A few months ago I told you that I had to stop writing the blog (https://oraclefromomaha.wordpress.com/about/) because I had just finished school and joined the investment management business. Well, now that I’ve decided to temporarily work for myself again, I am back! Much has happened in the last few months so it is appropriate to share this update with you.
Comments on Market Volatility
The stock market has had a hell of a rollercoaster ride in the last few months. I think the fact that the quoted value of the stock market could fluctuate by 2-3% a day is simply further proof of structural pricing inefficiencies that exist due to psychology (since the intrinsic value of companies don’t fluctuate nearly as much on a given day). Disciplined value investors embrace such price volatility as opportunities to hunt for bargains and will be rewarded in the long run.
This isn’t a blog about macro forecasting or market timing, but I do have a few thoughts to share on the market itself.
1) Fundamentally, valuations are not in the bubble territory by any stretch of imagination. The S&P trades somewhere around 15-16 times 2015 earnings, and the earnings are growing much faster than nominal GDP. I think one fact that people often overlook is that close to half of the revenue of the largest American companies is generated outside the United States. The average company in the S&P500 is a VERY international business, and will enjoy organic growth exceeding U.S nominal GDP growth for a VERY long time. That has a huge impact on valuation, because in most present value of cash flow calculations, the one factor that has the highest level of sensitivity to the valuation output is the terminal or long-term growth rate of a company. A change from 3% terminal growth to say, 4%, can often lift up intrinsic value estimates by 15% – 20%.
2) Many market commentators (including the Fed chairwoman, coincidentally) seem to be under the impression that while the stock market is fairly valued, there are pockets of bubbles in certain industries, particularly among tech companies.
I’m not so sure. First of all, most “old-tech” companies that have proven business models and a track record of profitability (ex. Qualcomm, Microsoft) currently trade for multiples below that of the S&P. Many have lazy balance sheets and untapped borrowing capacity, and some have even recently become quite shareholder friendly and embarked upon sizable repurchase programs. I don’t think there’s a bubble there at all. Valuation appears much richer among the “new-tech” companies. Unlike most value investors, I actually believe that there is a very high chance that many of these companies will be able to eventually justify their current market value. I have low hopes for the ones that operate in capital intensive industries that are relatively easy to commoditize (such as 3D printing, GoPro), but high hopes for many internet properties that currently dominate their markets (such as certain mobile applications, Netflix, Linkedin, even Facebook), and have incredibly attractive incremental economics from growth. I think the mobile revolution is very real, and similar to the rise of the PC twenty years ago, the majority of the wealth creation on the mobile platform will be enjoyed by those that are earliest to enter the game.
3) So what’s a reasonable long-term return to expect from the stock market? I think the most scientific way to calculate that is to use a variation of the dividend growth model, and it works something like this:
Expected long-term return = current free cash flow yield + long-term organic growth rate of free cash flow
In this calculation we are replacing the traditional “dividend” with free cash flow, since dividends only tell you how much a company is paying out, rather than its ability to pay out cash. Obviously most companies don’t just pay out 100% of their FCF and instead allocate some toward other options (buybacks, M&A), but we can reasonably assume that the average company has a “value-neutral” FCF allocation policy, where average out, buybacks and M&A are neither value-destroying nor value-creating, so a dollar allocated toward a buyback or an acquisition is just as valuable as a dollar paid out in dividends. The second component of the calculation is concerned with growth. Since we are making the “value-neutral” assumption (that all FCF is just as good as being paid out in dividends), the growth rate should exclude any effects of buybacks and M&A, and therefore the one that should be used is organic growth in FCF.
Currently, the FCF yield of the S&P 500 is somewhere around 6%. Long-term organic growth is a guess about the future, but a reasonable guess is that given the S&P’s exposure to higher growth markets, it can grow 1% in excess of nominal GDP. If the U.S. grows 2% real in the long-run, with 1% inflation, nominal growth will be 3%, and organic earnings growth will be 4%. Therefore, our calculation says buying in at today’s level, the stock market should provide a 10% long-term return. Bill Gross would disagree very strongly with me. But that’s fine; so far he has been dead wrong and I think he will look very bad on this topic ten years from now (https://oraclefromomaha.wordpress.com/2014/03/08/standardized-faulty-thinking-bad-assumptions/).
