the good from the great, and take the good or the mediocre and potentially turn them into something much worse if it’s not done well.
Secondarily, over time, companies will get the shareholders they deserve. If they’re doing things wrong or right will eventually manifest itself in the shareholder list. This is a key topic for this era because there are some big things happening in the way corporate governance is executed, at least in the US. The index funds are here, and they’re massive. They’re often the biggest shareholders in any given company, and they have many benefits. I am by no means discouraging index funds as a concept for there are many benefits from the rise of Vanguard and others, but corporate governance is not one of them. In any company’s life, if you’re looking at a 5-, 10-, 20-year period, you’re almost guaranteed to have at least one event where there will come a vote that’s extremely close. If all of your shareholders are passive or checked out, you could lose your company to a somewhat arbitrary decision coming down essentially from ISS or Glass-Lewis or non-economic factors. This is something no one wants.
Additionally, the activists are coming, and this does have the attention of many boards and companies. They’re scared and rightly so. By the time the activists arrive, it’s generally too late, in my view. Therefore, the idea is to engage with your shareholders and have the right capital allocation environment to generate the right kind of shareholders so that you don’t get to the point where the activists come.
On top of that, long-term engaged shareholders are a vanishing breed. Whether they’re big institutions or sizable blocks of retail shareholders, they’re shrinking, dying out and being replaced largely by the index funds and some of the large pension funds. The holding period has declined rapidly, and it’s devolved into this unhealthy, unproductive shareholder environment that companies need to pay attention to and try to fix.
Capital allocation is a fluid process. The number one rule is that it’s an ongoing process. There is no finish line, conditions change, and your capital allocation decisions have to be adaptable. A thoughtful framework is all that’s required. There are no hard-and-fast rules, and no one size fits all. This is what I would refer to as a decision tree, which is not as fancy as it sounds. It is essentially a common-sense list of priorities. If you see a company which doesn’t publish this, you should ask. If it can’t walk you through this, it’s a problem, and it needs to be addressed.
There are some common traits I see at companies with good capital allocation regimes and good corporate governance. Number one is that they have an investing mindset, which doesn’t mean you used to run a hedge fund though it can certainly be helpful. There are plenty of CEOs who had an investing background in some way, shape, or form. They were a venture capitalist, a real estate investor, or a fund manager of some type, and then they somehow ended up in the C-suite at a company. There are also plenty of CEOs with absolutely no background in investing, people who previously worked as lawyers, marketing executives, or operations managers. Still, when it’s explained to them, they get it, and this investing mindset then permeates through the whole organization.
At least as important is what not to do, first and foremost pretend like it doesn’t matter or deny there’s a problem. You see lots of individual practices that are particularly dumb, and eliminating them would be a big step in the right direction.
What I like to see in terms of overall corporate governance is a dedicated, and better yet, interdisciplinary capital allocation team at some level of the senior management. I certainly do this with my own investments during what I call pre- and post-mortem – looking in advance at what could go wrong, what actually happened at some point down the road, what worked and what didn’t. Companies that can establish such discipline internally are particularly effective. At the board level, I would advocate for a capital allocation committee. That’s not to add one more layer of committee or bureaucracy but to highlight the fact that this is something really important. There are shockingly few companies doing this or even mentioning it anywhere in their corporate governance documents, charters, and by-laws. I found out by searching SEC files, EDGAR, and SEDAR, and doing simple Google searches. There were shockingly few that mentioned any sort of capital allocation committee as a function, even if it’s just a sub-function of the finance committee. I also did a little survey among 50 of the Fortune 500 companies and found fewer than a third even had a finance committee. You don’t know what’s happening in all these board meetings. They’re talking about finance issues and capital allocation, but I think it would send a powerful message and be effective if they made it much more of a priority.
The second thing is finding at least one or two people to serve on the board who actually have the capability and the background diversity to think like an investor, to bring an independent board level view of capital allocation, to act as a check on the CEO and the management team, and to make sure the board has its own opinion. They certainly have their own opinions on other topics. Why wouldn’t they have an in-house expert to do this for capital allocation? It would make plenty of sense.
