What’s the True TAM of Search?

For work and personal reasons I’ve taken a 3 year leave of absence from the blog. Now that I’m “working” for myself again, there will be plenty of time to get back to the community and share random thoughts.

As the blog has taken on a decidedly technology focus in my absence, the first topic that’s piqued my interest is the concept of information distribution. I will be writing a series of posts on it, ranging from topics like how information distribution has evolved in the Internet Age, how business models are affected and moats are created and destroyed in the process, how its evolution differs between China and the West, and any investment implications. I suppose a lot of this stuff you already know because it’s just common sense and some of it, if you didn’t know, is probably pointless crap to you, so I’m going to break tradition with the usual long-winded style of this blog and keep the posts short for your benefit. Hopefully you will enjoy the new format.

 

Part 1 – The TAM of Search Engines

 

I don’t own Google but I follow the company a bit. This is not an expensive stock. With some reasonable adjustments it’s not hard to get the core search business trading at less than 20 times underlying earnings. The main pushback on the bull thesis that’s emerged in the past year or so is the extent to which the search engine business is nearing saturation, considering that Google and Facebook now account for over 70% of online advertising globally (ex-China). At some point the party has to end if you’ve already won all of the chips, right?

Not that I’m bullish on Google or anything but I think this train of thought really misses the point in the greater context of information distribution on the Internet. To truly appreciate the nature of information distribution, we need to think in a broader context and challenge some assumptions: what if “online advertising”, or even “advertising” is not the right way to measure the TAM (total addressable market) for the search engine business?

For starters, “advertising” is only a subsection of what we label as “marketing”. Just think about how much commissions department stores pay their salespeople. While these costs are not considered advertising in strict definition, it is quite conceivable that some of these dollars would get re-allocated to search engine advertising as retail sales move online and brands shift their budgets accordingly. Similarly, companies spend enormous sums on things like trade shows, business travel, sponsorships, cold calls etc., all of which are marketing channels for potential customers to learn about their products. All of that information could conceivably be acquired by the same customers with a simple click on a search engine, a shift in information distribution that is well underway today.

If we think in these terms, the TAM for search engines would be an order of magnitude larger than the figure that’s often quoted by investments analysts which limits the TAM to a narrow definition of “advertising”.

And we are just getting started.

If we correctly define the role of search engines, we can see that what they are really designed to address is actually something much broader – “search cost”. Search cost is the biggest component of what economists label as “friction cost” in an economy and it can exist and be addressed in many different forms. For example, before the invention of the Internet, the most widely used tool for addressing search cost was actually the physical location. Imagine you owned a 200,000 sq ft building in downtown Manhattan. If you used that space for storage, chances are you would be able to charge the same rent as a 200,000 sq ft warehouse situated in the suburbs; but if you turned it into a mall it would likely bring in many times the amount of rent that an equivalent mall can bring in outside the city. All of that excess rent is a form of marketing that brands and retailers pay to address “search cost”. In a purely online environment, the physical location is disintermediated and what companies would otherwise pay in excess rent in an offline setting would presumably get re-allocated in the form of Amazon commissions or Google keyword ads (By the way Amazon is really just another search engine with a “vertical” emphasis – even though Amazon commissions are not labeled as “advertising” in accounting terms, they are in every sense a form of advertising in substance; we will explore the topic of “vertical” vs “horizontal” search engines in detail in the next post).

In fact, in a market like China where online penetration of retail is comparatively high, the fungibility of rent vs. online advertising is already on full display as many retailers and brands in their expansion strategy now routinely conduct a cost of traffic comparison between setting up new physical locations and raising the budget for Tmall keyword bidding, as if those were interchangeable marketing channels.

As a thought exercise, imagine a world where at some point in the future all consumption moves online. What will happen to the way search cost is addressed? Excess retail rent will be fully eliminated, direct-to-consumer sales will no longer exist as a profession, travel agents will be out of their jobs and we will no longer pay late fees at libraries (which won’t exist). At least in theory, all the money spent on these belong in the TAM of search engines. Once you add up everything, the real TAM becomes quite considerable. Hell, I wouldn’t be surprised if search cost consumes 10 – 20% of GDP for a lot of countries.

The often debated metric of advertising spend as a % of GDP, in my opinion, is more or less a meaningless statistic as it is merely an output of how we label and account for different buckets of search cost. Take Alibaba vs. Amazon 3^rd Party as an example, one is the largest advertising platform in China and the other reports close to zero advertising revenue. In substance both sites serve a similar purpose of generating traffic leads for retail merchants; they simply report the nature of their revenues differently. As a result, this causes “true” advertising spend in the US to be under-reported compared to China. Personally I don’t take this metric very seriously as it is too narrowly defined to have any informational value. What matters more is search cost dollars not advertising dollars.

On an unrelated note, this search engine discussion brings up an interesting point about the danger of the traditional top-down “TAM analysis” that analysts employ when attempting to size the potential of disruptive technologies. With any business enabled by new technology, while the existing size of the market provides a useful reference point for TAM, it is often a very imprecise one because it assumes a static relationship between the size of a market and the technologies that enable it. What we often forget is that the size of a market is actually an output of technology constraints and as technology evolves, the market size evolves with it.

I will give you one example. Vipshop is the dominant online off-season apparel retailer in China. The bull thesis for this name is relatively straightforward: apparel retail in China is a $300 billion market of which the off-season segment is about 20% of overall sales. This would suggest a TAM of $60 billion which given Vipshop’s $8 billion of revenue means the company is less than 15% penetrated. Selling off-season apparel online is a superior model that will displace offline retailers and Vipshop, similar to TJ Maxx in the US, is the undisputed leader with an unassailable competitive position.

I actually don’t disagree with the second part of this statement (competitive position) but the first part (TAM) is problematic. This is because as an off-season discounter Vipshop procures the majority of its inventory from excess inventory in offline channels. As apparel retail continues to shift online (already at 40% online penetration in China, even 50%+ in some cities), the availability of this excess inventory shrinks significantly because online in-season retailers have much lower inventory needs than their offline counterparts (online means no inventory needed for in-store display, shorter supply chains and better sales predictability). In other words, the more apparel sales shift online, the smaller Vipshop’s TAM will get – there are always two sides to every coin. Vipshop’s share of its TAM is therefore a fair bit overstated, which seems to explain why growth has slowed from 80% to 30% in less than 2 years.

Actually, most of the time, new technological developments have a tendency to shrink the TAM as technology is usually deflationary (the search engine being an exception), so be careful when you see IR slides of tech companies where management takes an estimate of the market size today and declares that number as their company’s financial destiny – it most likely overstates the actual TAM.

—- to be continued…

UPDATE: I’M BACK! AT LEAST FOR A WHILE

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 2/3^rd 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).

New Stocks

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:

1. 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.
2. 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.
3. 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.
4. 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.

Alibaba Part 2 – An Overview

Alibaba is a big internet conglomerate. Outside its core e-commerce business, it owns a whole bunch of other assets (internet search engine, 3^rd party payments systems, online video sites, cable internet, social media, cloud storage, digital map services, among other things). However, most of the profitability of the company still derives from its e-commerce platforms, which are separated into four main business lines:

Alibaba.com: the original Alibaba.com is a B2B platform that acts as a middleman between wholesalers/manufacturers and retailers. It also facilitates transactions between Chinese exporters and foreign importers and it’s the real deal – I used to be able to buy (real) 92.5% sterling silver jewelry from certain wholesalers for $3 a piece and drop-ship them on eBay for $40, though the shipping cost ate up most of the merchandise margin. The site has been around for fifteen years and is, needless to say, the biggest of its kind in the world, by a long shot.

Taobao.com: Taobao is Alibaba’s C2C platform or China’s eBay. The site was launched in 2003 and quickly became the third most visited website in China. Taobao provides an exchange for over 7 million vendors who reportedly have placed over a billion products on the site. Taobao’s core customer base is small vendors and the site does not charge them a commission on their transactions. The vast majority of Taobao’s revenue is derived from advertising fees that it charges certain vendors wishing to use premium services.

TMall.com: TMall is Alibaba’s newest B2C platform. Launched in 2008, TMall is a sales platform for established vendors and charges a commission fee for providing the “real estate”. Virtually all large domestic/foreign brands have a presence on TMall, which boasts 70,000 brands. Vendors choose TMall over Taobao because TMall membership exposes them to greater sales by placing their products ahead of Taobao sellers. I believe TMall is currently Alibaba’s most profitable business.

Alipay: Alipay is basically the PayPal of China. It charges a fee every time a transaction is processed through its service platform. Alibaba owns a large stake in Alipay. The rest of the company is owned by employees and the company’s founder.

Ecosystem

Over the years, Alibaba has created an enormous ecosystem unmatched in scale and has made use of very innovative incentive systems to improve the quality of its seller base.

Alibaba uses the usual eBay type ratings system to reward customer service. Higher ratings usually indicate more customer satisfaction, and more traffic is allocated toward better performers. My experience has been that any store with an overall rating lower than 4.6/5.0 will struggle to get customers.

The company also has a zero tolerance policy toward counterfeit products, and does a very effective job regulating vendors. Alibaba’s platforms all require vendors to deposit a large amount of cash upfront; customers can send complaints to the company when they receive counterfeit products and when verified, Alibaba charges the vendor a hefty penalty fee on its deposit.

On TMall, Alibaba charges store owners a fixed “technical service” fee every year and provides vendors with a pre-determined sales target. Vendors that manage to hit these targets can get 50% – 100% of the fee refunded back to their accounts.

Customer service from both Taobao and its vendors is excellent (Amazon-level excellent). Over the years, Taobao/TMall has built up significant infrastructure, which includes the largest call center in the world, to assist customers with their shopping experience. Vendors are usually required to provide refunds within seven days with no conditions attached.

