Some Things I’ve Learned over the Years

First some housekeeping. I will be launching a Delaware-based fund/partnership early next year with more details to come over the following several months – so this blog will either turn into a private one exclusive to members within my own network or become a much more casual platform. Needless to say, I am fortunate to have built such a network of like-minded individuals who I highly respect and are much smarter and better investors than myself. I certainly look forward to continuing the dialogue!

An Obsession with Studying the Superlative Business:

Over the years my approach to sourcing ideas has evolved. By far my favorite approach to sourcing ideas now is to identify the very best companies in the world (the top 0.01%), whether public or private, study them in-depth, and subsequently draw the most fruitful lessons I can from them. I love this approach as I have discovered that studying the few companies I admire the most can teach me much more about business than your average run-of-a-mill company. My evolution in sourcing is also a function of compounding my knowledge base of different businesses over time, and slowly realizing that most ideas, no matter how optically inexpensive they may look, simply aren’t investable for a highly concentrated, high hurdle-rate oriented investing approach. In my mind if you’re truly a highly rational concentrated investor, your opportunity cost for owning any name should be absolutely massive. Another way to think about this is to invert the common “low P/E/multiple approach” to sourcing ideas: find the companies with the best chance of maximizing long-term earnings power first, then figure out the right price to pay to ensure the desired margin of safety. For the people who are still stuck in Ben Graham’s “valuation-first/cigar butt” world, my valueless opinion is that the faster you get to Munger’s approach, the better off you’ll be long-term as an investor. Hint: You’ll be much smarter.

What makes a superlative business? To answer this question in a paragraph would be a disgrace to this blog. But here are a few things to think about: they are managed by exceptional people who are obsessed about winning, and have no other major distractions in their life other than the company they manage. You can perhaps think of them as similar to Nietzsche’s Übermensch – a small subset of the human race – and in this particular case the business world – who are making serious progress in advancing humanity forward and are driven by their own independent set of values (not those of others a la the herd). These values are typically formed by unique personal experiences.

Culturally, some of these companies share common traits. They don’t shy away from taking risks and view failure as an option; strictly speaking, they play to win, not to lose. To say that they have an entrepreneurial culture is an understatement. Having such a risk-taking culture helps mitigate risk aversion bias which plagues most companies and people. Just from the realization of this bias alone, I have always approached decisions on assessing the risk of not taking any risks.

What else? Speaking from a numbers perspective, they have an exponential return on invested capital when measured over a multi-decade horizon. This is a function of the business’ competitive moat growing wider over time which can yield a non-linear long-term return on capital profile. If you are an exceptional business, you are by my definition a super durable business that can withstand the test of time and also enjoy an open-ended runway of growth. As for the classical economists who promote competition as the best form of value creation for all – they are all wrong. Like Peter Thiel said, competition is for losers and monopolists are for the studs. Since most businesses do not fit this profile, this is where being forced or at the very least having the intention to hold a business for 10 years or longer should greatly limit your range of investing opportunities.

Let’s think about all the companies that went out of business over the past century or so. How many of these companies that were in business 50 years ago actually stood the test of time? I think the ones that have survived had the leadership and a company culture able to withstand and adapt in rapidly changing competitive environments. Having an innovative culture, with the open-mindedness for business model evolution goes a long way towards staying in business. I don’t think at this point I even need to point out that these companies have a long-term orientation. Without these traits, no matter how dominant a business may be now, it lacks the qualitative characteristics that enable it to stand the test of time. You can see examples of these businesses all the time: once dominant companies that are now having their moats being eroded away by superior, more nimble organizations, and will soon become a shadow of their former selves. Think IBM, Oracle, Viacom[1], and the US department stores.

Take Oracle for example, the upside case expressed by some is that this is a rather cheap stock with an attractive near-term FCF yield. While their on-premise database and application businesses are in secular decline, this is a slow and measurable rate of decline, as switching costs are substantial and enterprise relationships are very sticky; and as the Oracle installed base continue to migrate their workloads to the cloud, Oracle should be able to retain the customer relationship despite cannibalizing itself. What I think the bulls fail to appreciate is that the economics of Oracle’s on-prem business (which is bound to shrink significantly) is much more attractive than what will likely become of their cloud business (which is bound to become the main value driver of the company). Oracle was extremely slow to transition their product to a cloud environment, where switching costs are much lower as customer uptimes are way shorter and having a proprietary/unique tech stack is not as important as offering a lower price tag to enterprises at scale. In fact, the most successful database cloud provider in the future will likely win by offering a much cheaper product based on open-source technologies. Hint: I’ve written up this company on this blog.

Leading disruptors that had no highly profitable legacy business attached such as AWS and Workday in infrastructure/platform cloud services and HRM applications, respectively, already know the endgame scenario in enterprise software, and are investing all their resources and efforts towards positioning themselves for it. What Workday is doing specifically is disrupting Oracle and SAP in HRM & Financial Management applications. In classic innovator’s dilemma fashion they attacked the SMB/smaller enterprise market first with a largely price-driven strategy and a product incrementally “good enough” for customers that outweighed performance-based concerns. So Oracle is fighting a multi-front war and even as it manages to grow their cloud business at a rapid clip (no one disputes this fact) to help offset on-premise attrition, the overall company margin profile of a lower tier cloud software business will be much, much lower than their licensing/maintenance software model – that I can almost guarantee you. It’s not a coincidence that there’s a similar industry narrative for the Pay-TV/the cable networks and department store industries: despite transitioning their business models they all face the same threat of being largely dis-intermediated and thus becoming much less profitable. In fact, we’ve actually seen a similar movie before in the classified section of local newspapers as content and ad dollars largely shifted to digital/online channels. Ask a millennial if they check the local newspaper/classified section when they are looking for a local gig and you’ll know what I’m talking about.

Another common theme among these long-term losers is that they typically opt to use share buybacks/financial engineering as a pitch to shareholders in a desperate attempt to drive outsized short-term EPS growth. This is all but a mirage in value creation – especially for those that elect to lever up to buyback overvalued stock like what some of the cable networks have done over the past several years. Why are they doing this? Hint: it helps to read proxies; sometimes, you’ll figure out that either the CEO/controlling shareholder is a super wealthy empire-builder or will likely retire in a few years. Financial engineering can only take you so far, and scaling value creation successfully via M&A and buybacks over a multi-decade period with a secular declining core business is extremely rare in my view. What’s typically more common is self-dealing and/or integration train wrecks. As a result, it would be an absolute nightmare to hold a share of a business like this for the next 10 years. OK, you may have guessed now that I despise IBM and Oracle and don’t think too highly of their leadership. For good examples of companies that have been successfully navigating these software industry changes, I would look to Microsoft and Adobe Systems.