Investor relations (IR) gets back into how you tie this all together. In most cases, IR tends to be a dedicated function of the company that exists on its own. It tends to be about how you interact with Wall Street (the sell-side analysts in particular) and keep them happy and how you get the stock price as high as possible. Neither of those is productive and could, in my opinion, be quite counterproductive. The IR function ought to be an in-house but cross-functional role, some role within the CFO or controller’s organization, not a permanent thing one person does forever. Make clear that what you’re trying to do is communicate as needed, not just because you feel like you have to because the calendar is on a certain day or because your peers are doing it. Provide the information you want if the roles were reversed and you were a significant shareholder. I always prefer written communication as I find it more effective.
There are a number of companies I consider particularly good in that regard. The point is not that any of them are perfect – they certainly aren’t, nor are they perfect investments or even good ones. By no stretch of the imagination am I evaluating any of these on the basis of price and value and their investment merits. These are companies I found to be, at least in one or two or three notable ways, extremely well managed, thoughtful, and effective in what they’re trying to do. There is no ideal, perfect company, with perhaps one possible exception, which is, of course, the company in Omaha. When I bring this thing up in talks with CEOs, management teams, or even other investors, I’ve noticed you either get a visceral reaction to Buffett the personality or the very reasonable response “I’m not Warren Buffett. I’m not running Berkshire Hathaway, and I don’t have these circumstances, so this stuff doesn’t apply to me.” That’s fine, but my point is there’s only one Warren Buffett and one Berkshire Hathaway. You don’t have to be that. What you should try to do is make incremental progress to a better company and a better you. If you take some of the best practices companies other than Berkshire Hathaway have figured out, you can make a huge difference and make your company far more valuable over time.
One of the best examples of what I’m talking about is Constellation Software. This is a Canadian-based company which has made dozens and dozens of acquisitions over the years in various vertically managed software companies. It’s a pure software technology company, so about as far as you can possibly get from Berkshire Hathaway and Warren Buffett. However, the CEO, Mark Leonard, is enormously thoughtful in what he does, and his results speak for themselves. This company IPO-ed in 2006, not even that long ago. This is the kind of investment that if you can identify it and find it early – which, unfortunately, I did not – it could literally change your life and your career.
I don’t think it’s any coincidence that capital allocation is at the very heart of this company. Mark Leonard didn’t have an investing background, more of a VC-type background, but he gets it. If you look at what he’s done and where or how he’s laid things out over the years, you’ll see a highly consistent framework, which is the most important thing. This was obvious in the prospectus when they filed to go public in 2006, but there are also fantastic, thoughtful shareholder letters. The management provides written responses to investor questions. Instead of doing a lot of time-consuming sell-side conferences or one-on-one meetings, which are also quite inefficient, you submit questions. They take the meaningful and thoughtful ones, reply to them, and file their responses so that everyone can read them. If you ask me, that’s the most obvious thing in the world to do. The IPO prospectus says, “At the heart of our business model is the effective allocation of our capital.” If that’s not a clear, impactful, and meaningful mission statement, I don’t know what is. It ought to be the case for every company. Constellation Software publishes case studies of things it has done; it has a very effective board of directors; and it actually tries to develop capital allocators at each level of the company, which is something I consider particularly unique. I don’t think I’ve ever seen it in another company beyond perhaps Berkshire, where they try to nurture the capital allocation function amongst their other executives.
The prospectus of 2006 details what Constellation does and why, along with providing the capital allocation framework. It is very specific to the software business, but all companies ought to have something like this – not in terms of the details, but how they go about allocating their capital, what they do when cash is available, and, just as importantly, what they do when they don’t have opportunities. Constellation Software also ties its compensation plan to it, which is absolutely crucial. It makes sure people are tied to a return on capital and not just blowing capital out the door with no concept of an opportunity cost.