Untapped Pricing Power

While the media/investment community has placed most of its focus on the company’s transaction volume (already in the hundreds of $billions, I think sooner or later will hit a $trillion), one aspect of the business that has never been discussed much is the company’s enormous untapped pricing power.

Taobao, for example, does not charge a sales commission and only makes money on advertising and premium services. eBay, which charges similar fees for these services, takes an additional 10% commission from sellers on the total value of their sales (I closed my store when I figured that I was really working for eBay rather than myself).

That’s a massive difference. Taobao reported $240 billion in transaction volume last year. If they just charge an extra 5% fee on that sales base, that’s an additional $12 billion, 100% margin revenue stream. That alone can justify even the highest estimate of Alibaba’s value!

And a fee scheme like that is very feasible. The average gross margin that vendors can make on Taobao sales is FAR higher than 5% (I believe in the 20% – 30% range). As long as they can realize an incremental gross profit higher than the fee, vendors are willing to stick with the platform.

TMall, which serves established vendors, charges sales commissions that range from 0.1% (mobile phone plans) to 7% (jewelry) of revenue, with most product categories in between 2% and 5% (here’s the fee schedule – http://rule.taobao.com/tdetail-11.htm?tag=self, you can google translate it and check it out yourself). TMall stores are usually operated by brand-name stores that enjoy higher mark-ups than Taobao vendors, both due to their brand value and also lower COGS (they buy inventory in bulk). The majority of these storeowners also operate physical locations that often charge them 20% + of their revenue on rent (not to mention other overhead associated with physical stores), and TMall provides real savings that currently far exceed what it charges.

I think Alibaba’s current business strategy is to use artificially low fees to attract new vendors onto its platforms, then gradually increase its “cut” as transaction volume matures. Jack Ma is a serial monopolist with a very long-term investment horizon and I doubt he will be content with leaving tens of $billions of free money on the table.

Structural Advantages of E-Commerce in China

E-commerce has structural advantages in China relative to more developed economies. I touched upon a few of those in my last article, but here is a more complete list:

Frictional cost: transportation via China Post (state-owned parcel monopoly) is ridiculously cheap. As I mentioned, shipping a pair of 5-lb boots costs US$1.70 from Guangzhou to Beijing, and will arrive on the same day. From San Diego to Seattle, using FedEx for the same service, that will cost you $86.24.

Overhead savings: rental costs are usually a much bigger % of retailers’ cost structure in China than developed countries. This is because 1) concentration of population (people live in apartments rather than houses) in neighborhoods drives up the value of good locations; 2) commercial real estate has to compete with residential real estate for land, which is in a bubble; 3) labor costs close to nothing which means the fixed cost has to go somewhere to make sure the average retailer makes no economic profit (ECO101).

There is little overhead selling merchandise over Alibaba’s platforms. As I mentioned, the commission rates are also very low and are a variable cost, which provides more business certainty to the seller.

Distribution channel: China’s logistics and distribution infrastructure has yet to consolidate. Distribution networks are very under-developed and retailing often involves layers of middlemen that eat into margins. Going online helps retailers circumvent much of this cost.

Capital Constraint: Small vendors (representing over 99.9% of all Chinese retailers) have no access to the banking system, which only lends money to state-owned enterprises or the politically connected. Removing the capital requirement in building out a physical location removes a huge burden.

Also, retailers often have to borrow money from shadow bankers at above-credit card level interest rates to finance their inventory. The possibility of drop-shipping and the data-driven nature of e-commerce sales reduce inventory needs.

E-commerce allows retailers to go capital light. That’s really helpful in a place where capital is scarce and expensive.

Internet Usage: Unlike developed economies where over 80% of the population uses the Internet, China’s internet penetration is below 50%. Out of a population of 1.35 billion, only 618 million had access to the internet in 2013. Increasing internet penetration, especially in broadband and mobile, will drive more traffic to e-commerce sites. Alibaba’s customer base has been expanding at a rate of roughly 60 million people per year in the last five years, the equivalent of the population of the U.K., every single year.

Smog: This gets ignored often but is really important. China is the most polluted country in the world and the air is killing people (http://www.cnbc.com/id/100871380). Reducing exposure to non-filtered air (that’s what you get when you step outside of your apartment) is on the top of people’s priority nowadays. Shopping online helps people do just that.

What’s Alibaba Really Worth

People have been talking a lot about Alibaba lately. Normally names like this don’t make their way to value blogs that easily because, well, IPOs are for patsies, especially hot IPOs, right?

This CNBC article (http://www.cnbc.com/id/101596620) suggests that the latest estimates are between $80 and $150 billion. This is up from just a few $ billion four years ago and $40 billion just a year ago and has raised a lot of bubble talk among investors.

I don’t believe Alibaba is a bubble. In fact, I think if Alibaba’s valuation falls anywhere between that range, it’s going to prove itself to be a wonderful exception to the IPOs-suck rule.

Here’s why:

Plain and simple, Alibaba is an unregulated toll road on Chinese consumption. It provides a platform that serves hundreds of millions of consumers as well as tens of thousands of independent retailers over the Internet and it’s growing crazy fast.

To give you a perspective on the sheer scale of Alibaba’s operation, USD$5.7 billion of transactions were recorded on the company’s e-commerce platforms on last year’s Singles Day (equivalent to Cyber Monday in the U.S.).

$5.7 billion, in just one day! By comparison, the entire U.S. population spent “just” $1.5 billion on Cyber Monday in the same year. Alibaba takes a % cut from sales over its e-commerce sites for “rent”, which translates into a very high quality royalty stream.

The total sales that transacted over Alibaba’s sites in 2013 was in the hundreds of $billions, and this is despite that only 15% of the Chinese population has access to broadband Internet. Alibaba’s market share in Chinese e-commerce is estimated to be in between 80% and 90%, and will be the biggest beneficiary of rising internet penetration and per-capita consumption in the most populous country in the world.

The company made almost $3 billion last year and if I have to take a guess, it will probably make $4 – $6 billion this year (top-line alone grew 66% in Q1). The company has one of the strongest and fastest growing business franchises in the world. At an $80 billion valuation, Alibaba will likely trade below a market multiple over this year’s earnings! Even at $150 billion, valuation seems very reasonable and I am tempted to pick up a few shares.

A Few Case Studies

For your interest, I dug up some old files on a few similar “toll road” companies to see how they did after their IPOs. I wrote these cases a few months back so note that the numbers are a little outdated but still in the right ballpark.

Google (NASDAQ: GOOG)

Google is basically a tollbooth on the Internet information highway. Google went IPO in 2004 at $85 and earned $1.46 a share that year, so the price tag (P/E = 58) looked pretty hefty back then. Anyone who was discouraged by the high P/E multiple would have made a very dear mistake not to buy: Fast forward to today, the stock trades for $1,215 a share, adjusted for splits!

Despite the monstrous 1,329% run, I still can’t think of anyone sane who argues that Google is overvalued today. So if you take today’s price as a proxy for fair value, and discount it back ten years at a 10% discount rate, the intrinsic value of Google at its IPO was $468 a share, or a whopping 320 times earnings!

Baidu.com (NASDAQ: BIDU)

Google did really well in the year after its IPO, and its track record provided a good environment for the debut of another hot Internet stock – Baidu. China’s Google went public at $2.70 a share (adjusted for splits) and went up 350% that day. However, even if you bought the stock on the close of the IPO date at $12 a share or 80 times the company’s 2004 earnings ($0.18), you still would have made a nice 1,517% return over the subsequent nine years.

Discounting today’s price ($182) at 10% back nine years, Baidu’s intrinsic value in 2005 was $77 a share, implying a “fair” P/E multiple of 514 x!

MasterCard (NYSE: MA)

The credit card companies are a regulated tollbooth on global commerce. MasterCard was “demutualized” by its member banks (don’t they regret that?) in 2006. Adjusted for splits, the stock debuted at $4.50 a share, which implied a multiple of 17 x relative to the $0.27 a share they earned in 2005. That certainly didn’t look dirt cheap, right?

The stock trades at $78 a share today, for a cumulative return of 1,733% over a period of eight years (and this is ignoring the small dividends MA paid over the last few years)! What’s more amazing is that $78 discounted at 10% a year back eight years would have yielded you an intrinsic value of $36 a share, or a fair P/E multiple of 135 x!

Visa (NYSE: V)

When Visa was demutualized in 2008, its IPO was at the time the largest in U.S. history. The deal was significantly oversubscribed, and part of the reason was that people saw MasterCard had done so well after its high multiple IPO, they were hoping for a repeat of the experience with MasterCard’s larger competitor. Unlike MasterCard, Visa was also shielded from anti-trust liabilities through terms established among its franchisee banks, the benefits of which look like peanuts today but was a big thing back then. Consequently investors participating in the IPO paid a much higher multiple for Visa than they did for MasterCard.

Visa’s IPO price was $44 a share, a multiple of 34 x over its pro-forma EPS in 2007. Was paying up for quality the right move? You bet. The stock currently trades for $225, which discounted back six years would be worth $127. What was the fair P/E multiple back then? 98 times.

The reasons I used the four examples highlighted above are:

1) Their core businesses today are still more or less the same as what they were when the companies went IPO, so no significant changes have taken place to materially alter the  initial investment theses;

2) All four companies have funded the vast majority of their growth with internally generated capital, not other people’s money;

3) Most of the value creation has come from business growth rather than capital allocation – the economic characteristics of the businesses mattered far more than the people;

4) Not many people argue that these stocks are overvalued today (in fact many smart value investors are still buying them) so it’s not unreasonable to use their current stock prices as proxies for their intrinsic business value.

The pattern was quite uniform among all four companies – their growth and business quality were so systematically underappreciated by the market that conventional valuation tools were simply rendered meaningless as the companies quick grew into and surpassed their valuations.