One final thought on enterprise software is that the technology stack along with how it is sold is evolving over time. The reality is that no new software engineer today looking to build the future is getting trained in .Net, C# or the Java tech stack. With the rise of AWS, a public cloud platform that sells software infrastructure basically as a utility, we are now transitioning to an era where software pricing is based on volume/usage instead of subscription. As a brief history, Software 1.0 was the era of on-premise solutions based on the licensing/maintenance contract model, Software 2.0 was of course the rise of the Software-as-a-Service (SaaS) model with Salesforce as the industry pioneer, and Software 3.0 as mentioned is evolving into software-as-a- platform. AWS is undoubtedly the industry pioneer in this model but there are some smaller, emerging cloud platforms such as Twilio, Atlassian, Shopify and New Relic. Once a platform becomes nearly ubiquitous amongst third-party application developers, an application (such as Uber, for example) can outsource certain platform-as-a-service functions to a platform such as Twilio (in this case communication-based functions such as texting/SMS and voice), and be billed on a volume basis by Twilio. Utility-based business models that become ubiquitous are extremely attractive, and AWS is at the center of Software 3.0.

Something else I’d like to talk about is investor herding. As you may have noticed I’ve written up some pretty well-known “hedge fund hotels” on this blog. Some investors appear to automatically assume that a hedge fund hotel must be a crowded trade. As a fundamental investor I don’t think one can draw any conclusions on what a business is worth based solely on knowing the shareholder base. I think my friend at one of the well-known Tiger cubs said it best: In general hedge funds (at least the top-tier, fundamentally-oriented, research-intensive ones) are better stock pickers than the average market participant. Theoretically they have the better resources, talent and a sensible incentive structure for the investment team to generate sustainable alpha. However there may be periods such as recently where a redemption cycle in full swing can cause outsized short-term volatility in shares with a cap table heavily skewed towards hedge funds. This doesn’t mean the intrinsic value is impaired as the market price reflects the consequence of forced selling.

This broader issue appears more like a psychological issue to some and is certainly not a rational stock picking process. Guys that actively avoid hedge fund hotels might have what I like to call the contrarian syndrome where they are biased to shun from ideas that are widely-held by savvy investors. The opposing psychological bias of herding is certainly a notable risk as well.

The beauty of the market is that there is always a winner and loser in every transaction and almost every participant has a different reason for transacting. I’m sure there is a subset of “value investors” who look at Amazon stock and think it’s grossly overvalued trading at >160x PE. Then there is a subset of “momentum” oriented investors that must own the stock and chase performance at any price. Bottom line is market consensus is objectively captured by the price offered and whether there is a large margin of safety is dependent on one’s estimate of intrinsic value. To their detriment, people seem to over-complicate things due to certain innate tendencies.

JD and Amazon: Scale Economics and the Customer Experience

I’ve talked about both JD and Amazon quite extensively on this blog, but I can’t resist talking enough about them.

Some define these businesses as internet companies, whereas others may label them as online-retailers or e-commerce companies. Honestly, I think these are customer experience companies. It’s the same way Tony Hsieh defined Zappos (the online shoe retailer that Amazon acquired). Zappos’ company culture was highly customer-centric. Zappos call centre representatives would be more than happy to spend hours speaking with lonely bored customers who just wanted to talk to someone. To reinforce the company’s culture and values around exemplary customer service, every new Zappos hire would be required to work in the 24-hour call center for a minimum period of time. JD for example makes sure that each call center rep is actually physically smiling when they say hello to a customer on the phone.

Why are the best consumer-based internet companies, and online retailers in particular, obsessed about the customer experience? The Stratechery blog, in my view, is the best blog online focussed on TMT industry analysis and strategy that talked about an interesting theory called Aggregation Theory. My own take on this theory is that since the marginal cost of distribution or the user acquisition cost approaches close to zero over time for many internet platforms, only the companies that are able to provide the best user experience at scale are able to capture these exceptional unit economics, and in turn commoditize suppliers (product exclusivity is a non-factor) and thus become the long-term industry winner. This theory aligns with the conventional wisdom in e-commerce (all the industry leaders agree), that the best way to maximize value in mass-market retailing is to provide the best customer experience.

Some value investors avoid investing in technology-based shares due to their admitted inability to predict long-term changes in such business models. If we invert this view and focus on what’s not likely to change, we can build conviction around certain long-term drivers. For example, there is almost no question that 10 years from now, customers would want a wider selection of products from Amazon, a better customer experience, and even more competitive prices. Within its major markets, no other company on Earth will be able to add more value to the customer long-term around price, selection and the customer experience than Amazon. Whether a T-shirt is ordered on a virtual reality platform and then delivered to the customer’s door by a robot or drone, or whether an apple is purchased at a no checkout Amazon Go store 10 years from now are frankly quite irrelevant as long as the business has experimented to figure out what provides the best customer experience at scale. In other words we don’t know what the precise economics of the business will look like 10 years from now but what we do know is that the moat is primed to grow wider over time and the business will be much more valuable than it is today. And that, to me is enough reason to invest at the right price. Think of this as a channel-agnostic or you can even say business model agnostic approach to long-term shareholder value creation, and more of an enduring business recipe for success. The companies that understand this are bound to win.

I think the only e-commerce competitors that will survive the ever-expanding Amazon retail onslaught and also perform well will be the very specialized, pure-play online retailers that are already the market leaders within a very particular niche or specific product category (they’ve already built substantial scale and market share in such category). As an example, AO World is an extremely customer-centric, UK-based retailer that specializes in selling 3C and home appliance products online. AO is a structural share gainer in the UK-based market for large home appliances and electricals. The barriers to entry in selling large home appliances are higher than the average retail product due to a specialized logistics and fulfillment requirements for this category. The logistics infrastructure required for bulky “white appliances” such as refrigerators, washers, and dryers requires 2-men delivery crews who are specially trained to install such products at the customer’s home and the company has to provide high-quality post-sales service. This is simply not a piece of the value chain you can outsource to third-party delivery firms and expect high customer satisfaction. In fact I am not aware of any reputable third-party logistics firms that provide large home appliance delivery services. On top of being able to operate the physical element of fulfilling orders more efficiently than your largest direct offline and online competitors, the widest selection of brands of SKUs within the specific category at competitive prices are required for completing the flywheel (achieving sustainably attractive ROICs long-term). In terms of the customer experience selling appliances online over brick-and-mortars yields another considerable advantage as legitimate product reviews/online video reviews are easily assessable.

Some other European-based pure-play e-commerce companies that should do well despite Amazon include: Zooplus which is an extremely well-managed online retailer specialized in selling pet supplies, Yoox-net-a-Porter sells luxury apparel online, and ASOS is an online apparel retailer (with little customer overlap with Amazon) that sells fast-fashion apparel largely to the millennial demographic. What these e-commerce companies have in common are a product selection unrivaled within their specific category which no other retailer can match – including Amazon. This is in part due to the massive SKU count required and the more “long-tail” nature of such categories – especially the apparel category which I will discuss in more detail below – which is not easy for a subscale competitor to replicate. Despite this, there is no question that the business of online retailing will always have the “Amazon overhang”, and likely some competitive pricing and margin pressure will exist no matter the category, but I’m a believer that there is space for multiple category winners and Amazon won’t dominate every single vertical. There’s a big difference between business durability and profitability… it appears that if you have the right time horizon, prioritizing the former over the latter could be a very wise decision, but most investors and CEOs don’t have the right time horizon.