4) If the market is going to return somewhere around 10% over the long run, consistent with its historical results, then the “correct” valuation should be dependent upon discount rate assumptions.
If interest rates stay where they are currently, from now to perpetuity (3-4% ten-year borrowing cost for the average S&P 500 company), then the stock market is probably trading at around half of intrinsic value, because sooner or later every rational corporate manager will have figured out that if they can borrow money at 3% fixed into perpetuity, and buy back stock that sells for a 6% free cash yield that can grow 4% a year, it won’t take that long to buy back every share from the public and go private. Prolonging the record low interest rates for a very long period will eventually deliver the effect intended – a massive transfer of wealth from the irrationally risk-averse to the rational economic agent.
If interest rates go back to historical averages (say 5-6% risk-free, 7-8% for companies), then the “buyback arbitrage” becomes economically very marginal, and the market is probably fairly valued where it is. In other words, the current market valuation is discounting a much higher interest rate assumption.
Looks to me we are currently in between the two scenarios.
Update on Companies
Virtually every one of the companies mentioned on this blog has gone through some significant changes in the last six months. Here’s a summary:
FTD: As predicted, Greg Maffei made a move on FTD, which merged with LINTA’s Provide Commerce subsidiary. I mentioned before that FTD’s spin status gave it an unfavorable tax position, since spincos are subject to taxation if sold within two years of the spin-off. Maffei’s solution to the problem is to keep FTD public, while trading Provide for FTD equity. Now that Liberty owns 35% of the company, it will be virtually certain that FTD will follow the same levered equity shrink strategy as other Liberty entities. I expect FTD to announce a material stock repurchase program.
While all this is good, FTD’s operating results have been disappointing. With sales barely growing, the current 10 x FCF multiple no longer seems very attractive (though including synergies, this could get down to an 8 x multiple). I think I originally had somewhat underestimated the effect of competing networks such as FLWS undercutting on pricing, as well as the gradual but visible deterioration in the economics of FTD florists (kind of similar to how a franchiser might suffer when his franchisees start suffering). The stock has done okay since the UNTD spin-off and I have sold my shares. With Liberty’s involvement I expect the company to do well, but not well enough to justify my opportunity cost.
DirecTV: AT&T offered to buy DTV, and they are getting a good deal considering the multiple they are paying and the potential synergies. Mike White will likely stay around for a while to manage integration and will probably get a new CEO job afterward, and I sure will keep an eye on whoever that’s going to hire him.
On a side note, AT&T’s merger with DTV will mark the second time that Malone has traded something for AT&T stock. The last time was not very pleasant.
AIG Warrants: AIG has executed reasonably well, and now with tangible book at over $75 a share, the stock basically trades at 2/3rd of liquidation value. I continue to believe that the company is significantly over-capitalized and a material capital return program is on the horizon. The warrant, which offers long-term levered upside, has actually underperformed the stock, and looks pretty attractive where it’s trading.
AIG has also gone through some management changes. Unfortunately Benmosche has been diagnosed with terminal cancer and he has been replaced by Peter Hancock, who has been around for a very long time. I don’t know much about Hancock other than that he has been the heir-apparent and is well regarded by his peers.
Liberty Interactive: LINTA has finally executed on the QVC tracker transaction. The original proposal was to fold LINTA’s disparate group of e-commerce properties into a separate tracker; this was cancelled and instead the e-commerce companies were transferred to LVNTA for $1.5 billion enterprise value, payable in LVNTA shares. Clearly the market thought that LINTA got the better end of the bargain, as LVNTA shares cratered over 20% immediately after the re-attribution announcement. The remainder of LINTA (QVC and roughly 40% of HSN) was then given a new QVC ticker and the LVNTA shares received were paid out to the new QVC tracker holders.