The Wonderful Virtual Toll Road

So what is it that made these “toll roads” such good investments when they went IPO at what seemed to be outrageous multiples? I believe they all shared the following traits:

Moat: They have extremely strong moats (network effect, or economies of scale reinforced through a positive feedback loop) that made them dominate their respective industries. Google and Baidu were basically national/multi-national monopolies, while Visa and MasterCard operated in a global oligopoly (also arguable if they were monopolistic themselves given that almost all vendors HAD to accept both cards). The barriers to entry were so great that substantially all of the value created by the growth in their industries accrued to the bottom line of these companies.

Growth Option: Their growth was assisted by significant secular tailwinds. These companies were virtually guaranteed to sustainably grow at a high rate and this was pretty much the consensus among market participants at the time they went IPO. The credit card brands grew on the back of a multi-decade long global transition toward a system of paperless money, while the search engines grew alongside the internet industry.

Scalability: They are technology/brand platforms that operate on the extreme high end of the scalability curve (we will talk about this in the next article I will post). Growth required little to no capital, and the incremental returns on capital for these companies kept on improving as they grew. Very few businesses operate with a structure that allows them to escape the natural diminishing returns phenomenon, but these companies did.

Margin Expansion: The “platform” nature of their business model meant that they operated with a mostly fixed cost structure. As revenue grew rapidly, margins also improved substantially as most of the new revenue fell onto the bottom line.

Does Alibaba fit into this framework? Let’s see:

Moat: Alibaba is certainly as monopolistic in the e-commerce business as Google ever was in search engines. It dominates over 80% of e-commerce volume in China and no competitor comes close. Alibaba’s moat is the network effect – buyers attract sellers and sellers attract buyers.

Growth Option: Say what you will about the Chinese real estate or credit bubble (yes, both problems will bite them in the ass eventually), consumption per capita in China is only going to go up, not down. In all likelihood, it’s going to go up at a very high rate for decades to come.

In addition, E-commerce will continue to take market share from brick & mortar retailers as it offers significant cost advantages (5% fee for selling on Alibaba’s T-Mall vs. 20% + rent on revenue for b&m).

Furthermore, transportation costs are extremely cheap in China. Shipping a pair of high-heels from Guangzhou to Beijing (equivalent to distance between San Diego and Seattle) via two-day express costs only RMB 10 (USD $1.70). Even your beloved Fred Smith can’t offer that kind of service.

Scalability: The e-commerce technology platform has literally infinite capacity when it comes to handling orders. If an e-commerce site is not scalable, I don’t know what is.

Margin Expansion: Similar to the above, most of Alibaba’s costs are fixed. Just for fun, let’s see if their margins went up at all in the last few years:

Yep, they did.

Check check check check. The icing on the cake is that Alibaba also (partially) owns a wonderful online payment franchise called Alipay, which dominates that business in China (you are right to think of it as the PayPal of China, except it’s bigger than PayPal! http://www.bobsguide.com/guide/news/2014/Feb/12/alipay-surpasses-paypal-as-leading-mobile-payments-platform.html)

Valuation

Okay, suppose Alibaba IPOs with a 30 x multiple, how is that cheap? Well, another way to ask the same question is: what can justify Alibaba deserving a multiple higher than 30 x?

Just for fun, I reverse engineered a present value calculation that indicates the average bottom-line growth that needs to be achieved over the next ten years for a company to deserve a 30 x multiple (assuming a 10% discount rate, 5% terminal growth, and value-neutral capital allocation):

The number is 10.4%. That’s the annualized bottom-line growth Alibaba needs to achieve over the next ten years for the stock to grow into its valuation. Hell, Alibaba grew 66% top-line in the last quarter alone! Can they grow 10.4% a year for the next ten years? You be the judge.

So what’s Alibaba worth? I have no idea and would be very skeptical to see anyone else reach an estimate with a high degree of accuracy. All I know is that it’s going to grow like mad for a very long time and it’s worth a lot more than $150 billion.

How to Play Alibaba

The most direct way to gain exposure to the company is to buy into its IPO. The problem with that is you have no idea what they will price the IPO at, and if you only have access to the secondary market (like me), you don’t know how much a premium you have to fork over on the first day of trading. If the company is valued at the low end of the indicated range, $80 billion, buying the stock is a slam dunk. If the company is valued at the recent “whisper” number, $250 billion, then you’d have to put a lot more faith in the growth prospect/management to get a satisfactory result out of an investment.

There are two alternative ways to participate, however:

Yahoo: Yahoo still owns a quarter of Alibaba. Yahoo has a market cap of $36.7 billion. I haven’t crunched the numbers, but back-of-envelop, you take out a few $billion for Yahoo US and Yahoo Japan, 25% of Alibaba is probably valued in between $25 to $30 billion.

That’s not bad except that stake is untaxed. Yahoo has a very low tax basis for that stake and the “hidden” deferred tax liability is quite significant.

An equally important issue is based on what I’ve read about Marissa Mayer (paying $58 million to hire a COO just to fire him a year later; paying Dan Loeb to get out of the stock, and this: http://www.vanityfair.com/business/2014/01/marissa-mayer-yahoo-google), I have no faith in the management’s ability to act as an intelligent steward of Yahoo’s valuable stake in Alibaba. Maybe they will sell it to buy something else to chase growth, who knows?

Softbank: Softbank owns about 37% of Alibaba and has a market cap of $90 billion. I haven’t looked into their domestic business/Sprint that much to figure out the implied value of their stake in Alibaba, but the company seems a lot more interesting than Yahoo.

The CEO is a real entrepreneur who started with nothing and is now the richest man in Japan (well, he was set back by $85 billion speculating in the dot-com bubble, but he certainly changed his ways afterwards). I also think his wireless strategy in the U.S. makes a lot of business sense.

Conclusion

If I have to take a guess which company will become the most valuable business franchise in the world in ten years, Alibaba is my top contender. However, investing in a Chinese internet company involves risks.

The biggest risk to Alibaba the stock is that Jack Ma isn’t that keen on keeping minority shareholders happy. Reportedly he separated Alipay from Alibaba in 2011 without consent from the company’s largest shareholders on the grounds that new regulations on third-party payment systems necessitated the change (which was actually true but he still should have asked first). The good thing was that the issue was eventually resolved between Ma, Yahoo and Softbank, but it still left a bad taste in a lot of people’s mouths.

I think once Alibaba goes public, the risk that Ma may screw minority shareholders will likely decrease given the increased public and legal scrutiny. However, should Softbank or Yahoo decide to exit parts/all of their shareholdings after the IPO, the concentration of shareholder power will also get diluted, potentially making it easier for minority shareholders to get screwed.

The VIE structure that Alibaba will employ should also be monitored to ensure that minority shareholders are protected from employees stealing parts of the business.

Disclosure

I am looking into Softbank and may very well buy a few shares if I like it enough.

 

 

George Soros REIT Report

Some people asked me where they can locate the George Soros REIT report that I mentioned in the last post.

You can find it in “The Alchemy of Finance”. The report is replicated on page 61 to page 63; the author’s follow-up analysis (page 64 – 68) is also very instructive.

Random Thoughts on Moats and Competition

http://mattturck.com/2014/03/19/can-the-bloomberg-terminal-be-toppled/

The link above is an excellent analysis of Bloomberg’s moats that I found on a tech start-up blog, which highlights an interesting point:

The best way for an investor to examine a company’s economic moat and competitive positions is to take the point of view of a potential entrant into the industry, and figure out how much it would cost to replicate/disrupt the incumbent’s business model. 

I’m sure there are many sharp minds out there who already employ such a framework in business analysis. What really differentiates the quality of the analysis though, in my opinion, is the approach people take in understanding the relationship between cost of replication and economic moats.

First – Level Thinking

I teach a little value investing night class and read a lot of analysis every year from the students. One thing people often do is they look at a business and make an educated guess about the cost of replicating its business model. When that cost is very high, they conclude that the business has a high barrier to entry, which entails the existence of some forms of a “moat”.

But that’s not a complete analysis – most capital intensive businesses have a high nominal cost when competitors seek to replicate their resources, yet very few of them have moats. At the end of the day, the size of the cost of entrance should not be a prohibitive factor as long as the said entrant has ready access to capital markets (which is especially ample for large public companies merely making a push into a different vertical).

For example, a skyscraper office tower can cost hundreds of millions of dollars, if not billions to build – a significant sum, yet 80-story office buildings get built all the time, often right next to four or five other 80-story office buildings! The nominal cost of entry in this case is obviously not a significant enough deterrent.

Second- Level Thinking: An Improved Framework

This is because it’s not the nominal sum of cost of entry that creates moats. What really matters is the return on capital that an entrant can generate and the “cost of capital” associated with entrance. While giant office towers cost a ton of money to build, office tower operators do not have much of a moat – new entrants trade a low cost of capital (interest rate on development debt) for a reasonable return on capital (margin on sale, or net rentals yield should he choose to rent it out). As long as they can obtain proper financing, the economics of the business does not discourage them from entering into the business.

A real moat exists when the 1) cost of capital (for a well-financed and rational new entrant) is greater than the 2) long-term steady-state return on capital after entrance. This in turn forms a barrier to entry that discourages new players from emerging and allows the incumbent to earn above-average economic returns. Potential entrants are kept at bay not because they are discouraged by the initial capital requirement, but because they figure that there are better ways to make money. A complete analysis of moats, therefore, would require the analyst to make an educated guess about each of the two variables.

A Case Study: Part of the rationale behind Berkshire’s purchase of Coca Cola in 1987 was that Buffett estimated it would cost over $100 billion for a new entrant in the soft drink business to replicate Coke’s brand and distribution scale. Coke made a little over $900 million in 1987 and could reasonably make $1 billion the next year. That means if I were to start a viable competing brand, I would have to spend $100 billion and many years of energy to get $1 billion of annual earnings (in reality it would be much lower than $1 billion since returns for all industry players would shrink once a new entrant turned a duopoly into an oligopoly). That’s a sub-1% return on capital. Even if you factor in the long-term growth in earnings, the steady-state return would be nothing spectacular.