JD is the only e-commerce company in the world that I know of that’s successfully building a multi-category last-mile delivery network that includes both bulky home appliances and fresh groceries. In fact from my knowledge only JD, AO World, Suning and Gome sell large appliances at scale with a specialized self-owned last-mile delivery network; Ocado specializes in selling groceries online but I am unsure whether they operate their own last-mile network. These two categories (the aforementioned large appliance category) – and the cold-chain logistics/fulfillment network required for fresh produce delivery are extremely difficult to replicate as it is not simply a question of having the capital required to build such a network at scale but also how efficient the network is over time. For example for Alibaba to fully match JD’s cost advantage on a per order basis it would require them to in-source all the product inventory themselves and build out a high-quality, modern warehouse network requiring close to 50 – 100mm sqm of GFA if we take the average SKU or order count per GFA for JD and apply it to Tmall’s order volume (this is a rough calculation but given we know that Tmall’s total order volume is a multiple of JD’s – the gross floor space that will be required is safe to say massive). We know this scenario is basically near impossible for several obvious reasons. I will not spill it out in detail here but very briefly Ali has a very software-centric culture, there are already existing 3PL firms that Ali’s merchants rely on which are improving their own efficiency over time, local government zoning laws near major cities are a pain in the ass and China likely doesn’t have 50 – 100mm sqm of GFA of strategically located real estate for modern warehouse buildouts (in fact it might not even have 20 – 30mm and of the total modern warehousing stock available most of it is already taken). Let’s not forget that JD is relentlessly improving their fulfillment network every year and will likely get to 2 – 3 hour delivery windows for most of its network within the next 5 – 7 years due to its huge lead. Taobao sellers often evade the VAT tax and a significant number of them experience chronic losses in the chaotic Taobao marketplace. The fragmented nature of Taobao/Tmall means those small sellers can never benefit from the same type of scale advantages that JD’s 1P operation could. Instead they have to rely on BABA to improve its platform/logistics each year to catch up with JD but even those improvements aren’t going to structurally alter the cost structure of the sellers. In short if you do not own a hub-and-spoke fulfillment model yourself, replicating a direct-seller (1P)’s cost advantage such as JD’s is nearly insurmountable.[2] Data and software can only take you so far without getting your hands dirty with the physical. The lesson here is if you want to secure the best customer experience, you have to in-source the entire value chain. An interesting note: Bezos has apparently said that one of his biggest regrets when starting Amazon was that FedEx and UPS already had the network in place for highly reliable and express parcel delivery services.

 

Thinking Deeper about Online Direct-Sales (1P) vs Marketplace (3P) Models

Two of the largest retail categories (globally and in China) are fast-moving consumer goods “FMCG” and apparel; these categories are growth opportunities for JD as the former is under-penetrated and the later JD is under-indexed to. The former I believe JD is likely to win given the nature of the category and JD being able to leverage its 1P strengths: low return rate, time-sensitive, high SKU count but a bit more standardized on average than apparel, high inventory turnover, high order frequency, specialized logistics required (for fresh groceries) and some health-sensitive products. Recent professional third-party independent surveys support a roughly 50/50 incremental share split between JD and Ali supermarket. I believe whoever has the superior logistics network wins in this category long-term as functionality and price appears to be the major customer purchase considerations. More standardized items and low-SKU count categories (more leverage with suppliers WRT volume rebates) should also attract a more diversified traffic which should help fuel the 3P business grow its selection of merchants and products. Unlike electronics and home appliances, greater expansion into FMCG will capture a broader customer base which JD can use to cross-sell a greater selection of higher-margin apparel, cosmetics, household goods etc in a virtuous flywheel.

Apparel is totally different animal. Many apparel products are driven by fashion where emotion is a larger element in the purchasing decision; this is thus a slightly different type of user problem for online retailers to solve. It is no surprise that the marketplace model works more effectively for apparel merchants vs. selling wholesale as long-tail traffic and demand is dispersed across many different SKUs (with tens to hundreds of millions of SKUs potentially in the apparel category). Tmall’s marketplace as opposed to JD Mall is simply designed/tailored for a better/more user-friendly experience for browsing hundreds of different products/SKUs within the same category such as apparels (takes an hour to find the perfect pair of shoes?) and as a result is a fantastic property for monetizing purchasing intent via ads as engagement is high[3]. We are already seeing Ali’s management switch the narrative from GMV growth to rev growth which is driven by ad revenue streams. This is in contrast to JD’s and Amazon’s site/app which you could label more as “functional utilities” as their user interfaces enable speedy customer checkouts.

JD has had only limited success in selling apparel inventory directly aside from success in more standardized apparel products. This is not to say that they can’t expand their apparel marketplace GMV longer-term if they work on positioning their fashion merchants/sites effectively (such as investing in developing separate, customized sites for individual merchants a la Tmall so that certain apparel merchants have less brand dilution if they list on JD, improving the overall tech stack for their 3P merchants via tools and features, and increasing customer traffic to the overall JD platform which will make it hard for apparel merchants to ignore longer-term. There is also evidence from professional third-party surveys that suggest that JD’s lower overall traffic conversion rate compared to Ali is due to their more limited selection. I don’t see why this can’t change as their product selection expands. Amazon Fashion for example started off targeting the low-end of apparel brands, and continues to work its way up to the higher-end.

So FMCG category is super strategic to building a one-stop shop online shopping platform -> JD must win, Apparel -> not a deal breaker to the long-term thesis but provides additional upside optionality if category expansion is successful.

 

Revisiting the JD Thesis

“When the facts change, I change my mind, what do you do, Sir?”

– John Maynard Keynes

I’m starting to get lazy writing this post 😦 so let’s use point-form notes for this section:

-Remember Bezo’s quote about there being two types of companies: the ones that always try to charge more and the ones that lower prices over time. The latter are applicable to many high-turnover, structurally low-margin retailers who maximize NPV by reinvesting efficiencies into lower price given the rather price elastic demand profile of their category. Examples include many supermarkets, ultra-deep discount retailers such as Costco, Aldi, Lidl, and major categories on Amazon and JD. People often focus on the first-order effect of lower prices = lower margin, and higher volume, but forget to take into account higher volume rebates from suppliers/better mark-ups over time and higher cost efficiencies/inventory turnover = some margin recapture longer-term. As a result such pricing decisions adhere to the goal of maximizing the long-term absolute dollar free cash flow per share, not long-term margins.

On operating leverage:

-Marketing and advertising expense leverage (which is not often talked about) kicks in over time as less traffic will be sourced from third-party traffic and more directly from organic sources such as new customers from either the WeChat/QQ Mobile channel or JD’s app/website. 5 – 7 years from now this will largely be a purely discretionary expense for a dominant franchise such as JD.