I think both QVC and LVNTA are now undervalued. Taking into account the Japanese minority interest, as well as changes in interest expense due to the various changes in capital structure, QVC should earn somewhere between $900 million to $1 billion in FCF next year. I expect repurchases to reduce share count to 440 – 450 million by Q4 2015, so on a per share basis QVC will generate $2 – $2.3 in free cash next year. The stock currently trades at $26; now $3 of that represents QVC’s interest in HSN, which I expect to be eventually monetized through a merger. You are effectively paying $23 for the QVC business, or a multiple of 10 – 11.5 times next year’s FCF. This is also ignoring the asset value of the QVC Italian and Chinese businesses, which are not contributing to the free cash flow but nonetheless quite valuable.
I think LINTA’s case is pretty representative of how Malone’s “moving stuff around” creates value over time. When I first wrote up the stock, it was trading for $23 and 10 – 11 times free cash flow. A year passes by, adding back the LVNTA dividend (~$5 per LINTA share), the stock now trades at an effective $31 – a 35% return, and yet QVC is still selling for 10 – 11 times free cash flow.
I blame this result on sorcery.
Altisource Portfolio Solutions: This stock has been decimated since it was written up, even though fundamentally nothing has really changed much. I will provide a more detailed update on this stock this weekend. I remain convinced that Erbey has integrity and Lawsky has blown relatively minor issues way out of proportion. I know many people who have capitulated in the panic but that’s not value investing. I haven’t sold a single share of my stock (but it is no longer my biggest position following the price decline).
Bought Softbank: Since Alibaba’s IPO, Alibaba’s valuation has grown from $68 a share to just under $100 – a near 50% jump, yet Softbank, which owns 34% of Alibaba, has dropped 10% during the same period.
Currently Softbank trades at a market value roughly equal to its ownership stake in Alibaba, which means you are getting Softbank Japan (the most profitable wireless network in Japan), Yahoo Japan (the dominant Japanese search engine), a resurgent Sprint, and $ billions worth of venture capital investments all for FREE. At the helm of the internet empire, Masa Son is a world class investor who has managed to compound Softbank’s stock over 20% a year since the company’s IPO in 1994.
I estimate that the NAV of Softbank’s ex-Alibaba assets to be $80 billion, which means the stock trades at a 50% NAV discount. Each of the components in the sum-of-parts calculation also has significant upside potential, especially Alibaba, which I think is VERY misunderstood in the West.
I will do a full write-up on Alibaba and Softbank in November. There’s lots of uninformed crap out there about Alibaba and I’m going to present a variant view.
Bought eBay 2017 January calls: EBay is separating itself into two companies next year and I think it’s pretty plain obvious that the sum-of-parts value of eBay is a lot higher than where the stock is trading. The more profitable eBay marketplace business, which has been a solid 10% grower, easily deserves a 20 x multiple even if growth tapers off to high single-digits; while Paypal, which has been growing at a more rapid 20% – 25% per annum, can be worth as much as 30 x – 40 x. In other words, the intrinsic value of the combined eBay/Paypal should be a blended multiple between 20 x and 30 x, much higher than where the stock is valued today.
Another piece of good news is that the current eBay CEO, who has been in charge since early 2008, will be out once the spin-off is completed. He’s not very good. Having gone through two years’ worth of conference call transcripts, the only impression I’ve got from the man is that he specializes in consulting speak.
More importantly, capital allocation has been absolutely horrendous:
1) EBay bought GSI for $2.4 billion in 2011; now it’s barely doing $80 million in EBITDA and no longer growing.
2) EBay bought Skype in 2005 for $2.6 billion. John Donahoe sold it at exactly the bottom of the market in 2009 for $2.75 billion to private equity firms, who subsequently flipped it for $8.5 billion just 20 months later (not to mention the blatantly obvious conflict of interest on the eBay Board).
3) The company has done a moderate amount of buybacks in the last few years. However, this was mostly used to offset huge amounts of stock options issued to employees. The share count is essentially flat since six years ago. Instead of aggressively shrinking share count during this time, the company has mostly hoarded cash, despite operating platforms with very low growth capital requirements.
4) Finally, Paypal should have gained independence from eBay a long time ago. There are virtually no synergies between the two companies (except some data-sharing, which can be resolved through a licensing contract) but plenty of dis-synergies because many of eBay’s competitors are hesitant to take Paypal as a payment partner as long as it stays under the roof of eBay.