As regards the board search criteria, there is a really interesting story here. Most will be familiar with Larry Cunningham, who is the author of several fantastic books and compiled the original magnum opus, The Essays of Warren Buffett with Buffett’s cooperation and approval. Larry is an expert, but he’s a law professor by background and training. Constellation tries to find board members who match specific criteria – it doesn’t view the board of directors as a country club for friends and cronies. It wants the board to add to the company’s success, which puts it in the top 1% of companies out there in my opinion. As part of this search process, Constellation’s management looks forward and says, “We’d like to find more people who understand corporate structure, culture, conglomerates, acquisition-hungry companies, and capital allocators.” Mark Leonard was familiar with Larry from his work and reached out to him directly as a part of the search. They started taking and did some work together on the side and some studies. Larry’s now on the board, which is just a fantastic example as to how this should work. Listen to them talking and you’ll hear how much value the company has derived from that relationship alone. In my opinion, this is what every CEO and every board should be doing.
Another good example is Texas Instruments. I think everyone should look through its IR materials, particularly those dedicated to capital allocation. This company is absolutely fantastic: it has presentations, and it puts videos on YouTube to make it clear this is important. “At Texas Instruments, we as managers think that allocation of capital is one of the most important jobs that we have“ – this is as clear and important a statement as you’ll ever see, and you almost never see it. These are not guys who think of themselves as Berkshire Hathaway or Warren Buffett knock-offs, but they get it.
What may be the most interesting thing is that when Texas Instruments had a regime change some years ago, it actively reached out to what it thought were the right kind of investors. I won’t name names, but it went to some people I think we would all agree are fantastic, patient, long-term investors and said, “We think that you guys will be the right shareholders to own our stock. We’d like to sit down and talk with you.” It worked because it was so intelligent and thoughtful. The logic was there, and the company ended up getting several 2%, 3%, 4%, 5% shareholders that stayed invested for years. Think about how much more intelligent that is than sitting there and doing conference calls and sell-side presentations where you might be yelling into the wind. You’re certainly not targeting the right kinds of people in this way.
Going back to the capital management strategy, the business model is built around four things the company calls its sustainable competitive advantage, and it has the discipline to allocate the capital to the best opportunities, but not because it feels like it has to. There is a strict hierarchy for these opportunities, and it makes perfect sense where and how it measures outcomes. It has targets and publishes the results, which is fantastic. Over the preceding decade, Texas Instruments allocated $72 billion of capital. If you had said in 2008, “Guys, we need to sit down and allocate $72 billion of capital over the next decade,” it probably would have been a pretty sobering thought at the time, but it’s true and is important. Every company has some version of this to think about.
Another great example is Morningstar, where we actually have something of a Warren Buffett link – founder Joe Mansueto is a long-time admirer, friend, and confidant of Buffett’s. When the company went public, it intentionally structured its business to be decentralized, have a long-term focus, and go out and seek the right kind of shareholders. It said, “We’re not going to take analyst meetings. We’re not going to issue any kind of financial guidance,” the latter being a thing whose popularity I still can’t fathom because it doesn’t benefit anyone. Morningstar has candid written IR communications as well, including published answers to investor questions.
Another really interesting one is Graham Holdings, which probably has the most direct tie to Buffett because he was a long-time shareholder and became a personal friend, mentor, and tutor to the management team and the family. Over the years, this company has been willing to reinvent itself in a capital allocation framework by selling its crown jewels, spinning off what was its cash cow, building a really diverse and talented board, going much younger with its executive team, and branching out into new industries. I feel as if management teams get trapped into thinking they have to be on the sell-side conference treadmill, that if they don’t have a presence there, they will lose out somehow. What if you just limited it to the ones which really make sense? Graham does exactly one sell-side conference a year – a UBS conference in December – and that’s perfectly effective and legitimate. An executive’s most precious asset is their time, and so why wouldn’t you want to be more careful in allocating your time to the few things that matter? Doing this once or maybe twice a year seems like quite a reasonable compromise.