-Additional upside from leveraging logistics infrastructure such as unmanned warehouses, self-driving vehicles, and drones to enhance their long-term structural cost advantage. The automated warehouses could decrease their labour costs greatly as this is the biggest component of overall fulfillment costs. I have already noticed that their Asia #1 warehouse in Shanghai has increased its order processing efficiency over time from originally 16k parcels per hour to 20k now.

-If there is a hard-landing in China, offline retailers (mall-based or otherwise) will get absolutely crushed. Suning and Gome, in particular, are much less efficient retailers than JD on every key retailing metric such as inventory turnover, and OpEx as a % of direct-sales. In such a scenario JD should benefit even more as the secular shift to online sales accelerates.

-The overall margin expansion story may be delayed by a more few years (due to aggressive price investments into the FMCG category) than what I originally thought before they reach a steady-state level, and their steady-state margin profile may be lower than what I originally assumed (4 – 6% of Net GMV). Mid-case, at a 3.5% operating profit margin as a % of Net GMV by 2021, with the earnings power capitalized at a very conservative 18x – 22x exit EBIT multiple (or less than 25 – 30x FCF with an implied terminal FCF growth of ~6% assuming a 10% cost of capital), and adding up all the other hidden assets and FCF generated over the interim years, JD shares could potentially be worth between $137 – 166 by 2021YE. This valuation assumes zero upside optionality from all the FCF that will be generated in the interim. I think these exit multiples could potentially be very, very conservative as there’s nearly a non-existent risk of long-term disruption (commercialized teleportation is unlikely) for the dominant retailer whose main competitive advantage derives from scale. By this time they should also at the very least be larger than the current size of Amazon’s entire retail business. As additional downside protection in the absolute worst case scenario, it appears Walmart and Tencent have taken a keen interest in JD and have been buying more stock recently around these levels. In the worst case scenario, could they be a liquidity provider of last resort, or even acquire the entire company? It still gives me a bit of comfort that there is some sort of valuation “floor” here…

Amazon: Still the Best Business in the World

To reiterate the original thesis: Amazon is the best company in the world managed by one of the greatest investors in the world and is one of the most compelling multi-decade compounding stories today.

Who would have guessed 10 years ago that AWS was going to dominate public infrastructure computing and be worth several hundred billion dollars or multiples of Amazon market cap at the time? Not even Bezos. Even without AWS, an investment in Amazon shares would have yielded a fantastic 10-year return. The lesson here is that upside optionality is almost always underpriced for the exceptional business. As for the investors that always have a bias for overvaluing predictable cash flow streams[4] and over-rate mean reversion-centric theses, the people with this mindset will almost always mis-understand Amazon. Exceptional businesses are exceptional businesses for a reason – their returns on invested capital do not mean-revert to the average company over time.

So if we model nearly $500bn of net GMV by 2021 or a 5-year high-teens CAGR, an operating profit margin of mid-single digits on Net GMV (50% contribution profit margins for 3P sales, 5% contribution profit margins for 1P sales), and assuming the Prime business remains largely a cost-center or is around break-even levels on a rough contribution profit basis, there is a viable path to $30bn of retail operating profits by 2021.

Under this scenario and assigning a 20x multiple on 2021E EBIT, the retail business alone could be worth ~$570bn by 2021 on a future earnings power basis, or slightly above $1,000 per share. I remain a firm believer in the multi-year margin ramp-up of the retail business given all the potential leverage below the gross margin line that should kick in from increasing asset utilization rates from the fulfillment centers, increased warehouse and sortation center automation (which would reduce labor as major input cost), and potential mainstream breakthroughs in driverless vehicles and drones. With 3P GMV potentially consisting up to two-thirds of total company GMV 5 years from now, the higher-margin contribution profit mix from this segment, along with higher product margins for the 1P business from volume scale, category expansion (as Amazon is currently under-indexed to higher-margin categories), should drive overall consolidated retail margins higher substantially. Another perspective on long-term margins: as customer acquisition costs approach 0 long-term for the online retailer, marketing expenses alone which is currently around 5% of total retail revenues, will be purely a discretionary growth expense.

On the terminal value considerations, Amazon’s market share of total US retails sales excl. gasoline is only ~3.4%; their online share is closer to 35% of all US e-commerce sales. I’m honestly not sure if these figures are on a GMV or net sales basis, but that’s inconsequential and is a rounding error in a multi-decade DCF model. Obviously, not all transactions globally will shift online but we don’t even have to assume 50% end-state penetration in the US to create a massive TAM here. This is true today and will remain true even 5 – 10 years from now. With that said, assuming we discount our capital at 8%, I think an implied 5% perpetual growth rate on 2021 projected cash flows will look very conservative 10 – 20 years from now.

On AWS, the public cloud computing infrastructure and platform-as-a-service TAM is at minimum $500bn globally and likely closer to over $1 trillion if we include SaaS applications. Assuming base-case scenario 45% EBIT margins (incremental EBIT margins are already well above 40% as per the latest Q) on a 40% revenue CAGR to 2021, AWS could be earning around $30bn of EBIT and capitalized at 25x could be worth $750bn or over $1,500 per share 5 years from now. As for Google Cloud I think they have some room to grow and they are the leader in cloud-based AI features but aside from that I think their company culture sucks and their moonshot track record has been horrific. Hello drones, Hello Google Fiber. Despite Google cloud trying to differentiate mainly by price on core compute and storage cloud services, we are already seeing the leaders AWS and Azure operate in a highly oligopolistic manner with pricing cuts passed on to customers shallower than the implied Moore’s Law cost savings. Quite frankly, it is pretty embarrassing for a company like Google to have ceded to Amazon such a massive lead in public infrastructure computing when they already had the largest server infrastructure available globally. I think it just goes to show much big of a difference company culture can be to creating shareholder value.

Finally, we have the $140bn of FCF (~37% of Amazon’s market cap today) that could potentially be generated in the interim 5 years. To assume all this cash will be reinvested at a 0% rate of return is extremely conservative in light of management’s approach to allocating capital (which is to continually invest in high IRR projects on a 7 – 10 year horizon to the dismay of the vast majority of public market investors) and the widening moat which continues to offer attractive incremental reinvestment opportunities over time.[5] Jeff Bezos is by far one of the best and most under-rated (in my mind) investors in the world; allocating capital to someone smarter and a better investor than myself with such an exceptional track record of value creation is almost never an unwise decision I think. I believe my numbers have not priced in a more bullish scenario that accounts for additional upside in promising opportunities such as India e-commerce, higher monetization of FBA, Prime video streaming/Amazon studios, potential last-mile logistics for C2C, B2B, B2C commerce, Freight forwarding/logistics, at-home personal/virtual assistants, E-Sports via Twitch, O2O services and countless other adjacent markets that have yet to be tackled and that no one has yet to appreciate.

                       

The Personal Growth of an Entrepreneur

I’ve been hearing from pretty reliable sources that over a recent period Richard from JD hasn’t been working as hard as before, he’s been pleasure tripping around the world over the past year or so with his wife, and he recently purchased a private jet and a few large homes.