The departure of Donahoe will almost certainly signal a shift in strategy in terms of capital allocation, as the new CEOs will be under enormous pressure from activists to unlock value. EBay currently has a substantial $9 billion net cash position (more if you count the equity investments which are sitting on the balance sheet at close to nothing) and based on my estimate, will generate over $12 billion in free cash flow between now and the end of 2017. I believe the majority of the free cash flow generation will be used to fund repurchases at both companies (In fact, in Dan Loeb’s eBay write-up in Q3, he is expecting eBay (post-spin) to buy back a third of its share count in two and half years). Anything less drastic will almost certainly trigger an aggressive response from Icahn and Loeb and result in a nasty board fight.
Currently the company hasn’t given a lot of details about the spin-off, other than that eBay will bear the existing debt load. Without knowing how to allocate the huge Corporate overhead, it’s difficult to do a sum-of-parts analysis right now. However, as discussed earlier, the combined company should be worth between 20 and 30 times earnings.
I am projecting $5 billion in 2017 net income for the combined companies. If they spend $12 billion on buybacks over the next three years at an average price of say, $70 per pre-spin eBay share, then pro-forma share count will be reduced to 1.05 billion, resulting in roughly $4.80 a share in free cash flow. On a 22 x multiple, the stock will be worth $106 per share.
If the companies become more aggressive and lever up to 2 times EBITDA (est. $8 billion for 2017), assuming a 3% after-tax borrowing cost, 2017 levered free cash flow will be $4.5 billion. Pro-forma share count will drop to 760 million (more consistent with Loeb’s expectation), at an average purchase price of $80. Per share free cash flow will grow to almost $6. On a more optimistic 25 x blended multiple, the stock will be worth $150.
The way I am playing this is through 2017 January LEAPS, because by that time the stock should already price off of 2017 projections. I bought the $40 strike variety, which is now trading around $15. If the stock goes to $106 like described in our base scenario, the call will be worth 4.4 times today’s price. If Loeb gets his way and manages to pressure the company into launching a more aggressive repurchase program, the call will be worth 7.3 times today’s price.
I should also note that with the $3 premium built into the call, you are effectively paying $55 a share for the stock. I believe both Carl Icahn and Dan Loeb bought their eBay stakes this year, when the stock has traded mostly in the mid-50s. I view their cost (mid-50s) to be a long-term price floor, since neither activist has enough patience to watch the stock languish over the next three years. In other words, if management doesn’t do SOMETHING soon, someone WILL push them to unlock value.
At the end of the day you got two of the most aggressive activists in the world heavily in the stock, watching over two new CEOs with no public company track record and (correspondingly) little loyalty from public shareholders. I will be VERY surprised if this stock doesn’t do well over the next few years.
Bought Fiat-Chrysler (FCAU): This is a company with a pretty defiant ticker symbol (just try to pronounce it!) and run by someone with a pretty strong personality.
I have kept an eye on this one for a very long time, and finally decided to pull the trigger when the stock tanked following the company’s announcement to list on the NYSE (apparently there were short-sellers who spread rumors that the company would not obtain the necessary shareholder support to “officially” merge with Chrysler, which turned out to be false).
FCA is cheap on any metric, and is currently selling for a discount to both GM and Ford. One reason for this mispricing is that FCA continues to be viewed as a failing European automaker, despite doing most of its business in North America (through the rapidly growing and profitable Chrysler). The “legacy” European business is currently incurring minimal losses, and is operating at the lowest capacity utilization of any global automaker. These plants will be eventually filled with Chrysler and Maserati production.
The rest of the company is all hidden gems:
1) FCA has a huge business in Latin America, with the highest market share (20% +) in Brazil. While this business has struggled in the recession, its long-term prospect remains bright.
2) The under-penetrated Asian business represents mainly the JEEP brand, and is only 6% of revenue. The JEEP brand has a very interesting but little known advantage in China, because in Chinese, the word JEEP is actually synonymous with SUVs (many people refer to all SUVs as jeeps). Since the introduction of SUVs to the Chinese market in the 1990s, JEEP has basically been getting two decades of free advertising from other automakers. FCA is building a new JEEP plant in China and is looking to sell 800k high-margin JEEPs there by 2018.