With Credit Acceptance Corp, the business model may put some people on edge, but the point here is how it goes about using its capital allocation practices to benefit the company and make it more valuable over time. It says, “We have used our excess capital to repurchase shares only when prices are at or below our estimate of intrinsic value.” This should be obvious, but it’s rarely said out loud. The company acknowledges the fact that its assessment of its own capital position and valuation is subjective – another thing that is obviously true but needs to be said out loud and be at the top of mind.
Here’s another interesting part: it cites two board members with very deep investment experience, revealing they are the ones who steer capital allocation at the board level. It’s awesome to have a CEO saying, “Look, I think I’m a great executive. I run this company, but these two guys on our board are better investors than I am, so I’m going to defer to them in decisions where we may disagree about what to do with some of our capital allocation decisions, like repurchasing stock.” How many CEOs have the self-awareness or the security to say and do this? That is exceptional and highly admirable, in my opinion.
Cimpress is another good example and quite an interesting company. Its CEO did not have an investment background, but he had that “aha” moment. When someone explains to you how capital allocation should work, you really ought to be able to get it in the first two minutes because if you don’t, you’re probably never going to get it. Here, the light bulb went off, and the rest was history. Cimpress does some really intelligent things, such as track all of its investments and repurchase activity. It has a document which covers its long-term incentive compensation plan, and I think it’s particularly clear and admirable. It writes an annual letter explicitly talking about capital allocation, which is fantastic as well.
Amazon is probably one of the best-known companies in the world, but I think its capital allocation, IR, and communications efforts are underappreciated aspects. With its size now, these matters far less but certainly mattered a lot back in the day, particularly after the dot-com implosion, when the company was in a bit of trouble and the stock was beaten up. The way it went about discussing its capital allocation framework and cultivating the relationships with its shareholders absolutely mattered and was hugely important. This is a classic tech and – for the moment – disruptive company, but the statements you can see in its shareholder letters ought to resonate with any of us, no matter how stodgy our views might be.
Phillips 66 is at the opposite end of the spectrum, a commodity energy company, but look at this: “We buy our shares when they trade below intrinsic value” or “We operate in a volatile industry, but we ought to be resilient through industry cycles by strategically investing our capital in a way that adds value to our business and our shareholders.” As far as I can tell, that is unique among all energy companies and makes it stand out. It has done quite well because of it.
It has also published the way it goes about calculating its returns on capital, which is another thing I’ve never seen an energy company do before. I’ve looked at plenty of them, not so much recently, but in my prior life, and it’s amazing to me how much return on capital gets completely ignored in this industry, particularly by E&P companies. Phillips 66 isn’t an E&P company, but the way it does this is uniquely thoughtful in the industry.
Sherwin-Williams is another great example, with a very clear and consistent capital allocation philosophy. There are certain things I may not consider ideal, which applies to all of these companies. Sherwin-Williams has taken this attitude that it will never hold cash. It wouldn’t bother me if a good company with a thoughtful capital allocation framework allowed cash to pile up for a year or two. You don’t want to hold an undue amount of cash for a decade, but this company has a very strong view the other way. It’s fine because that’s its framework, its business, its culture, and its goals, and you can see here how it’s working.
One other thing that makes Sherwin-Williams stand out is that it was one of maybe a couple of dozen large public companies, at least in the US, which were actively buying back their shares in 2008-2009. Everybody was buying back their shares in 2005 and 2006. Pretty much every stock got hit hard during that period. When a lot of them became very cheap, the buyers all disappeared, even among the companies with the capital structure, the excess cash, and the cash flow to buy. However, most of them didn’t have the courage or the framework in place to execute on it while Sherwin-Williams did. That’s incredibly important and valuable, and it should be commended for it.
WABCO is another company which had the courage to do it in a contrarian way. An example I want to call out is Jacques Esculier, who is a great capital allocator and did this in September 2011. You may remember there was a scary period in that year. The euro crisis was beginning to flare with Greece and some other countries. There was this pervasive fear that we were going to have a double dip and go right back into a nasty recession, like the one we’d just come out of, and a lot of stocks, WABCO in particular, were being hit hard. The company had a dedicated special call, announcing it would go out and buy back a lot more stock, telling people about it to address fears, concerns, misconceptions, and just provide an update on how things were really going because it was a pivotal time. It bought back a lot of stock and did well on it. It was a very intelligent purchase at the time.
