Some Things I’ve Learned over the Years

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

An Obsession with Studying the Superlative Business:

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

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

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

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

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

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

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

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

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

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

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

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

JD and Amazon: Scale Economics and the Customer Experience

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

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

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

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

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

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

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


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

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

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

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

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


Revisiting the JD Thesis

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

– John Maynard Keynes

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

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

On operating leverage:

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

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

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

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

Amazon: Still the Best Business in the World

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

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

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

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

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

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

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


The Personal Growth of an Entrepreneur

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

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

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

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

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

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

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

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

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

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


Inductive Reasoning

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

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

My main points are as follows:

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

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

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

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

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

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

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

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

On Investing in China

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

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

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

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

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

Here are LKY’s own words commenting on Xi:

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

 – Lee Kuan Yew

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

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

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

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

Liberty Global / LILA/K

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

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

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

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

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

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

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

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

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

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

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

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

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

Houston, we have a cost problem:

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

Patrick Drahi is still a stud:

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

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

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

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

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

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

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

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

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

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

Happy Holidays,


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

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

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

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

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

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

Idea Overview:

Occasionally when the stars align Mr. Market presents us with a phenomenal long-term investment opportunity. I believe a long position in the shares of (“JD”) offer such an opportunity for investors to compound their capital at exceptional risk-adjusted rates of return over the next 5 – 10 years (or potentially decades into the future).

JD is China’s largest online direct-sales company and trades at 2.4 – 2.8x 2020E EBIT and maintenance FCF respectively. The company has a great “flywheel” business model,[1] and benefits from several powerful secular tailwinds, which will help sustain a massive open-ended growth runway. Equally as important, the company is controlled and managed by a phenomenal CEO who is an extremely competent operator and has a great track record of growing shareholder value per share while prioritizing the interests of minority shareholders.

I believe JD shares are easily worth multiples of the current stock price under any reasonable, conservative scenario, and even under a draconian scenario I see the shares compounding at 20 – 25% annually over the next 5 – 7 years. In the most likely future outcome, I believe JD’s intrinsic value per share can reach $140 – $180 by 2020, which would yield a MoM of 5.7x – 7.4x over the next 5 years, or a 40 – 50% annually compounded internal rate of return.


Key Value Drivers in Thesis:

  • JD’s competitive advantages are strengthening over time; core operating margins are on the verge of a multi-year inflection as Gross Merchandise Value (“GMV”) continues to grow at a market-leading rate.

Partly due to ongoing current investments into fast-growing, emerging businesses that have been internally incubated (JD Finance and JD Home/Daojia), JD has yet to report positive GAAP operating profits. These segments are currently loss-making and have masked a steadily improving margin profile for the core JD e-commerce business, which should expand its gross margins closer to 20%+ and operating margins as a % of net[2] GMV closer to mid-single digits over the next 5 – 7 years.

The key drivers behind this inflection are: 1) a direct-sales product mix-shift away from relatively low-margin electronic products to higher gross margin categories such as home appliances and general merchandise[3], along with higher mark-ups, 2) the growth of contribution profits from third-party marketplace businesses such as commissions, advertisements[4] and logistics & warehousing services, which are all very high-margin or are under-monetized services, and 3) greater scale economies. Specifically, rapidly growing first-party unit volumes will increase bargaining power for procuring merchandise from suppliers, and a steadily incremental increase in order density in under-penetrated cities will lower JD’s average fulfillment cost per order over time.


  • JD Finance’s value is massively under-appreciated by investors.

JD owns 85% of JD Finance which serves as an internet-based lender and payments processor to suppliers/wholesalers, 3P merchants, and customers within JD’s e-commerce ecosystem[5]; other ancillary services include crowdfunding, insurance and wealth management.

This unit will become entirely self-funded for the remainder of this year and benefits from leveraging the rapid growth and transaction data of JD’s core e-commerce business within a closed-loop ecosystem. JD Finance may potentially IPO in the Chinese A-share market sometime in the early 2017 timeframe, which would create a clear catalyst to unlocking its under-appreciated value. An IPO or spin-off will also remove its reported losses off of the core e-commerce business PnL.

A private funding round led by Sequoia in January valued this business at around $7.2bn, or ~25x 2015 sales. If valued at 5x 2020E sales post-dilution, JD Finance could be worth closer to $12.3bn to JD equity holders five years from now, and would make up more than ~40% of JD’s entire enterprise value today.


  • JD is led by one of the world’s best CEOs. Richard Liu is very shareholder friendly, has extremely high integrity, and has created one of the most well-managed and successful e-commerce companies today.