Despite how reliable my sources may be, I’m not sure to what extent they are true, or how much it actually matters. It is also important to discern between fact and rumour. There were rumours that the company was going bankrupt right before it IPO’d in 2014. There were also rumours that Richard was shacking his former personal assistant while still dating his current wife. The lesson is we have to be very careful when sourcing news from potentially fake or unreliable sources.

I think to some extent, someone’s personal life can be “walled off” from their business life, and thus should be off-limits for judging a person’s character. I’m sure the range of opinions on this topic is very wide, so whatever. I personally have a more “laid-back” view than others. Common sense is if someone is snorting cocaine every day, they are not fit to be CEO. They don’t have to be a saint or the perfect man who’s going to marry daddy’s little girl. As for the private jet and mansions, let’s be real here: most of us are not going to stay in the same home like Buffett did if we became billionaires. Richard came a long way from being dirt poor and surviving largely on a potato diet. At this stage money shouldn’t really be the primary motivator for him since he’s worth over $7bn. With that said, he’s recently moved his bed into his office and is essentially living at the company now.

My own hypothesis on his recent behaviour (and I am making no excuse for it) is that his management style might have changed after he got married late last year. I think he might have went through a phase – call it a mid-life crises. This is a man in his early 40’s that didn’t get married until last year because he dedicated the vast majority of his adulthood towards building JD. As far as I’m concerned, he deserved a long honeymoon.

After getting married, and seeing JD become a much more successful company post-IPO and the Tencent Partnership, perhaps he just wanted to put in less facetime in the office, and at the same time tried implementing a more decentralized management structure. Steve Jobs for example who is another legendary tech CEO was a giant asshole before falling in love with his wife. He would often yell at his employees for minor mistakes. Richard was a bit similar during JD’s early days; according to many JD employees, he was not an easy boss to work for. What’s interesting is that he’s been physically absent from the company for long stretches of time in the past. For example, he studied overseas for over a year prior to JD going public, and the company was still firing on all cylinders during this time.

It’s obvious he didn’t like how the marketplace was being managed by Haoyu Shen. Now that he’s axed him, he’s taking greater direct control of the business again. So I do believe leaders can change over time, and their motivations can certainly change – this is all part of growing and learning as a person and entrepreneur.[6]

In terms of the company’s performance over the past year or so, the transitory issues surrounding JD’s marketplace segment was a bit concerning, so some criticism is warranted. However, on the most important operating metrics/key drivers such as net GMV, 1P and consolidated gross margins, operating cash flow, the incrementals, and the cash conversion cycle, business is actually looking quite good. I think the investment set-up looks quite favorable going into 2017 as margins begin to inflect materially and as we lap the transitory GMV issues.

One final point is that even if you believe there is a risk of an empire-building mindset, keep in mind that SBC is a major part of employee comp, similar to Amazon. Richard may be a billionaire but he absolutely needs his employees to work hard to fulfill his long-term vision, and if the JD stock price does not go up over time, employee productivity will likely be affected. This in my mind is basically an insurance policy for Amazon and JD shareholders or any investor invested in a similar company with a super wealthy CEO and like-minded employee comp structure.

Big picture: Richard has accomplished what few have (no unambitious or unmotivated person builds one of the best e-commerce companies on the planet, period), he’s still a very young CEO at 42 and has the potential to remain an effective CEO for the next few decades as long as his motivation remains intact. To the interests of long-term JD shareholders, a young benevolent dictator is a thing of beauty.

As much as you can admire someone for his past accomplishments and for what they say, actions always speak louder than words. So if I find out he’s partying every day I would dump the entire JD position immediately.

 

Inductive Reasoning

I take a management-first approach when it comes to investing in emerging market companies so I spend quite a bit of time conducting due diligence on the people behind the company. On a deeper note around the topic of Richard’s integrity (central to the JD thesis), I’ve summarized my thoughts below.

There are many frauds in China and one obviously has to be weary of investing in stock scams and promotions. My own experience of studying frauds is that the vast majority of them are typically run by highly promotional management teams that rely on deception in order to enrich themselves and sell stock at a highly inflated price. There is no solid evidence that I’ve come across to hint that this is anywhere remotely close to the case of JD.

My main points are as follows:

-As mentioned in my JD paper, Richard hasn’t sold a single share post the IPO event, he’s paid an annual salary of Rmb1 per annum, and has a 10-year option vesting plan. I also mentioned about the accounting differences between JD and Alibaba regarding purposely defining GMV in a much more conservative manner than Alibaba. As per footnotes in the filings, if defined on an apples-to-apples basis under Alibaba’s definition, JD’s reported GMV #’s would be at least 45% higher (~$200bn in gross GMV for 2017E, or ~80% of Tmall’s projected 2017 GMV size). We know Alibaba’s accounting is sketchy and Tmall’s disclosed GMV is overstated – but by 2018-2019 JD’s GMV could be higher than Tmall’s if measured on a like-for-like basis. Also worth noting is that JD’s largest direct retail competitors such as Suning, GOME, Amazon China, and Dang Dang are struggling and have no incentive to report bad numbers. I find it highly unlikely that Richard would have this type of compensation scheme and have the co’s numbers reported so much more conservatively than their largest peer if it was a fraud.

-JD use to deploy a very unique recruiting process which is very telling. They only hire fresh graduates with no previous work experience post-graduation for their management trainee program. From my knowledge, the focus of their recruiting process is not centered around in-person interviews because they are looking to avoid hiring people that are very good at selling themselves in person, which would potentially disadvantage other applicants that may be a better fit for their company but who are not as good at interviewing. Instead, there is a “final written exam”, where the topic is unknown beforehand. Before all the applicants sit down for this exam, a person from JD approaches the applicants, and essentially offers a bribe where they will reveal the topic of the exam for a cash compensation. This is actually the real test and there is no written exam. If the applicant takes the bribe, they failed it. I am not aware of any other company that tests potential applicant’s integrity this way.

-The recently released “corruption memo” revealing the names of the 10 employees who were arrested by police – this was not a “leaked” memo as reported by Western press sources which probably screwed up on the translation. It was released publicly on purpose likely as a warning to future employees on the consequences of acting illegally such as taking bribes from suppliers. Richard’s early life experiences of having employees embezzle money out of his first restaurant business that went bankrupt has driven him to a zero tolerance policy towards any corrupt behaviour at JD. Delivery personnel are not allowed to receive gifts from customers such as water, for example.

-JD’s largest shareholders were was a sign to me, but not a given conclusion. It is really not so much that these investors are among the largest shareholders of JD that gives me any comfort, but how Richard has dealt with them in the past which is telling. The Tiger Global deal was a particularly telling one; the company was in desperate need of cash and weeks away from bankruptcy, but Richard still did not renege on his verbal deal with Tiger (which was less attractive than the new competing offer). In terms of investing alongside some of the best investors in the world, I think a critical lesson can be drawn from the Valeant episode. I suspect due to massive commitment bias they were all unable to clearly see the red flags emerging in Mike Pearson’s behaviour, the flaws with the VRX business model, and how aggressively he ran the company.