Netflix is probably among the most analyzed or overanalyzed companies in the world. I don’t have any strong opinions about the things that normally get debated about, but most interesting, in my opinion, is how the company used capital spending, not in the sense of debt and equity or other securities but as a weapon to swamp its competitors. That’s fascinating and worth studying and considering.
Another thing that jumped out was its board practices. Netflix doesn’t have a typical board by any stretch of the imagination. Rather than publishing some massive 100-page document for a board book for each meeting, it restricts communication to relatively short memos directors can access, edit, comment on, and amend over time. Thus, you get more of a living document to mark and track your progress, just as I keep a running notebook with everything I’m doing, looking at, and thinking about. I use it to track my thoughts and progress over time, and Netflix does the same thing with board-level communications. As far as I can tell, that is unique among all boards of directors.
Netflix also encourages its directors to get out and get involved with the company. Rather than go to some board retreat or to a meeting in a sterile conference room, directors are urged to get out at least several times a year and go as observers only. They’re not supposed to influence or interact with the meeting itself but go to lower level staff and executive meetings and watch how the company operates in the wild. I find this an enormously intelligent practice. The company has got some great IR documents and practices as well – the effort and thoughtfulness it has put into its IR are impressive.
Henry Schein, a dental and healthcare products and distribution business, has had some fantastic results in using a value-based approach in repurchasing shares and making acquisitions. It has done over 200 acquisitions in the last couple of decades and invested massively in organic growth, new product lines, and new geographies. One thing I find extremely interesting and which ties into this whole concept of IR and corporate governance is that Henry Schein doesn’t let the tail wag the dog. It clearly and explicitly states that the company does not exist for the investors. The investors are important, and it acknowledges it can’t exist without them, but it’s not going to let things get out of order. I’ve been thinking about this a lot lately. Herb Kelleher of Southwest, who recently passed away, was very clear about this as well. You must have the right order of priorities. For most companies, there’s a reason why equity holders are the residual security in the capital structure. If a company is being run properly, they ought to often be the residual consideration in that process as well. If you’re not putting your employees and your customers ahead of your shareholders, something’s probably out of order and probably going to go wrong.
Daily Journal is an odd duck but a fantastic example of capital allocation. It built up a massive cash hoard over several years leading up to and including the financial crisis, when Charlie Munger was at the helm and had been for many years. Then, in one fell swoop, in March of 2009, it made a massive investment in a handful of high-quality financial assets at exceedingly low prices, and it has held them ever since. It’s been almost a decade now, and we know how well that’s done. It has also been extremely patient, willing to invest and take a lot of pain and suffering in its digital transformation into more of a software company. That’s the right way to behave, in my opinion.
Post Holdings is another example. Bill Stiritz is still there and actively involved. The way the company goes about this is really intelligent. It had a call a couple of months ago where it said, “We want to reach out to our shareholders and have a conversation. We’re doing this convertible preferred offering, and here’s why.” It makes all the sense in the world, but most often, you don’t see it at all. You just see a press release or a filing. I think it helps to go through and explain why you’re doing something in common sense terms and language to your investors, and you just don’t see that enough.
Another excellent example is AutoNation, where Mike Jackson has been the CEO since 1999. He is about to retire, but he’s overseen repurchases of 85% of the shares during his tenure, often at exceptional values because the industry is cyclical. As the company says, “We use the choppiness in the US vehicle market to our advantage. We, from strength, can repurchase our stock.” It’s been a huge homerun largely because of that.
Here’s something interesting: for many years, the lead independent director was Mike Larson, who is a fantastic investor and runs Bill Gates’ family office. Mike Jackson was literally a car guy. He understood cars and dealerships but not capital allocation necessarily. And say what you will about Sears, you’d probably still rather have Eddie Lampert on your board compared to a lot of other people. Mike Jackson commented in an interview that Mike Larson and Eddie Lampert tutored him and taught him how to think about capital allocation. As the CEO put it, he got a PhD in capital allocation from these investors, who owned 15% and 16%, respectively, of the stock. Almost 1/3 was in the hands of two individuals who had board seats and each stuck with the company for over a decade – this is enormously powerful on multiple levels.