On the other side of the equation, natural risk aversion, exacerbated by the sheer size of the capital requirement (risks in gathering $100 billion of financing) and the potential execution risks of frontally challenging a well-entranced incumbent, means the “cost of capital” to a rational investor would be extremely high. How much return would investors/lenders demand if you asked them for $100 billion to start a new global cola brand in 1987? There’s no way to know that precisely but it would be a very ugly number, certainly ugly enough to discourage someone from chasing a sub-1% return.

Additional Complications

In many cases, even the framework above carries significant limitations. This is because one aspect of competitive analysis that is frequently under-appreciated is the role played by irrational financiers.

Suppose you own a cable system in Los Angeles that makes 14% on capital a year. You have a decent business on the video side that only competes with two satellite companies and a very good business on the broadband internet side where there’s not much competition. You have a nice little semi-regulated natural monopoly whose moat derives from the fact that your infrastructure efficiently serves a market that is limited in size – there’s simply not enough room to provide adequate returns to two local players. Plus, if a telco operator wanted to invade your territory with a fiber rollout, they would also be sub-scale in content acquisition, face franchising issues with municipal governments, and cannibalize their existing DSL service.

Well, it all sounds good but even with the odds heavily stacked against them, Verizon decides to overbuild in your city anyway, with no compelling economic justification. It’s unlikely that the return on the fiber overbuild can justify the cost, but they can afford it, and the “growth” their shareholders would like to see has to come from somewhere. The net effect is that despite the presence of a strong moat, the uneconomic entry permanently impairs the value of your cable system, and there’s nothing you can do except to share your misfortune with your competitor’s shareholders.

The irrational growth in the example above is financed internally, likely a result of some forms of institutional imperatives – escalation of commitment, empire building, you name it, but it’s not the only way moats can be threatened by irrationality. The existence of a dynamic, but perpetually inefficient capital market means there will always be some irrational behaviors backed by equally irrational financing, and the adverse economic effects on incumbents can be especially enduring when the scale of irrational competition snowballs over a positive feedback loop, or as George Soros calls it, “reflexivity” (his 1970 essay on investing in REITs illustrates this effect well and is a must-read).

This is because even if the entrant’s business plan is uneconomic, as long as it is perceived favorably, investors will finance the venture at a low cost of capital (happens more often in the equities market). The entrant takes the cash and reinvests in profitless growth, which reinforces investor recognition in its growth prospects. The achievement of growth causes capital markets to continue to reward the venture with ever-higher multiples over whatever irrelevant financial metric (just not free cash flow) they can stretch to justify, further lowering the cost of capital, and allowing the firm to finance more “growth”. The end product of a flawed investor perception is a self-fulfilling cycle that allows many uneconomic entrants to stay in business at a significant scale for prolonged periods, wreaking havoc to the incumbents and causing permanent damage to their value. There are quite a few good examples of such a phenomenon today in companies that operate under a hot idea but never seem to make money.

I think there are four major reasons for the existence of long-term investor misperception:

1. Accounting shenanigans that make the economics of the entrant appear artificially appealing, such as under-depreciating assets, or paying salaries in options/using non-GAAP standards to show a much higher EPS.

2. Concepts that appeal to hope/imagination/emotions. Air travel used to be such a hot idea (investing in it turned out to be not so hot). Incumbents in such industries often do not have any moats to speak of in the first place, which means excess capacity financed through investor misperception often leads to across-the-board value destruction on a massive scale. Other examples include renewable energy, gold mining, etc.

3. Investors extrapolating abnormal returns during cyclical upturns into perpetuity.

4. Most important of all, the presence of a promotional management that is very capable of consistently selling its idea to the investing public.

The reason I mention this is that it adds a new dimension to competitive analysis – an investor must not only understand the rational economic behavior that drives investment return outcomes, but also the effects of market sentiment on the fundamentals of real businesses.

In my opinion, the safest way to invest in quality (moat) and make sure the value of the moat does not get diluted by irrational competitive behavior is to invest in companies with moats so strong that no irrational entrant can sustain competition, even backed with significant financing.

The network effect often constitutes such qualities. Companies that benefit from the network effect are usually “cooperatives” that provide some forms of a service platform. They tend to be monopolies (since there is no reason for anyone to use a smaller network that brings less value to the party) and operate with a very large fixed cost structure. Successful entrants must overcome years of huge losses while attempting to present to their customers a difficult value proposition that a smaller network can be superior to a larger one – a virtually impossible task given the nature of the effect itself. Consequently, new entrants are killed off very quickly and cannot generate the momentum necessary to form a positive feedback loop in capital markets.

Conclusion

Not sure how I wandered off from Bloomberg to promotional managements, but modern competition has multi-dimensional dynamics and is pretty confusing to think about.

“Standardized” Faulty Thinking & Bad Assumptions

Death of Equities

Bill Gross is an interesting fellow who has been on the news a lot lately, which reminds me of a very influential article that Mr. Gross wrote about one and half years ago called “We’re Witnessing the Death of Equities” (http://www.pimco.com/EN/Insights/Pages/Cult-Figures.aspx). It’s a very interesting article, because in there Mr. Gross provides some very discomforting statistics and arguments. Here’s a basic summary of it:

1) The stock market has generated a 6.6% annual return in the past 100 years, while real GDP growth during the same period has only averaged 3.5%.

2) Therefore, the value of stocks has grown at a rate disproportional to overall wealth creation in the economy, and equity holders have enjoyed a long period of abnormally high returns at the expense of other stakeholders of the economy (ex. bond holders, government, laborers)

3) Based on this argument, Gross believes that the historical out-performance of stocks has been “is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned.”

4) Anyone who utilizes the “buy and hold” approach to investing and expects similar returns going forward is basically delusional, lazy and unsustainably benefiting at the expense of other members of society.

5) Many savings institutions build this historical return figure into their  future projections; if the expected returns do not materialize, however, a serious mismatch between assets and liabilities will arise.

6) And we are basically screwed, unless the government produces a lot of inflation to get us out of this problem. Expect lots of inflation in the future.

One Bad Assumption 

When the article was published, it attracted a ton of attention and was re-posted by many mainstream media outlets. Many high profile market “strategists” also went on national TV to voice support. This shouldn’t be very surprising – Bill Gross is a very authoritative figure on macroeconomic issues and a very articulate man. His arguments were quite convincing, and if the outcome proved to be anywhere close to what he predicted, it spelled huge trouble for anybody who was heavily involved in the ownership of U.S. equities. The S&P  has risen 36.5% since the article was written (or 40% if you add back dividends), so “the death of equities” clearly hasn’t been the case so far. But who knows? It’s only been a year and half, and if Bill Gross was really right, we are only 40% more screwed now than we were a year and half ago, right?

I always thought this was a quite instructive case on the role of faulty assumptions and how they can sustainably lead to even faultier conclusions. But some faulty assumptions, for one reason or another, tend to “stick”, and even the foremost experts can fall prey to them if they’ve never been challenged. The reason I say this is that Mr. Gross’s argument, while appearing convincing, is actually very easy to discredit. All you need is Chapter 1 of Intro to Statistics.

The pitfall of Gross’s article lies in this paragraph: “…6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?” 

What’s wrong with this argument is that it assumes stock market returns and GDP growth are comparable figures. They actually aren’t at all. This is because in formulating his argument, Mr. Gross failed to take into account a critical distinction: the value of the stock market is a stock variable (something that accumulates over time, like a balance sheet), while GDP is a flow variable (something that is generated within a specific period of time, like an income statement).

Comparing growth in a stock variable and growth in a flow variable is meaningless, because the two variables are not meant to be proportional to each other in the first place. The correct statistic to compare GDP growth with would be earnings growth. Earnings are a component of GDP; both are flow variables and represent what is produced by a specific economic agent within a specific period of time. Most sources I have read so far suggest that nominal earnings growth in the last 100 years has been roughly 5% – 6% a year; taking out 3% inflation, real earnings growth has been 2% – 3%, which is a lot more consistent with the 3.5% real GDP growth that Mr. Gross cited. This is important because if earnings have grown at a similar rate to GDP, then equity holders have basically received a “fair share” in the continued prosperity of the American economy, and all of Mr. Gross’s subsequent arguments in the article would be invalid.

Another way to think of this is that rationally, stock market returns shouldn’t really have much to do with GDP growth at all. If stocks are fairly valued (suggesting that their prices already reflect the expectation of lower GDP growth in the future), the logically expected return one can generate is simply the discount rate applied against the future expected cash flows of companies in calculating the value of stocks. If that discount rate is 10%, then long-run stock market returns will average 10%, regardless of whether GDP is growing at 8% or 0%.

Why didn’t Mr. Gross take this simple idea into consideration? I think it has to do with how the metric GDP has been consistently abused in the field of economics in general. This is because economists frequently use the term GDP to describe the total size of an economy. That is a very misleading practice because GDP is a flow variable that only represents the value of all of the “new stuff” that’s produced within a given year. To say that GDP measures all of the activities of an economy would be to suggest that anything that wasn’t produced that year that participated in economic activities simply did not constitute part of the economy. It’s analogous to using revenue to measure the total size of a corporation, but as we know the more relevant measurement would be the corporation’s enterprise value. You often hear people say that billionaire X is richer than country Y because X has a greater net worth than Y’s GDP. That statement suffers from a similar problem.

The sentence “If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year.” also suggests that Mr. Gross confused GDP (a flow variable) with wealth (a stock variable).  GDP is not the size of an economy, but the total gross growth in the economy in XXXX year (before depreciation). GDP growth, therefore, is “the growth in the gross growth relative to the previous year”, not “growth in total wealth”.