-Sidney the CFO is the one who typically meets with groups of large investors. Sidney is quite non-promotional and I personally find management’s long-term expectations for the business (20% consolidated gross margins, low double digit 1P margins) very reasonable. As for Sidney’s 8 – 9 months at Longtop Financial – the massive accounting fraud – after speaking with a few people familiar with “ramp-up periods” for new CFOs in major companies, there is typically at minimum a 1 – 2 year transition period for a new CFO to get very familiar with a company’s books and controls. Since Sidney was at Longtop for less than a year, it’s possible he figured out pretty quickly that the company was sketched and left shortly after finding a new CFO role. Perhaps more importantly, his name was not brought up in the subsequent investor lawsuits.

-The company has the best fulfillment service in the world, period. These are some incredible achievements that I think required real human ingenuity, talent and hard work. Generally speaking, I don’t think people with this kind of vision/ability would commit fraud – it wouldn’t be worth the risk of losing it all. Also, the founder-CEOs that committed massive public company frauds were all super promotional (think Mike Pearson, Bernie Ebbers and Eike Batista) yet JD hardly has an IR effort! This is not a business model centered on paying for friendship/companionship such as a MLM scheme, or price-gauging on life saving drugs, this is about passing on as value to the end customer as possible via supply-chain efficiencies.

-Third-party data supports JD’s numbers. The best data is from the State Post Bureau which is the state regulator that monitors all express activities in China. They publish stats on total express delivery revenue which historically has tracked BABA/JD’s combined GMV almost perfectly (historical correlation > 99%). From this data point, we can deduce that as long as BABA’s GMV has been roughly right, then JD’s GMV would have to be at least roughly right. For JD’s numbers to be fake, both JD and BABA would have to be fudging numbers in concert which is highly unlikely given their animosity toward each other. In addition, Tencent has perfect visibility into JD’s WeChat-related sales data. I think they would have sold their stake a long time ago if there was something fishy here. Instead, they have been recent buyers of stock at these levels.

-Last but not least, Richard’s personal motivation portrayed through his company speeches and Chinese interviews where he says he wants to sell only high-quality authentic products to every Chinese citizen and take good care of all of JD’s employees by allowing them to retire in dignity if they work hard. I find it pretty unlikely that a fraudster would publicly announce these types of admirable goals, essentially live in his office now, and not sell any of his paper stock tomorrow worth around $7bn in aggregate and just quit. JD is one of the most customer-centric companies I’ve studied – similar to Amazon – it would be highly unusual for a fraudulent company to pass on so much value to the customer. If I had to create a fraud, I would first try and make sure that it appears very, very profitable… is this not common sense? And honestly, if I wanted to create a get-rich quick scheme, I definitely wouldn’t compete against Alibaba.

On Investing in China

Is China an investable market? I think studying the history and development of China in the 20^th century and analyzing long-term trends provides us with some insights here. We know post the Mao era/Cultural Revolution – roughly from the start of Deng’s leadership – that China has been reforming its economy. Deng normalized diplomatic relations with the US, instituted major market reforms including the development of a private sector and market economy, opened the country up to global trade and foreign investment; this subsequently lifted the majority of the population out of poverty over the past several decades. Deng was a very practical leader, and ridiculed the notion that it was better to be poor under socialism than rich under capitalism – a common mindset among China’s leadership during the Cultural Revolution when untold numbers of people died from famine. This was in stark contrast with the Mao school of thought which valued egalitarianism above all else (a value aligned closer to Stalinist and Marxist policies). We know Mao’s intentions were good but his policies were a great failure.

Let’s face it, democracy has its issues as demonstrated by the recent US election, and is not the best fit for every country in the world. There is no one more credible or smarter about the issues surrounding Asian economic development and politics than the late Lee Kuan Yew (LKY), or the father of Singapore. LKY valued a clean government free from corruption, with high standards in ethics, integrity, competence, and intelligence; he wanted a society driven by meritocracy, a highly educated workforce, and of course respect for the rule of law. For example, he made sure that the compensation of senior government officials were closely tied to the compensation packages of private sector CEOs in Singapore, which helped reduce corruption. On the social stability front, there were no poor ghettos in Singapore despite there being visible Indian and Malaysian minorities who lived harmoniously alongside ethnic Chinese Singaporeans. In each individual neighborhood in Singapore, Singaporeans of different ethnicities were forced to live alongside each other proportional to the national ethnic population mix. This ensured that there would be no minority ghettos like we see in many countries in Europe, where resentment can easily breed into violence as seen today.

LKY believed in social Darwinism, but he was primarily a pragmatist with a largely non-ideological approach towards governance. Singapore was essentially a real-life experiment of the Hobbesian model (a social contract between the people and the State, where some liberties and freedoms are given up in exchange for security and social stability) which became extremely successful. During LKY’s era as the unequivocal benevolent dictator of Singapore until his retirement, Singapore’s GDP per capita grew from a third-world country level into now one of the highest levels on the planet.

The miracle of Singapore did not go unnoticed by the Chinese. Circling back to China: it is now a middle-income country, on its way towards becoming a high-income country over the next several decades. Some can say China is actually the most capitalistic country on earth that still labels itself as a communist one.

Ever since Xi took office, consolidating power and eliminating government corruption has been his main priorities. Some factions of the military were loose cannons under Hu Jintao’s administration, and were dangerously anti-American; Xi basically threw all of these crazy generals in jail. It is also important to note that Xi’s de facto second in command, Wang Qishan, (who’s in charge of the corruption crackdown) was a student of history and the Singapore model, was greatly praised by LKY as one of the most capable people of China, and has no offspring who would benefit from him enriching himself.

Here are LKY’s own words commenting on Xi:

“I would put him in Nelson Mandela’s class of persons. A person with enormous emotional stability who does not allow his personal misfortunes or sufferings to affect his judgment. In other words, he is impressive.”

 – Lee Kuan Yew

Xi is smart and what he understands is that conflict with the US will derail China’s long-term growth. As a result, cooperation is the only viable path the country can take towards its goal of becoming a 21^st century superpower. As for the VIEs issue specifically, an action by the Chinese government that effectively wipes out foreign investors is an action that goes against all of what the Chinese government has been trying to achieve over the past 4 – 5 decades: long-term economic development and global cooperation. What the political figures who have the most credibility on the US-China issue (Deng, Xi, LKY, and Henry Kissinger – arguably the greatest statesman in the 20^th century and the person who laid the groundwork for the normalization of diplomatic ties between the US and China in the 70’s) all have in common is they simply value pragmatism in their statecraft over ideals.

As for the Taiwan issue, the island can be wiped off the face of the earth by the PRC overnight, so I don’t think it’s wise for Tsai Ing-wen to fuck around here. We also know Trump is an idiot and needs a bit of time to be lectured/advised on international relations. I think what’s driving current Taiwan – PRC relations is largely a very complicated history and social animosity between the two peoples. Sadly these things do exist like other common prejudices, no matter how much some people hate to admit. For the record in Asian circles the unofficial social pecking order among Chinese people in East Asia are Hong Kong > Taiwan > Mainland China. It’s also not a coincidence that the GDP per capita of these three “states” follows the same descending order. Over the next several decades, as China outgrows both special regions economically, this will likely change.