Another fascinating example is BNSF. In a recent interview, outgoing CEO Matt Rose looks back on his career and how things are going, also touching on the way capital is spent. He points out that Wall Street and the sell-side analysts in particular are pressuring some railroads to spend as a percent of revenue, which he thinks is nonsense. “We don’t spend capital as a percent of revenue. We spend it based on gross ton-miles we haul. Bridges don’t wear out with revenue; they wear out with units and gross ton-miles.” This makes all the sense in the world, but it’s somehow apparently being lost in the financial community right now. He also talks about how a lot of companies have adopted a capital-light model, which for many industries and businesses is the right thing and is enormously powerful. According to him, it doesn’t make sense here, and he thinks that every industry and every business can benefit from growth. I find this a really interesting framework and the right way to put it. He also talks about the unwritten commitment the company has to be a good steward of capital in its regulated environment – most companies are not regulated anywhere near the level that railroads are.
Allow me to sum it up by referring to a presentation General Electric gave in November 2017. John Flannery, the CEO at the time, made an explicit push to put a new emphasis on capital allocation principles and priorities. He added a finance and capital allocation committee to the board, which I think is enormously commendable. He cut the size of the board and introduced some more shareholder-friendly things. It’s not easy, and I think he did all the right things in this regard. GE had been going a certain way for years, and this wasn’t enough to save it, which demonstrates there is no one true path. You have to do a lot of things right. This was one way to make some incremental improvements and something they tried to do.
The following are excerpts of the Q&A session with Phil Ordway:
Q: Could you elaborate on Amazon as a case study? The company has been faulted by some investors for not focusing much on profits. How do you square that with its good capital allocation?
A: I wouldn’t want to position myself as an expert on Amazon, but one thing that jumps out to me is that the company always had a framework in place which made a lot of sense: “We’re investing in the customer first and investing in our company to serve the customer first.” Rather than take a dollar of margins today, it prefers to reinvest that dollar of margin, drive down prices, and reinforce the whole company instead of running it to maximize capital today. I think it worked marvelously for Amazon, but the dangerous thing about it is that you see other companies end up in a sort of “Waiting for Godot” situation – they all talk the right game of deferred gratification by saying, “We’re going to invest for today to make tomorrow stronger.” That’s fine, but there has to be a tomorrow.
What’s most interesting about Amazon is that value was always there, and it absolutely worked; the capital allocation internally was very intelligent, and the fact that there wasn’t profit should not come first. Costco could serve as a good comparison. It obviously shares a lot of commonalities with Amazon in ways people may or may not think about. Amazon Prime, for example, certainly mimics closely the Costco membership model for good reason, and that, in my opinion, allowed it to make a lot of the leaps it did.
If you look back at Costco, it IPO-ed in 1985, and its first annual report came out in early 1986. It’s an absolutely fantastic read from the days when you could get a 25-page annual report that told you everything you needed to know. Costco wasn’t profitable at the time, not even close to it, but it was growing like crazy, memberships were doubling and tripling over a year or two, and you could see the business model, the framework was there. The company was talking about what it was doing and why and executing on it, but the profits weren’t there. I was talking to somebody at the company not that long ago, and I found out Costco had been in the Midwest for over 20 years. It has been growing like crazy in this region – I think it is up to 85 or 100 stores or something like that in the area out of the 700 or so stores it has in total – but as a whole, the Midwest business went profitable for the first time ever only in 2018. You’d think this is a disaster and terrible capital allocation, but the company was just playing a much different longer game. I think what matters is that it never changed the framework and the goal post. It didn’t try to distract people and say, “We screwed up. Let’s focus on something else.” It was always very consistent and logical, which is not to say it didn’t adapt and change courses. These are also the things I would highlight about Amazon.