Mr. Gross does not say that GDP growth is the growth in the gross growth of an economy, because that sentence is very confusing to say. It’s easier to say that GDP growth is the growth in wealth, but it’s also wrong. Whew, news of the death of equities has been greatly exaggerated.

China Musings

So I was in China for a few weeks for the holidays and this is an unorganized collection of my observations there and a few Chinese stock ideas. I grew up in China and view things there with a slightly different perspective from the traditional Western visitor so hopefully you will find this interesting. Also, I wrote this article two weeks ago but because WordPress is blocked in China, I have had to wait until I came back to Canada to get it posted so keep that in mind. Some things in here like stock prices and verb tense are consequently outdated.

General Observations

1. The average standard of living has markedly improved in the last five years. The best evidence for this is the dramatic reduction in bicycle use across major cities. Shanghai is so crowded with cars that the municipal government is charging new drivers RMB 73,500 (US$12,000) a pop for new license plates, the price equivalent of a small sedan.

2. Real estate in large cities is still booming. Prices are up something like 10 – 20% in Beijing and Shanghai in 2013. You wouldn’t believe the number of times I’ve been told that real estate prices in China can never fall.

The so-called “investment properties” in China are mostly left unoccupied after they are purchased because most people feel that the rent isn’t high enough to justify the hassles of having a tenant (imagine that!). The last time I checked, the value of an “investment” was defined as the future cash flows discounted back to present. Maybe the laws of economics don’t work in China, or perhaps “investment properties” is just another fancy label to mask uneconomic, speculative behavior in a seemingly invincible market.

I also find that financial illiteracy is quite widespread among high net-worth individuals, who often have extremely unrealistic returns expectations for their investments. Why bother learning about investing theory and capital markets when you can make an easy 30% buying “investment properties” in Beijing, an easy 35% buying art pieces, or when you really run out of options, park your money in “risk-free” 5-year municipal bonds at 11%?

And then there are stories like this http://www.theage.com.au/business/china/why-i-became-a-shadow-banker-in-china-20130709-2pnvi.html which just makes your brain bleed. Why shouldn’t I lend money to florists, restaurateurs, fish farmers, vegetable growers, roadside hawkers when I can make 24% a year doing it? The author asks. He would be well-advised to ponder over a better question: “Why should I make 24% a year doing the same thing that everyone else is doing?”, or “Why should my customers borrow at 24%? Can a florist, a restaurateur or a fish farm earn a higher return to justify a 24% cost of capital?” I think people have a good reason to be concerned whenever too much money is being made too easily, and China concerns me.

3. Weathermen use the word “smog” as if it were an actual weather condition in China. The air in Beijing smelled like jet fuel, even after I left the airport.

4. Inflation has been very high in consumables. In my experience food prices have tripled from what they were five years ago. Price levels of big-ticket items have, however, mostly stayed flat. This is a good thing because the affordability of durables is a main driver of improvements in the standard of living.

5. There is currently a very serious shortage of skilled labor in manufacturing. I spoke with a few business people there and was told that 1) university degrees are too easy to obtain and new graduates only want office jobs, even if they pay less than manufacturing jobs; 2) turnover is very high so the high costs associated with training unskilled labor frequently can’t be justified. A government push to increase the minimum wage by 13% per year is also not helping.

6. The local government built this giant seven-story mall (building on the left) a year and half a ago and it’s right next to where I’m staying (Tianjin, the 4^th largest City in China with a GDP per capita on par with Beijing and Shanghai). Prada is a big tenant in there and I’ve visited that store about fifteen times, including on Saturday nights and the evening of January 1^st.

Other than myself, not a single time have I seen a customer in that Prada store (no one was even in there to inquire about the products).That was a little strange.

Shinzo Abe’s Yasukuni Shrine Visit

This is the dominant headline subject in China right now. Every time I turn on the TV there’s always a news anchor or “political analyst” blasting at this guy that I almost feel bad for him.

Just about the most unpopular man in the world at the moment, Shinzo Abe has been compared to a war criminal, a fascist, a Nazi sympathizer, a terrorist and a psychopath, among many other nasty things on the Chinese media. When Abe requested to meet with the Chinese and Korean leaders to reconcile, the official Chinese response was “the Chinese people do not welcome him”.[1]

An Internet poll on Weibo (think Twitter in China) shows that three quarters of the respondents would support a boycott of Japanese products in response to Abe’s political gesture. I bet Akio Toyoda will have second thoughts about getting this guy re-elected a few years down the road.

My father’s Honda lost a front wheel to sabotage the other day. Hm, why wasn’t I surprised?

CNR Mall

CNR Mall (CNRS) is the Chinese home shopping JV that I mentioned in the LINTA article. I’ve watched almost 30 hours of this stuff and talked to a few people who buy things from them regularly. Here are my observations:

1. There are five sizable competitors in the space. I watched all of their programs and found CNRS to be the most QVC-like. The biggest of them all I believe is a channel run by the state TV monopoly CCTV so I was wrong about CNRS being the only brand with a state-media affiliation –  there are two of them (CNRS is owned by QVC and the state radio monopoly). The other home shopping channels are operated by provincial network companies but are usually available in multiple provinces.

Home shopping in China accounts for a much smaller % of total retail sales than in the U.S. and the industry is growing at solid double digit rates. Another factor that makes China an interesting market which nobody has mentioned is the fact that women in China retire at the age of 50. They receive reasonably generous pension payments from the state and there is nothing that says they can’t just stay home and watch this stuff all day long.

Already a multi-billion dollar industry, I would not be surprised if the Chinese home shopping industry exceeds the size of the US market in ten years.

2. At least where I was, the local cable system gave CNRS the best channel placement, even better than the CCTV network.

3. Shipping for any order above RMB180 ($30) is free and the service is very good. My mother regularly buys things from them and they usually arrive in two days.

4. The home shopping channels provide real savings to consumers. My observation has been that the channels generally price 15 – 30% cheaper than Taobao (Alibaba’s retail site) for identical products.

Even foreign vendors wishing to make a marketing push in China are attracted to the home shopping model. I had a conversation with a family friend who runs the Chinese subsidiary of a reputable travelbag brand. He told me that companies willingly offer large discounts to the home shopping networks because the free marketing provided is extremely valuable (perhaps more so in China than in other markets – keep in mind that these networks can reach something like a billion people which is more than the rest of QVC’s markets combined).

5. There doesn’t seem to be much differentiation between the five networks and I was very disappointed about that. CNRS is more upscale and sells slightly more expensive things, but most of their products are the same Chinese brands that everybody else is selling. I think the strategy that QVC communicated about bringing CNRS more US brands is key for them to take market share from their competitors.

On a side note, the vast majority of high quality content in China is still produced by the state monopoly CCTV (through 31 public broadcast channels and 12 pay TV networks) so cord-cutting is not a very significant threat in that market.

Chinese Stocks

Since this is a stock blog, it would be boring to make a China post without some comments on Chinese stocks. In the West, the Chinese stock exchanges are often portrayed as casinos where insiders and promoters rip off retail investors. That’s quite close to the consensus within China, where a lot of people have lost their savings speculating in the 2007 stock market bubble and have developed a bit of a Depression mentality with respect to investing in equities (The Shanghai Index wiped out almost three quarters of its value during the collapse in 2008; miraculously China’s economy grew 10% real that year).

But things can’t be that bad; after all, something has to be legitimate for an $8 trillion economy to function. Chinese stocks have done basically nothing in the last five years and are on average trading at 40% above book value. Reportedly, Howard Marks is finding bargains on the Chinese exchanges so it will be interesting to see how things will develop from this point.

Anyway, I am more interested in the Chinese stocks listed here. While there is no doubt that many of the Chinese companies listed on North American exchanges are frauds, many are also legitimate businesses. With many of these companies selling for single digit multiples of reported earnings, finding an honest one to invest in can be enormously rewarding.

My opinion on analyzing Chinese companies is that they should be assumed guilty until proven innocent. Using a checklist might help and a reasonably conservative checklist could include the following:

1. Not a reverse merger; went IPO with a legitimate underwriter. Some IPOs may be fraudulent too, but most aren’t.

2. Presence and condition of operating assets can be easily examined and verified. Internet companies tend to fit this bill quite well.

3. Management demonstrates a high willingness to avoid conflicts of interest (12 pages of SEC filings on related party transactions is always a bad sign).

4. Management demonstrates that it is not motivated to benefit at the expense of investors. There are only so many ways fraudsters can make money off of capital markets. They can raise cash and embezzle it. They can inflate the stock price and sell their personal stakes to the public. They can shift assets back and forth between the public company and their personal investment vehicles. Or they can just pay themselves an awful lot more money than they deserve. An absence of financing & related party activities, aggressive insider buying, management lock-in agreements, and a low salary are generally good signs that one should look for.

5. Uses a reputable auditor – while one may argue that even the Big Four have been repeat offenders in Chinese reverse merger cases, “boutique” auditors fare far worse. In fact, many of such entities were deliberately set up to service reverse merger frauds in China, while the Big Four at least have some incentive to defend their reputation.

Also, suppose you are the CFO of a legitimate Chinese company trying to get your company listed on the NASDAQ. If you have done any research at all, you should know as well as anyone that simply by virtue of your company being Chinese it will highly likely be suspected as a fraud in the United States. So if your goal is to instill investor confidence in the veracity of your public reporting, would you in your right mind hire “Albert Wong & Co” instead of KPMG just to save $300k a year in audit fees? Getting a Big Four brand name on your audit statement is the LEAST you can do to reinforce your legitimacy. To my knowledge, in the world of Chinese audit firms, the best track record belongs to PWC Zhong Tian, which has had relatively few frauds as clients and has been fired multiple times for refusing to sign off on auditing statements.