As for the event risk pertaining to a massive banking crises/currency devaluation, if you have an anti-fragile organization with ample liquidity and a quality LP base then you’ll likely benefit from such an event. Being the incremental buyer of last resort/provider of liquidity in times of great market distress has often times yielded very lucrative gains for the prepared… Most importantly, I’m not smart enough to know what the macro developments will be like over the next several years; I’ll admit it. Short-term political and economic based speculations are worthless and futile anyway. However, on the longer-term considerations, such as over the next 10, 20, 30, years, I’m confident that income per capita in China will grow enormously.

With all the added uncertainty that comes with investing in a foreign market – and one that is so culturally unfamiliar for many Westerners – why even bother? Quite simply, the exceptional return potential available at large scale. The number of long-term oriented institutional investors in China remains close to non-existent today. Honestly, investing is never easy, but structural advantages do exist for those open-minded enough to exploit them. The few smart, long-term oriented investors focussed on China such as Hillhouse and Capital Today got in really early, simply picked the best companies levered to the Chinese consumption and internet theme,  and as a result, accumulated a few of, if not the best investing track records over the past 10+ years. It didn’t take a genius to figure this out, but a disciplined approach to long-term investing.

Liberty Global / LILA/K

No post on this blog is serious without a discussion of a Malone-related company. It’s safe to say that ever since LILAK became a tracker, the story has been a complete shit show.

Has it historically been wise to invest alongside Malone? For the most part, yes. But now with dozens of related entities within the complex, we have to be very careful with picking the best story.

Let’s start with Global. First, the failed Vodafone transaction in the spring of 2015 caused the event-driven funds to sell en masse. The unofficial explanation provided by management was a valuation gap that couldn’t be bridged. This sounds reasonable. Vodafone is primarily a wireless company, and wireless companies in general deserve a lower multiple than higher-quality fiber/coaxial-based fixed assets. Soon thereafter, Fries starts giving out “long-term OCF” guidance of 7 – 9% OCF growth for the next few years (for the first time in the company’s public history, I might add) as the competitive situation in the Netherlands continues to deteriorate and the Ziggo integrations are becoming more challenging than originally estimated. Even up to this day, there is no indication that the KPN Fiber JV in the Netherlands is slowing down its FTTH rollout or its aggressive promotional pricing.

Unfortunately, the competitive position in Switzerland appears to be deteriorating as well. Most of Global’s issues in its most competitive markets is a problem of high population density making the economics of overbuilding a lot more attractive for European Telcos. The Netherlands for example, with a super dense pop/sq km of 400+, makes FTTH a very viable economic proposition over large parts of the country. On top, Gfast technology makes it possible to further upgrade copper networks in these shorter local loop markets; Gfast can provide downstream speeds up to the several hundred mpbs range with a relatively cheap incremental cost of capital compared to FTTH. Forced unbundling regulation of the local loop supported by many Socialist regimes in Europe also adds further competition by resellers. As the minimum speeds being offered by the Telcos continue to be well above the industry demand curve, pricing power for both duopoly operators and resellers will likely continue to be soft. Europe, in contrast to the US, is simply a much more competitive broadband market.

With these issues at hand, I don’t see a path towards 7 – 9% OCF growth. No one believed management’s announced guidance and for good reason. I think even 5% OCF growth including project Lightning could be a stretch. Now they’re saying 7 – 9% excluding Ziggo, just lol.

So why has Mike Fries suddenly become so promotional in such an “unliberty-like” fashion? First of all he got most of his options and RSUs struck earlier this year when the stock got absolutely crushed. Secondly, there’s the added incentive to sell/merge with Vodafone if your operating performance is deteriorating. It’s obvious a stronger share price brings with it a stronger bargaining chip to the table with Vodafone.

As stated, management’s rationale for demanding a discount on wireless assets given their lower quality is reasonable but what I don’t understand is the disconnect between paying 11x post-synergy EBITDA for an Latin American asset with a considerable wireless mix vs. not striking a deal with Vodafone at likely better terms and massive synergy benefits.

Now with the deteriorating results of CWC along with the accounting adjustment from IFRS to US GAAP for CWC/Columbus (shouldn’t they have adjusted their purchase multiple for these changes beforehand?), it’s obvious they overpaid.

The LILAK thesis for many Liberty followers was largely based on trust in the management team given their multi-decade success investing in and operating cable assets globally. This becomes even more important when it comes to investing in a business operating less familiar/foreign regions. But just the credibility I think Mike Fries lost over the past year or so with his sketchy behaviour should warrant some caution… I like to think as the management team you get the stock price and the shareholder base you deserve as results come in over time. Fries should seriously just focus on operating the business well instead of revising the guidance every single quarter.

LILAK a narrative parallel to TCI or early Global/UPC?

I don’t think so. TCI was an actual monopoly in the burgeoning US Pay-TV industry when wireless and high-speed data services were not around. TCI was a major financial backer of upstart cable networks which allowed the company to distribute exclusive programming in its pipes. Market power can be pretty insane if you control both the content in the pipe and the distribution. On the M&A front Malone was rolling-up local cable systems run by mom-and-pop entrepreneurs at valuations probably closer to 4 – 5x EBITDA. At peak, TCI had a 30%+ market share of all US Pay-TV homes. When cable and telecommunication assets were near/at peak valuation levels at the turn of the century, satellite distribution became an emerging threat, interest rates were heading up, and the balance of negotiating power was shifting to the cable networks, Malone sold TCI to AT&T. The timing was impeccable.

Will the CEO of LILAK be capable of executing such a successful playbook in Latin America? Maybe… but I seriously doubt it. Seems like it’s been dealt a much tougher hand.

Charter Communications / Liberty Broadband – Still the Best Special Situation Compounder that everyone has heard of

Houston, we have a cost problem:

Excluding programming costs, the average US cable operator has an OpEx per resi sub/month cost of ~$50. For European peers, this is closer to $15 per sub. Certainly household density, competitive intensity and labor costs play a major role here, but the gap is startlingly wide. It’s likely that for the longest time US cable operators were run by complacent monopolists. This may soon be about to change.

Patrick Drahi is still a stud:

Last year Altice entered the US cable industry with their purchase of Suddenlink and CVC, along with announcing massive cost cuts and synergies. Believe it or not, Altice’s $900mm synergy target for CVC is likely achievable and potentially conservative. Excluding programming, CVC had an OpEx cost per resi sub/month of $60 – 65. Assuming Altice fires all of the family friends the Dolan’s hired as middle managers earning a $300K+ salary, and stripping out the Dolan’s/senior management compensation, among other bloated HQ expenses, we could potentially get to roughly $100 – 200mm in overhead cuts. That leaves about $700 – 800mm left for resi sub-related cost cuts. The implied target OpEx synergies management are looking to shave are then around $20 – 25 per resi sub/month. If these targets are met, CVC’s OpEx per resi sub/month will be $40 – 45, which is still well above its European peers at $15 per sub! Numericable for example has an OpEx per sub/month of $15, and let’s not forget, France is a much more competitive market than FiOS territory. That’s just on the OpEx side, as we haven’t factored in any programming cost synergies with Suddenlink, or their plans to move towards more skinny Pay-TV bundles and outright drop certain networks. This could shave another few hundred million off. Finally, the CapEx per passing for CVC is much higher than European peers due to the many duplicate hardware in their network. If upgraded and maintained under Altice, this could shave another $100 – 200mm off long-term.