The quality of the people managing the business and their ability to intelligently allocate capital cannot be understated in a long-term compounder thesis. Up to this point, Richard has largely been correct on all the major strategic decisions for the business, and has executed near flawlessly towards becoming the dominant e-commerce franchise in China long-term. I believe his interests are well aligned with minority shareholders, and that he is working to maximize shareholder value for all investors.


Why does this opportunity exist?

  • The market’s failure to accurately price in JD’s earnings power on a longer-term time horizon has created a massive opportunity for fundamental investors willing to make a longer-duration investment. Namely, the scalability of JD’s business model is under-appreciated as FCF generation is back-ended; 5 – 7 years from now, margins are likely to be substantially higher as normalized earnings power continues to ramp-up materially. The fact that JD currently reports no positive earnings makes the idea optically unattractive to potential investors.

The Street in particular appears myopically focused on the next few quarters’ revenue prints and near-term margin implications, at the expense of developing a well-informed longer-term outlook. They are also focused on the wrong metrics such as total revenues and reported EBIT. Given the nature of JD’s business (1P + 3P platform), net GMV, normalized operating profit and earnings power are the more relevant valuation metrics.

  • Investors appear overly concerned about the credit quality of JD Finance’s lending business. In reality, management is prioritizing risk management over short-term profitability for this division. Current losses and the unfavorable working capital dynamics to the core e-commerce business have also contributed to near-term investor worries. Public disclosure of key metrics has been very limited, but I believe risk here has been over-priced.
  • General macro concerns over the health of China’s economy have depressed valuations across all sectors of companies operating in China. Chinese equity ADRs listed on US exchanges, in particular, appear unloved by Western-based investors and currently trade at large discounts. In reality, there is a large disconnect between China’s consumption vs investment spending, with the former expected to steadily increase over time, and greatly benefit businesses leveraged to consumer spending such as JD.


Core E-commerce Business Model and Competitive Advantage:

JD’s core e-commerce business can be divided into 2 segments: the direct-sales platform and third-party marketplace.

First-Party (“1P”) or Direct Sales Platform:

JD operates the largest online direct-sales platform in China (~$39.5bn reported GMV FY2015), enabling the company to achieve superior economies of scale in product procurement and turnover its inventory at a faster rate than any other national competitor. The business is run incredibly efficiently given its size; at an average inventory days of 32-33[6], inventory turnover is amongst the lowest of global and local peers such as Amazon, Walmart, Suning and GOME, despite its direct-sales GMV being a fraction of Amazon and Walmart’s GMV, respectively.

JD’s 1P business makes up ~57% of total company GMV. Electronics and home appliances are the largest product categories at 80% of the total 1P GMV mix, with the “general merchandise” category making up the remainder. Electronic products currently sell at mid-single digit gross margins, home appliances are at around high-single to low-double digits, and products within general merchandise have margins around mid-teens.


Third-Party (“3P”) Marketplace Platform:

JD’s online marketplace (~$29.5bn reported GMV FY2015) was launched in October 2010 and has already grown to ~43% of JD’s total company GMV. Similar to Amazon’s third-party marketplace business, there is a network effect at play here as more merchants attract more customers in a positive feedback loop. Third-party merchants are vetted very carefully to ensure product authenticity and must be able to meet JD’s demands for a timely supply of authentic products and also provide high-quality post-sales customer service.[7] Despite the careful vetting process, the business has been growing rapidly at an average rate of nearly 200% per annum over the past 4 years.


Why is JD’s Competitive Advantage Durable?

“The company that wins the customer’s mindshare, the company wins the ecommerce war.”

– Richard Liu, Founder & CEO


The source of JD’s competitive advantage is its end-to-end nationwide fulfillment network which allows the company to provide a high-quality, consistent and speedy delivery service at large scale; this strengthens customer loyalty/mindshare over time and increases economies of scale within a positive feedback loop; this in turn allows the company to price a wide selection of authentic products competitively and incrementally take market share within a largely 2-player B2C market with Tmall, creating a high barrier to entry to potential online shopping platforms.


“We believe that JD’s self-owned logistic network has become our core competitive advantage that consumers have come to trust.”

– Richard Liu, Founder & CEO


The nature of China’s e-commerce industry is different from that of western developed markets. Mainly, two stark realities that e-commerce companies have to address in China are unreliable, low-quality[8] third-party courier services and the ubiquity of counterfeit products[9]. JD has tackled both issues with great success to date by adhering to a stringent process of selling only authentic products on its platform and taking an asset-heavy approach to investing in its own in-house logistics network.[10]

This strategy is differentiated from Alibaba’s predominately asset-light approach[11] to last-mile delivery, but has allowed JD to build considerable brand equity over time with customers. In essence, the trust that JD has built with its customer base with respect to authentic products is a major intangible asset[12], along with the substantial scale benefits of owning the largest in-house logistics network out of all competitors.