6. Has a history of returning capital to shareholders. This is a necessary requirement because you never know if the cash is “there” unless a lot of it has been internally generated and paid out to shareholders in the past.

7. A catalyst on the horizon to unlock more value, usually in the form of a spin-off, a special dividend, or a large repurchase program. This is very important because many of these “cheap” Chinese companies end up staying “cheap” for longer than you want them to be. Requiring a catalyst is the best way to avoid that problem.

8. Obviously, accounting irregularities are an automatic no.

While this is a rigorous process and would eliminate many good investment opportunities, there are always over-achievers that pass the whole smell test. I usually combine this checklist with a screen for companies trading below 2.5 times net cash, and have found reasonable success with it.

SOHU.COM (NASDAQ: SOHU)

Date: 01/02/2014 / Ticker: SOHU / Price: $73.28 / Market Cap: $2,798 million / Idea Type: I don’t know

One opportunity that checked off on all of the above items was Sohu.com (NASDAQ: SOHU). I found that thing in late 2012. Back then it was such a steal that I seriously considered giving the chairman a phone pitch on the merit of a potential going-private transaction (just couldn’t find his phone number).

The math worked like this: the stock was $38. SOHU had $15 a share in corporate level cash, no debt and a 68% stake in a NASDAQ-listed subsidiary (NASDAQ: CYOU) valued at $23 a share in the market. The rest of the business consisted of the second largest internet portal business, the third largest search engine, the second largest online video business in China and a whole bunch of other things (such as half a $ billion worth of headquarter buildings) – fast growing, extremely valuable assets that you could buy essentially for nothing.

The company was founded in 1996 and was a pioneer in the Chinese internet space. In 2000, it became the second Chinese internet company to go IPO on the NASDAQ. SOHU is a household name and was at one point was the biggest Internet company in China.

The chairman (20% owner) was MIT-educated with a Ph.D in experimental physics and founded the company with seed money from a Sloan professor who remains a director and a significant shareholder today. PWC Zhong Tian has been the auditor and the company has had a flawless compliance track record as a public company for over a decade. The corporate governance is so good that SOHU received what I believe to be the highest recognition that any Chinese public company could possibly receive in North America – it was recommended by Citron as a long.

Management shows no motivation to screw shareholders. After SOHU’s IPO in 2000, they basically never raised money again and funded all of their growth with internally generated cash. They spun out their game subsidiary in 2009 and paid a big special dividend. They have also been buying back their own stock. The company has minimal IR efforts and the chairman despises Wall Street’s focus on quarterly earnings.

What would ultimately make the thesis work so well was the fact that management already had plans to unlock value from the “hidden” assets. They communicated at the conference calls that they would spin off the video business from SOHU and a web game segment from CYOU in a few years. In September they also sold a stake in their search engine business to Tencent, which valued that business alone at close to $1.2 billion ($32 a share). All of that was readily available information but just a little over a year ago the stock traded as if all of the operating assets of the business were completely worthless.

In half a year SOHU more than doubled and it turned out to be one of the highest IRR investments I have ever made. I sold my shares and it has slipped to the 70s. However, considering the significant growth in the business in 2013, I think a reasonable sum-of-parts analysis today could still easily get you more than $100 a share.

I find the stock somewhat attractive today and will re-open a position if it dips back to the 60s.

Nam Tai Electronics (NYSE: NTE)

Date: 12/27/2013 / Ticker: NTE / Price: $6.99 / Market Cap: $315 million / Idea Type: Special Situation

For almost forty years, Nam Tai has been an outsourcing partner to consumer electronics companies manufacturing components for electronic devices (mainly liquid crystal display modules or LCMs, the kind that is used on smartphones and tablets). This is a hyper-competitive industry characterized by single-digit gross margins, low returns on capital and little bargaining power over customers but NTE has managed to squeeze a decent amount of cash out of it.

In a strange turn of events, just as it was having a record year in revenue and profits, the company announced in April plans to shutter its core business and redevelop its main facilities in Shenzhen into a high-end commercial district. Its other facility in Wuxi, which had been idled by Q2 2013, would also be sold. To borrow NTE’s own words, the company is now “an electronics manufacturing and design services provider in the midst of transforming [themselves] to a real estate development company”[2]. The company also cut next year’s dividends from 60 cents to 8 cents. Unsurprisingly, the stock fell by half on the news.

The decision was made because NTE’s main customer decided to switch to a lower cost contractor for components and management felt that NTE would be unable to make money should it match the competing rate. NTE’s Shenzhen facility, however, is currently sitting on very valuable land that the company acquired for close to nothing in the early 1990s. The land is situated at a really nice spot, just six miles south of the Shenzhen Bao’an International Airport and ten miles north of the Qianhai Bay Special Economic Zone. The Shenzhen government is currently converting this whole area from an industrial zone into a commercial district and actively encouraging redevelopment projects such as NTE’s with extensive tax and financial incentives.

I know nothing about the business of sub-assembling iPhone screens but now that the stock has been conveniently reshaped into an asset story, things have just become a lot more interesting.

Valuation

The company had $238 million in cash and no debt as of Q3 2013. Excluding cash, net working capital was basically zero and I expect this to still be the case once the core business winds down. NTE’s contract was extended to Q4 2013 so it should generate cash for another quarter. To make things simple let’s call the cash pile $250 million, or $5.5 per share. The stock is trading at $7 so that means the rest of the business ex-cash is valued at only $1.5 a share.

NTE has put its Wuxi facilities and land on sale. The carrying value of that asset as of Q3 was $44.6 million or roughly $1 per share. The company also has 1.27 million sq ft of land in Guangming, which is a new high-tech industrial park in Shenzhen. Realistically I think the company can easily get $1.5 a share out of those two properties but to be conservative let’s say both of these assets are worth nothing.

The most important asset is the company’s land in Shenzhen which it acquired in the early 1990s and is being redeveloped into a commercial property. The land is 566,100 sq ft or roughly 52,600 m². If you read Chinese, you can find a list of precedent transactions on the local government website here: http://www.sz68.com/land/?s=1. I made it easy for you and organized all of the recent relevant transactions on a table:

Commercial land in the nearby Qianhai Special Economic Zone sold for between $17.5k and $63.7k per m² in 2013. NTE’s land is not in the special economic zone so it’s not worth as much, but it’s nearby enough (less than 10 min drive) that it wouldn’t be worth that much less.

To get a sense of perspective, let’s assume that NTE’s land is worth only $3.5k per m², or just 20% of the lowest price paid on the transaction list. NTE’s 52,600 m² is thus worth $184 million, or over $4 a share. If the land is worth $8k per m² then the whole lot becomes $420 million, or over $9 a share.

With these assumptions (without getting into taxes), if management simply sold the land and liquidated the whole business, you are looking at something like $10 to $15 a share in liquidation value.

But that’s not what management has decided to do. Selling the land may involve tax and regulatory issues and the company’s plan going forward is to basically liquidate most of its “non-core” properties and use the cash to develop a high-end commercial property on its Bao’an land, housing over 3 million sq ft of office space, malls and hotel rooms. Now that makes things tricky because real estate development exposes the shareholders to a host of risks (and also benefits) that a land owner is not exposed to. The company has hired three reputable consulting firms to conduct feasibility studies on the project and you can find their presentations here: http://www.namtai.com/investors#investors/news

The independent feasibility studies all show nice double digit projected IRR but I wouldn’t put that much faith in their DCF models. The chairman said on the last conference call that the company will likely first develop one building on a quarter of the land with a floor plan of 700,000 sq ft (65,000 m²). Management’s projection is that the first building will cost approximately $2,500 per m² so the total cost will be $160 million, with expected rental income of $40 million per year. On a 50% cash flow margin and 7% cap rate, that’s worth $285 million or $6.3 a share. That’s just a quarter of the project! You are still left with $90 million and three quarters of the land to play with. Putting a number on the future value of the whole project is impossible, since the whole thing is still in planning stage, but I think this illustrates pretty well that the property will be worth more than $7 (a LOT more if you think the project is worth more than the cash and the land value combined) once its fully developed.

Is It a Fraud?

I believe it is extremely unlikely that NTE is a fraud.

NTE was founded in 1975, went IPO on the NASDAQ in 1988, and transferred to the NYSE in 2003. It was not a reverse merger and has had a long history of SEC compliance. By “long”, I mean longer than any other Mainland company on a US exchange!

The company also has a long history of paying dividends, having paid out a total of $9 in the last fifteen years:

That’s a lot of dividends, especially considering that the stock is only trading for $7 a share today!

How do you know if the assets are real? Well, you can find their X million sq. ft of facilities right on Google Earth. In fact this company has had such a long-term influence on the local economy that the government literally named the two streets right next to them after the company. You can’t lie about that!

(Nantai Road = Nam Tai Road – just translation difference)

On a side note, NTE discloses the names of its two largest suppliers, which accounted for 95% of its revenue in 2012 so you can always call up Japan Display (formerly Toshiba Mobile Display and Sony Mobile Display) and Sharp for an enquiry.

The auditor is Moore Stephens, not a Big Four but nonetheless a multi-billion dollar global audit firm.

In terms of management, NTE is controlled by its chairman and CFO, Ming Kown Koo. Peter Kellogg, an American billionaire, has been a long-term director of the company and owns 27.3% of the company. Mr. Koo owns 11.7%.

Mr. Koo founded the company in 1975 with just a few thousand dollars, selling calculators in Hong Kong. He transitioned the business into an outsourcing operation in the early 1980s, relocating its operations to Shenzhen. Thanks to Mr. Koo’s vision, NTE was among the very first companies to invest in the Shenzhen Special Economic Zone after it was established by the Chinese Communist Party.