3) Ferrari and Maserati are 6% of total revenue but close to 20% of EBIT. Both are rapidly growing and very cash flow generative. FCA is also re-launching the luxury Alfa Romeo brand, using existing capacity and Ferrari technologies.
Early this week the company announced plans to spin off its 90% stake in Ferrari, which made the story just more interesting. Ferrari does about $500 million in EBIT, and has kept its production fixed at 7,000 units per year. Following a change of leadership at Ferrari, the company now plans to increase production to 10,000 a year, at which level Marchionne estimates Ferrari can easily generate over $1 billion a year in EBIT.
Estimates of Ferrari’s value are all over the place. The range I have seen so far from the sell-side is $7 billion to $11 billion. Now that produces some EXTREMELY interesting math:
FCA’s plan is to sell 10% of Ferrari in an IPO next June. Okay to be conservative let’s assume the market gives no credit to FCA receiving the proceeds. The remaining 80% stake will be distributed to FCA shareholders in a tax-free spin-off. Applying the 80% to the range above, the distribution will be worth $5.6 to $8.8 billion. The current market cap of FCA is only $13.8 billion, which means the FCA equity “stub” will be valued at a puny $5.0 to $8.2 billion following the spin-off.
In FCA’s ambitious 5-year plan presentation, Marchionne laid out a vision to achieve over US$6.2 billion of net income by 2018. Taking out Ferrari, which will earn at most $700 million after-tax even in the most optimistic scenario, the rest of FCA is projected to earn $5.5 billion. Let’s say he’s overly-ambitious and the company only manages to hit HALF the target – $2.8 billion, then at a $5.0 – $8.2 billion valuation, FCA ex-Ferrari will be effectively valued at 2 – 3 times 2018 earnings!
I think the valuation of Ferrari will likely be very rich upon an IPO. Given the prestige factor associated with Ferrari ownership, it will likely attract a number of suitors, and in an optimistic case can even trade like a football club. I can also easily see VW making a bid, having repeatedly expressed interest in the brand in the past. If that is the case, then the FCA-stub equity will be valued at close to nothing post-spinoff!
At the helm of the newly formed FCA group is an absolute kickass CEO. Sergio Marchionne is one of those rare managers that embody both the boldness of an effective operator and the savvy of a shrewd capital allocator. Since Marchionne joined Fiat in 2004, he has not only saved Fiat from the brink of bankruptcy, but also transformed the empire by acquiring Chrysler out of Chapter 11 for peanuts (total less than $5 billion). Chrysler returned to profitability in less than two years, paid down all government bailout loans, and is now generating $3 billion of EBIT and among the fastest growing automakers. In fact last month, Chrysler outsold Toyota in North America.
Aside from the Ferrari transaction, there are additional levers that FCA can pull to create value:
- I don’t believe that Chrysler has been fully integrated. Plans to relocate Chrysler production to under-utilized European plants, for example, have yet to materialize to any meaningful degree. Any additional synergies will create enormous earnings growth for a business that operates on low-to-mid single digit margins.
- The current FCA capital structure is pretty weird. The company has €28 billion of industrial debt and €18 billion of cash, for a net debt of €10 billion. FCA is earning nothing on its cash but incurring fairly high interest cost, especially on the Chrysler debt. Now that the two companies have officially fully merged, FCA will be able to access Chrysler’s cash position to use it to pay off debt, in the process eliminating a significant amount of interest expense. Any credit rating improvements that follow will allow the combined companies to refinance at a lower borrowing cost.
- FCA will have something close to $10 billion of pension deficit by the end of the year. Someone told me that this is overstated because the Italian government in some way subsidizes it (I didn’t understand it so if you know how please explain to me). Anyway, when interest rates start to rise the accrual value of this liability will shrink very rapidly.
- FCAU’s low profile IPO in North America has attracted very little attention from North American investors. Sergio is going on a roadshow this month to tell the story. Hopefully as more people realize that FCA is really more of a Chrysler story rather than a Fiat story, the stock will re-rate to a level more consistent with other North American OEMs.