So on Charter, I think the real, and still rather conservative, cost-synergies will be closer to $1.4 – 1.6bn on full run-rate numbers by 2019. Just the programming synergies alone could be $650mm in a few years if we assume Charter moves to TWC/BH’s lower rate card and if they achieve a pro-forma programming rate card in the mid-$50s per resi sub/month by year 2 post-merger. If we model just an OpEx per resi sub/month for Charter of ~$50 just from the scale benefits of merging multiple systems in a contiguous combined footprint, we can get to over a billion in OpEx synergies easily. Just from the OpEx and the programming synergies alone we can get to $1.6bn in cost savings or double management’s $800mm guidance. Also, this figure doesn’t account for the duplicative overhead and executive compensation costs for BH and TWC, nor any CapEx savings from the benefits of leveraging a larger sub base for purchasing set-top boxes, modems and other network equipment…

So over time, it’s very possible that the actual synergies end up being double or even triple management’s original $800mm estimate – which would still be a MSD % of pro-forma revenues – and roughly in-line with prior cable merger deal synergies.

Why is there so much upside on the table? It’s obvious there was management sandbagging from the get go. This was done to avoid overbearing regulatory scrutiny over job cuts and announcing an attractive profitability outlook for rationalizing a huge merger. Also, Rutledge’s compensation package (including options and RSUs with exercise prices up to the $500’s per share) for the pro-forma business was struck shortly after the merger closed, incentivizing him to downplay the potential upside. If these ambitious share price targets are met over the next 5 years, he will become a billionaire on paper. The only strong pushback I can think of is that Rutledge is not known as a cost-cutter, despite being a great cable operator. However, now with the Trump administration in place along with a less onerous regulatory environment, I see potentially more leeway for aggressive cost cuts. On the revenue front, the new industry-friendly FCC could mean the approval of data caps and usage-based pricing which would likely mean additional upside for broadband pricing.

As for the HSD penetration runway, If we define “high-speed broadband” as a service providing minimum downstream speeds of up to 25 – 50mbps, then “real” US high-speed broadband penetration is understated relative to published industry figures (which typically define a broadband household as one with any fixed-line internet connection including DSL). If high-speed broadband penetration defined under these minimum speeds eventually reaches 80 – 90% in the US over the coming 10 – 20 years (not unreasonable given the robust demand outlook), then it’s possible that Cable will take the vast majority of incremental share over the next couple of decades. We’ll likely move to 10GB eventually, but this will probably be closer to 15 – 20 years from now. Cable’s technology roadmap looks promising and it appears DOCSIS 3.1 alone (which is slowly getting rolled out by Comcast and Cox in select markets over the next few years) can get Cable to those speeds without upgrading the last-mile to fiber-optic.

Currently Charter’s HSD penetration is ~45% within its footprint. If the industry moves towards 90% penetration eventually, and assuming a 50/50 share split between Cable and FiOS (16% overlap), a slightly more favorable share split between Cable and U-Verse/upgraded DSL (25% overlap), and of course a 100% share split vs DSL in the rest of Charter’s network, Charter can potentially grow its top-line at at least MSD rates for the next couple of decades, driven by new net adds, modest base inflationary pricing expectations, upselling faster data speeds, and increasing commercial sub penetration. In any event, I think with the synergies outlined and the fantastic incremental margins from broadband subscription growth, Charter’s EBITDA margins should be closer to at least 40 – 45% 7 – 10 years from now, which would still be below Altice US’s targets for CVC and Suddenlink at 50% and European peers.

As for 5G, I’m too lazy to discuss that today, so let’s leave it for another time, or on a good day.

On valuation, assuming a continuously levered capital structure at 4.0 – 4.5x with aggressive capital redeployment into share buybacks, I see a pathway to $40 – 50 of fully-taxed levered FCF per share by 2020 or $20.5bn+ of EBITDA at a slightly less than 40% margin. At an implied 9 – 10x EBITDA exit multiple / or ~18x levered FCF per share of $40 – 50 (potentially very conservative assumed exit multiples given the aforementioned multi-decade attractive growth runway), Charter stock is worth $750 – 900 per share 4 years from now.

In conclusion, I believe Charter Communications / Liberty Broadband remains the most attractive cable asset to own globally and one of the most attractive long-term investments in the US large-cap TMT universe today. Did I mention John Malone? 🙂

“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” – Blaise Pascal

Happy Holidays,

Richard

[1]Outside of getting acquired which I think is increasingly unlikely other than a carve-out of the studio business, I still think Viacom is a short and the equity could potentially be worth close to zero 4 – 5 years from now. The cable network segment comprises of the bulk of the value of the company and earns juicy EBITDA margins north of 35%.

[2] We also know for a fact that their last-mile unit cost per order is lower or at least on par with any of the prices third-party last mile franchises charge to merchants (assuming we take into account all the costs across the entire last-mile delivery chain including inbound delivery, sortation centers, line-haul, delivery stations I estimate JD’s average fulfillment and last-mile delivery cost per order was ~$1.70/$0.85 in FY2015 (vs 8 – 10 RMB for the industry ASPs), at the same time JD’s service quality is superior (based on customer service ratings/surveys, cash on delivery service available), and faster, more reliable, with a friendlier return policy. So better service than the industry with a marginal cost structure equal to or lower than industry ASPs.

[3] In fact, e-commerce search engines will likely become the most valuable advertising properties long-term over horizontal search engines as incremental traffic growth increasingly shifts directly to e-commerce properties; these properties are superior in creating purchasing intent right at the bottom of the funnel.

[4] There’s a big difference between how asymmetric the risk-reward profile of an investment (or how wide the distribution of future outcomes) is vs. the probability of a large permanent loss of capital.

[5] The barriers to entry in new or adjacent markets are lowered due to the valuable customer data and existing scale built in an adjacent market.

[6] I’ve observed that successful leaders may have many different management styles and philosophies. If I had to guess the most important thing for a CEO on a daily basis is to prioritize tasks. But on a more strategic level prioritizing company long-term initiatives is as equally if not more important. How Bezos allocates his time within an increasingly complex business such as Amazon with many different projects and moonshots is a mystery to me. At Baidu you can bet Robin is spending most of his time on AI as he knows the search business will soon be in secular decline. Like a lot of great tech CEOs the recurring pattern appears to be that they are extremely passionate about their business, have a solid technical background, quite introverted and typically not very charismatic. The best tech CEOs have all these traits at minimum and are great allocators as well!