I’ve read quite a bit about Mr. Koo and have actually come to really admire this guy. What got me really interested in his story was this part of last year’s annual report:

“In connection with the appointment of Mr. Koo as Nam Tai’s Chief Financial Officer in March 2009, Nam Tai and Mr. Koo agreed to the following compensation arrangements: (1) a salary of $1.00 per month; (2) employment benefits comparable to those provided to other members of senior management, including insurance coverage, annual physical examination, golf club membership fees, and housing allowance for his apartment in Hong Kong of up to $0.02 million per month, plus all miscellaneous fees; and (3) compensation in the amount of $3.0 million after completion of three years’ service with Nam Tai as Chief Financial Officer.

The compensation payable to Mr. Koo for his three-years’ of service was not payable if Nam Tai replaced Mr. Koo with a suitable candidate within the three-year period ending February 28, 2012. In October 2010, Nam Tai appointed Joseph Li as Chief Financial Officer. In November 2010, as a consequence of his wife’s health, Mr. Li resigned as Nam Tai’s Chief Financial Officer and Mr. Koo again resumed in that position. However, despite his short tenure, Mr. Li’s appointment as Nam Tai’s Chief Financial Officer within the three-year period terminated the Company’s obligation to pay Mr. Koo at the end of the three years. Accordingly, the approximately $1.6 million we accrued since March 2009 for the potential payment to Mr. Koo at the end of his three years of service as the Chief Financial Officer was added to the Company’s additional paid-in capital on Nam Tai’s balance sheet at December 31, 2010 in accordance with the guidance under SAB Topics 1B.1 and 5T, and FASB ASC 718-10-15-4.”

So Mr. Koo’s tenure as CFO was only interrupted for one month and he let the company claw back his entire accrued salary for the previous 20 months! That’s a level of corporate governance rare among even U.S. companies.

Koo has run the company very conservatively for forty years, never used debt and never hesitated to idle a plant if it couldn’t secure a profitable contract. Never eager to please Wall Street, Koo implemented a policy of resetting dividends every year based on business requirements, hence the volatility in the annual payout.

In 2004, Koo donated HK$100 million (US$12.8 million and a significant portion of his net worth at the time) to the Hong Kong Baptist University in the largest single donation ever given to a Hong Kong university. I found this rare piece on Mr. Koo on the university’s website which I think everyone should read even as a business case: http://www.cityu.edu.hk/cityu/about/honorary/2013-hondr/en_koo.pdf

Here is an excerpt: “In 1985, as a result of a shortage of foreign exchange in China and the cancellation of a lot of orders due to the rapid change of the market, the business of the Nam Tai Group suffered, and the company was burdened with losses for three consecutive years. Orders for products fell, affecting even the business of the Japanese raw material suppliers. Even when the suppliers offered to release Mr Koo from the contract and lower the price, just as they had offered to other customers, so as to cut down on his losses, Mr Koo insisted that he would fulfill the terms of the contract. He would rather shoulder the loss than break his promise. Later, the Japanese partner helped him broaden his business on LCD monitors processing and referred him to new clients, which brought to the Nam Tai Group new opportunities.”

I can see why Peter Kellogg is staying around.

Optionality

1. Potential sale of the building after its completion

2. Potential liquidation of the company

3. Management raises the dividend once the property starts paying rent

4. NTE gets a good price for its Wuxi and Guangming properties

5. Demand for LCMs explode and NTE gets a new contract

Risks

1. Everyone and their uncle (except some people in China) think that real estate in China is in a bubble. The good thing is that the company seems more interested in renting its buildings out. The rental income is far safer than the real estate value.

2. Potential trouble from the local government – tax issues, building permits, and so on.

3. This is the biggest risk. NTE’s cash balance seems only enough for it to complete one building or one quarter of the project. If NTE’s management ever decides to borrow money to finish the whole project and real estate suddenly collapses in China, the shareholders are in big trouble. But given how conservative Mr. Koo is as a businessman I think it is unlikely he will allow the company to use leverage. In the more likely scenario, I think Mr. Koo will sell the first building once it’s completed and use the proceeds to complete the rest of the project.

Pattern Seeking

Interestingly enough, there are striking similarities between NTE and Automodular, a Canadian micro-cap I wrote up a while ago (https://oraclefromomaha.wordpress.com/2013/06/).

1. Both companies are subassembly businesses on run-off mode.

2. Both stocks got halved when the companies lost their contracts.

3. Both are run by shareholder friendly managements with a track record of paying out excess cash.

4. Both have a ton of cash and no debt.

5. And lastly, both companies fit into my favorite investment category – stocks with HUGE optionality trading below liquidation value.

Disclosure

The author of this write-up owns no shares in the company mentioned (NASDAQ: SOHU, NYSE: NTE) and may purchase or sell shares without notice. This write-up represents only the author’s personal opinions and is not a recommendation to buy or sell a security. No information presented in the write-up is designed to be timely and accurate and should be used only for informational purposes. Readers of the write-up should perform their own due diligence before making investment decisions.

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[1] Foreign Ministry Spokesman Qin Gang

[2] NTE 6-K, Oct 30^th 2013

Automodular – Activist Action

So Automodular fell from $2.52 to $2.17 in the last two days on the news that an activist investor owning 6.7% has joined the company’s board.

…. and yes, you read that right.

 

I’m rarely bothered by fluctuations in stock prices, but I thought that was funny, so I bought myself 1,000 shares in protest of the market’s reaction.

AIG TARP WARRANTS

Date: 11/23/2013 / Ticker: AIG-WT / Price: $20.50 / Market Cap: N/A / Idea Type: Special Situations

Apologies for not submitting any new write-ups in the last month. I seem to be suffering from a personal version of the “crowding out effect”, as prep work for the December CFA exam has visibly taken its toll on time allocated toward higher ROI activities (like writing this blog). I can’t help it; it’s an expensive exam.

Anyway, the case for AIG’s common equity (NYSE: AIG) has been laid out very well by some high-profile value investors, like this one: http://www.fairholmefunds.com/sites/default/files/CaseStudyII180612.pdf. The stock has been a bit of a hedge fund hotel in the last two years and has seen a nice rally, but the fundamental case remains intact:

1. AIG still trades at a meaningful discount to tangible book, which won’t last forever for a somewhat above-average insurance franchise.

2. Benmosche & company continue to make enormous progress improving operating metrics.

3. Much of the capital return story has yet to play out as the company remains overcapitalized.

You can find plenty of detailed write-ups on the underlying stock, so I’m not going to repeat what everyone else is saying here. This write-up will mainly focus on the AIG TARP warrants, which everybody knows about now but remain poorly understood. I believe the warrants provide a unique levered opportunity for investors to participate in the underlying equity. Under conservative assumptions, if held to maturity, the warrants can be reasonably worth 3 – 7 times their current price by the time they expire.

 

Overview

AIG’s warrants were issued in January of 2011 as part of the US Treasury’s TARP effort. Basically all of the too-big-to-fail institutions were forced to issue these warrants; each came with special terms. AIG was among the last to do the deal which means that its warrants will expire the latest. The special features of these TARP warrants are:

1. They are super long-dated. Most of the TARP warrants (including the bank warrants) expire ten years after issuance. The AIG warrants were issued in 2011 January and expire in 2021 January, so there is still seven years and two months left on them.

2. They are superior to long-dated call options, as the warrants come with special anti-dilution adjustments that protect the warrant holders against dividend payouts and a host of other potentially dilutive transactions (stock dividends, rights offerings, above-market tender offers).

3. I don’t think anyone has written anything about this effect so far, but the anti-dilution adjustments under some circumstances can even be accretive to warrant holders in that they may accrue more value than the notional value of a dividend when that dividend is paid. I will explain the math in detail.

The warrants are somewhat illiquid, because 1) there aren’t that much to trade around which discourages institutions from buying them 2) in the case of AIG a large % of the warrants are held by a few long-term investors whom I suspect will likely hold them to maturity so the effective float is much smaller than it seems. Bruce Berkowitz alone owns 24.3 million of these securities as of his most recent 13F reporting cycle which constitutes just a little under one third of all warrants outstanding.

The warrants have all the features of a long-dated call option except they come with protection (or even accretion) against dividend payouts and a number of other potentially dilutive transactions. The way I think of these instruments is that they are economically equivalent to a 10-year call option with a contingency value right attached. The CVR in this case is the anti-dilution adjustments which have the potential of making the warrants far more valuable than a comparable call options. Here is a summary sheet of what I estimate the CVR to be worth under each of my three scenarios:

 

The Math

The math involved in the calculation of anti-dilution adjustments is quite complicated. Below is the exact language on the subject from the warrants’ prospectus:

There is quite a bit of misinformation on this adjustment clause out there. A lot of people apparently believe that the strike price is adjusted down by the excess dividend over the $0.675 threshold amount (ex. The strike price will go down by $1 when a $1.675 dividend is paid). That is incorrect. In reality, the math is subject to two additional complications:

1. The adjustments will be made most likely on a quarterly basis as the dividends are paid. The dividend threshold per quarter will thus be 0.675/4 = $0.16875. Currently the stock pays a $0.10 quarterly dividend, which is lower than the minimum threshold so no adjustments are being made at the moment with respect to dividend payouts.

2. The adjustment is sensitive to the market price of the underlying stock on the record date. Since the stock will likely trade at different prices on all four quarterly record dates per year, the strike price adjustment downward will vary every quarter.