Q: What KPIs or metrics do you track to help assess capital allocation outcomes? At some point, it may not be enough to simply rely on anecdotal qualitative information from proxies and investor presentations.
A: Absolutely. I will, at least at first pass, be willing to accept what management is putting out there as the KPIs. If they don’t publish any, that’s a concern, but I’ll always have my own. I usually do it in a couple of ways, but I always track return on invested capital, and then track return on invested capital that’s incremental if you can do it. It’s sometimes a little hard depending on the business, but I think that’s the single one to focus on. You’re taking the dollar. You’re putting it out. What are you getting back for that dollar? You can do that at a high level. It’s even better to do it at a micro or a segment level if you can. It can get a little tricky and varies a lot from industry to industry. If I were dealing with a bank, I’d want to look at how many deposits per branch you have, what’s your efficiency ratio across the whole company, how that has changed over time, and certainly look at return on assets and return on equity to see how it all rolls up together. The efficacy as a bank is determined by how it gathers deposits and then redeploys that capital into income and yield-generating assets. If you’re looking at an airline, you try to get down to the level of individual plane and aircraft investments. You can’t really do that hub by hub although it might be possible if it’s a legacy carrier. You can get down into some granular data, see the returns at various levels of the company, and try to take it from there.
Q: What premium would you be willing to pay for good capital allocation? Maybe using Constellation Software as an example, a lot of the current valuation seems to assume continued future acquisitions at high returns on capital.
A: It’s a great question I have no great answer to. All I would say is that I would certainly place a value on it, and my appreciation for it grows every single day. There is too high a premium to place on it for sure, so I can’t give any specific advice. It’s dependent on your own specific views. If you wanted to take Constellation as an example, you’d have to evaluate both the business and the people involved and say what you think they’re going to do. Simplistically put, I would try to learn as much as possible about the business at a micro and operating level and place it in the context of where I think this business is going to be 2, 3, 5, or 10 years from now because I have no idea where it’s going to be on a short-term basis. Over the long term, the range of error gets pretty wide, so you have to be quite comfortable that the odds are in your favor. You just have to say, “What are the odds something goes really wrong here? What are the odds that something could go right? What’s most likely in between? And what’s a common sense price to pay for this? If I put $100 of my own capital into this company today, what are the odds that I ever get it back? What are the odds that it provides a reasonable return?”
One of my favorite things to do is look at two companies side by side. Start them at, let’s say, 2010, coming out of the financial crisis, but take their names off and make it a blind comparison. Then say, “Here are their financial characteristics.” You can ask people to value them then and what they would pay now. Alternatively, you can have the valuation as a starting point and then look at what has happened and how they’ve allocated capital because eight years is a meaningful amount of time. Say, “Here’s what they’ve done over these eight years,” and then “What’s it worth at the end?” When you do the big reveal and say, “Look at what’s actually happened here,” that’s where it becomes clear whether the business is worth some massive premium. You could have paid a much higher price back in 2010 for a good capital allocator versus an average one, let alone a poor one. That’s probably the number one thing. I wouldn’t be too worried about the premium. You don’t want to pay a crazy prize by any stretch of the imagination, but just avoiding the bad ones is a huge step in the right direction.
About the instructor:
Philip Ordway is Managing Principal and Portfolio Manager of Anabatic Fund, L.P. Previously, Philip was a partner at Chicago Fundamental Investment Partners (CFIP). At CFIP, which he joined in 2007, Philip was responsible for investments across the capital structure in various industries. Prior to joining CFIP, Philip was an analyst in structured corporate finance with Citigroup Global Markets, Inc. from 2002 to 2005. Philip earned his B.S. in Education & Social Policy and Economics from Northwestern University in 2002 and his M.B.A. from the Kellogg School of Management at Northwestern University in 2007, where he now serves as an Adjunct Professor in the Finance Department.
What I have yet to understand: If one cannot overcome the fear of being disliked, the expense paid is the only thing that makes anyone someone: oneself, and with it, one's life.
— Owen Hofmeyr (@MachHBInvesting) January 15, 2019