To illustrate how these complications affect the results, examine the following scenarios:

[Formula: New strike price = old strike price x (market price on record date – excess dividend over $0.16875) / market price on record date]

Assumptions: annual dividend = $1.675, quarterly dividend = $1.675/4 = $0.41875, current strike price = $45. Excess dividend = 0.41875 – 0.16875 = $0.25 per share

Scenario 1: The stock trades at $30/share on the record date, new strike price after dividend = 45 (30 – 0.25) / 30 = $44.625. Effective adjustment in this case = 45 – 44.625 = $0.375 per warrant

Scenario 2: The stock trades at $45/share on the record date, new strike price after dividend = 45 (45 – 0.25) / 45 = $44.750. Effective adjustment in this case = 45 – 44.750 = $0.250 per warrant

Scenario 3: The stock trades at $80/share on the record date, new strike price after dividend = 45 (80 – 0.25) / 80 = $44.859. Effective adjustment in this case = 45 – 44.859 = $0.141 per warrant

Notice the difference? The higher the stock price is, the lower the adjustment will be to the strike price. Notice under scenario 2 that the common (mis)perception that the strike price is adjusted by (excess dividend over 0.675) is only true under the rare circumstance in which the underlying stock trades at $45 per share on every record date before warrant expiration.

If you think that’s confusing, there is more: “Upon any adjustment in the exercise price, each Warrant will evidence the right to purchase the number of shares of Common Stock obtained by multiplying the number of shares of Common Stock purchasable immediately prior to the adjustment by the exercise price in effect immediately prior to the adjustment and dividing that product by the exercise price in effect after the adjustment. All anti-dilution adjustment calculations will be made to the nearest hundredth of a cent or 1/1,000th of a share, as applicable. No adjustment will be required if the calculation results in a change to the exercise price of less than ten cents; however, any such amount will be carried forward and applied in any subsequent adjustment of the exercise price.”

What this means is that whenever a dividend (greater than $0.16875 per quarter) is paid, not only does the strike price get adjusted downward, the investor will also receive rights to purchase additional shares for each warrant held, for free!

Let’s go back to our previous three scenarios to see how this will affect the warrant value:

[Formula: New no. of shares per warrant = Old no. of shares per warrant x old strike price / new strike price]

Assumptions: quarterly dividend = $1.675/4 = $0.41875, current strike price = $45, current no. of shares per warrant = 1.000

Scenario 1: The stock trades at $30/share on the record date, new strike price after dividend = 45 (30 – 0.25) / 30 = $44.625. New no. of shares per warrant = 1.0 x 45 / 44.625 = 1.008

Scenario 2: The stock trades at $45/share on the record date, new strike price after dividend = 45 (45 – 0.25) / 45 = $44.750. New no. of shares per warrant = 1.0 x 45 / 44.750 = 1.006

Scenario 3: The stock trades at $80/share on the record date, new strike price after dividend = 45 (80 – 0.25) / 80 = $44.859. New no. of shares per warrant = 1.0 x 45 / 44.859 = 1.003

The effects here are similar to those highlighted previously; the higher the stock price, the fewer additional shares (after adjustments) you will receive for each warrant you own.

Combining the two effects, you end up with an adjustment schedule that is very sensitive to the market price of the stock, which has a strong inverse relationship with the value of the anti-dilution adjustments – a lower stock price makes the adjustments more accretive.

If this mechanism reminds you of a stock repurchase program, damn right, because that’s what it’s trying to replicate (the end effects will be somewhat different due to other moving parts).

Therefore, if you are dead serious about holding the warrants to maturity, you want the stock price to be as low as possible in the years prior to expiration for the strike price to be adjusted down by a large margin, and then go to full value toward the end of the holding period.

Valuation

Valuing the warrants is going to be quite difficult given how many moving parts there are. Some of the key variables are:

1. Growth in the company’s tangible book value, which is determined by future ROE. Management’s targets for 2015 are > 10% ROE, assuming achievement of certain operating metrics (combined ratio in the low to mid 90s for the P&C business). AIG is currently doing around 7% – 8% ROE, so 8% by 2015 is a reasonable low case projection in a relatively normal big cat environment. I assume 7% ROE into 2015 and will use 10% ROE (base case) and 12% (high case) for run-rate ROE after 2015.

As a reference, AIG was doing in excess of 14% before the crisis, and most of its P&C and life peers are doing over 10%.

2. Capital allocation – here I assume a 40% dividend payout rate from 2014 and onward, and 40% of the earnings going into stock buybacks. AIG is currently far overcapitalized relative to its peers and management has indicated that significant capital returns to shareholders will be inevitable.

3. Future stock price (for anti-dilution adjustment calculations) – I project 12% annual appreciation in my low case, 14% in base case and 16% in high case. Recall that the higher the stock goes, the less accretive the anti-dilution adjustments will be. I think these numbers are fairly conservative.

4. P/B multiple when the warrants expire – below are my numbers, which are reasonably consistent with the current peer multiples.

 

Here are my models:

 

 

Depending on the future operating performance and capital allocation policy of the company, the range of potential outcomes is very large, which is reasonable to expect given the levered nature of the warrants. Another thing to keep in mind is that I am valuing these securities the old-fashioned way – held to maturity and valued on the basis of the intrinsic value of the underlying equity. If the underlying reaches fair value before the warrants expire, the IRR can be even higher than what I projected. With an option so long-dated, don’t even kid yourself with Black-Scholes; it’s useless.

Another interesting result is that the anti-dilution adjustments in two of the three cases turn out to be not only protective against “dividend dilution”, but also “accretive” to the warrant holders in that the values of their anti-dilution adjustments are higher than the future value of the actual dividends (compounded at 10%).

 

This is mainly a result of what I mentioned earlier – that the anti-dilution adjustments in fact resemble a share repurchase program. Accretion is realized when the dividends are paid and adjusted while the shares trade below their intrinsic value.

Warrants vs. Common Stock

I think the warrants are currently a better way to gain exposure to AIG than the common stock.

The warrants trade at $20.50 a piece. The “intrinsic value” of the warrant is $49.50 (stock price) – $45 = $4.50. The difference between the warrant price and the intrinsic value is $16.00 a share, so effectively you are paying $16.00 in interest for a non-resource loan to borrow $45.00 for seven years and two months.

That’s an implied borrowing cost of 3.96%! For 1% above the risk-free rate, you get not only the levered upside to the underlying, but also protection against losses exceeding $20.50. If you factor in any potential value accretion from the anti-dilution effects, the effective borrowing cost will be even lower than 3.96%. What a deal!

Warrants vs. Call Options

The anti-dilution adjustments can be very valuable even under conservative assumptions. However, even if we ignore the fundamental case for the stock, the warrants appear quite mispriced relative to traditional call options. Consider:

1. AIG’s 2014 January $45 calls currently sell for an implied borrowing cost of 6% (and you only get to borrow for a year and 2 months).

2. Black-Scholes gets you $23.3 for a 7.2 year call options (I used a 3 year average vol. of 36.5%)

This may sound strange, but I believe the mispricing of the warrants (relative to call options) will be corrected no later than October 14^th of 2018, roughly 27 months before the warrants expire. This is because AIG dealers set up 2-year LEAPS on the stock usually 27 months before maturity dates. The most recently available version expires in January 16^th, 2016 and became available on October 14^th of 2013.

The TARP warrants will expire on January 19^th of 2021. Should the warrants stay mispriced, one can simply arbitrage the difference on October 14^th of 2018, when the new January 16^th 2021 LEAPS gets introduced, by shorting the LEAPS and going long the warrants. Keep in mind that the warrant is simply superior to a call with the same expiration and should always trade at a higher premium.

Similar Opportunities

Hartford Financial Services (HIG-WT) Warrants, $9.79 strike, 2019 June – the fundamental case here is similar to AIG: a tainted but nonetheless solid insurance franchise that trades at 80% of tangible book. The HIG warrants here provide some fairly generous anti-dilution clauses, as the dividend threshold is only $0.05 on a $35 stock. The company already pays more than that so the anti-dilution adjustments have already kicked in. The current strike is around the low $9s.

The stock is at $35.56, so the intrinsic value of the warrant is $26.26. At $26.77 a piece, you are basically paying nothing for the time value of holding the warrants. Accounting for further dividend adjustments, the effective borrowing cost on these warrants will likely be negative for the holding period.

Wells Fargo (WFC-WT) Warrants, $34.01 strike, 2018 October – This one is unique. Wells Fargo is a much better quality business than AIG or the other big banks. Make a table of WFC’s ROA/ROE for the last 15 years and you will see what I mean. The stock trades at a 65% premium over tangible book but given how much faster it will compound its book value than its peers the premium here is probably justifiable (before the crisis WFC regularly traded for 2.5 times book which still didn’t deter Warren Buffett from holding a huge stake).

The intrinsic value of the WFC warrant is $10.35 and the warrants trade at $15.81. You are laying down $5.46 a share in interest to borrow $34 for 5 years, so the effective borrowing cost is 3% before dividend adjustments. The WFC warrants, though, have only five years left before expiration.

General Motors (GM-WTA, GM-WTB) Warrants, strike prices vary, expiration dates vary – GM is the new hedge fund hotel nowadays. I don’t know enough about car sales and labor restructuring to form an informed opinion about the stock itself but the warrants seem interesting from a pure valuation perspective.

The common is at $37.63 a share.

A series (expires July 2016) – trades at $28.01, strike price $10, so you are paying nothing for the time value here.

B series (expires July 2019) – trades at $20.25, strike price $18.33, also close to nothing for the time value. The funny thing here is that GM calls expiring in January 2015 with an $18 strike price is trading at $21.03 a piece. WHAT! An inferior option expiring 4.5 years earlier is more expensive?

 

There’s a finance professor of mine who has been a staunch proponent of the strong form of market efficiency. I am tempted to show this to him.

 

Disclosure

The author of this write-up owns shares in the company mentioned (NYSE: AIG-WT) and may purchase or sell shares without notice. This write-up represents only the author’s personal opinions and is not a recommendation to buy or sell a security. No information presented in the write-up is designed to be timely and accurate and should be used only for informational purposes. Readers of the write-up should perform their own due diligence before making investment decisions.