“The majority of JD’s customers has shopped on other platforms before but was tired of having to be on alert for fakes all the time. So they came to JD even though our prices may be a little higher than the other places.”

– Richard Liu, Founder & CEO


Key Pillars of Successful E-Commerce Platforms: Tmall & Taobao vs JD

Conventional analysis of e-commerce business models suggests that the key drivers to success are low prices, high-quality customer service and a wide selection of products. My research suggests that all three factors are important in the China market, but not equally so.

Based on surveys I’ve conducted on online shoppers in China and along with supporting research from proprietary, third-party studies[13], product authenticity is by far the most important factor for millennial and higher-income shoppers when deciding which e-tailer platform to stick with. The results of my own proprietary survey suggests that online shoppers rate delivery service and product authenticity highest on, whereas selection and to a lesser extent, competitive prices, are rated more highly on Alibaba’s major e-commerce platforms Tmall and Taobao.

Please see Appendix 1 for further details and the results of my survey.

The results of these consumer studies provide insights into how JD has managed to steadily grow its B2C market share – when measured in total transaction volume (GMV) – from ~17% in 2012 to ~22% in Q3 2015, according to iResearch. The major demographic groups that represent JD’s core customer base are technologically savvy millennials and higher-income shoppers, mainly between the ages of 20 – 45. These shoppers tend to be very sensitive to the speed of delivery, less price-sensitive and care greatly about product authenticity. Shipping speed in particular is very important in a market such as China, where customer behavior has already been modified to expect free and speedy shipping when shopping online.[14]


“The real Internet population is people born after 1985. January 2000 was the real beginning of China’s Internet. None of the key Internet players were really born before that. There were only about 4 to 5 million Internet users in China then, while there were 130 million in the United States. The people born between 1980 and 1985 had already completed their education in college by 2000. They mostly started using the Internet in a working environment.”

– David Wei, Founding Partner & Chairman, Vision Knight Capital


Price and product selection are still very relevant, especially in the online shopping world where search costs are very low, which is why I believe a platform such as Tmall will continue to do well and grow along with the B2C market for the foreseeable future. Tmall is Alibaba’s B2C marketplace platform (~$176bn annual reported GMV LTM). Combined, Tmall and JD have a 82% share of China’s B2C market, and both continue to take higher incremental share at a fast clip.


“I think low price is something a customer always wants and there is always the philosophy that either you want to offer customers the best price or you want to play smart. For traditional companies or offline companies, the information is not transparent: one location is different from another and hence it is hard for customers to compare, so may be they can do things differently. But for online businesses, people easily check up your prices, compare them and even complain about them. We receive a lot of such complaints every day. We will keep a low price policy forever.”

– Shi Tao, Vice President & GM of Global Business,


Taobao is the other major Alibaba marketplace platform that relies on low prices and a wide product selection as key selling points. Despite the size of Taobao (~$280bn annual reported GMV LTM), annual GMV growth has slowed considerably (~20% over the LTM). Given Taobao’s C2C business model and Alibaba’s limited ability to enforce product authenticity over sellers, fake products have proliferated over the platform.[15] Moreover, due to a lack of control over third-party merchants, return policies on Taobao are typically not as customer friendly as JD’s guaranteed 7-day, free return policy.


“If you need to return the goods to a Taobao seller, once the money is released, it can become quite a challenging experience. You never know how fast it will ship and whether the product is still in stock.”

– Toine Rooijmans, Cofounder, Dining City


Alibaba’s answer to Taobao’s reputation for fake products was the creation of Tmall. Tmall was spun out of Taobao in 2010 with the premise of guaranteeing authentic products. Although not completely devoid of fake products like JD[16], Tmall has been growing impressively with an annual reported GMV growth of ~50% over the LTM. Tmall has also been cannibalizing Taobao’s business, and given Taobao’s issues, I fully expect their business to continue to slow, and potentially start entering into secular decline over the next several years as transaction volume continues to shift from C2C to B2C.

china b2c

In my view the question that can summarize the entire “ vs. Alibaba”[17] investor debate is this: If there are primarily two dominant existing businesses/platforms operating within an open-ended, secular growth industry, and together they will take the lion share of future growth in a de facto “winner-take-all” outcome, would you rather be invested in the business that will very likely generate more value per unit of incremental growth over time in an exponential-like trajectory, or the business which currently has a more attractive and stable financial profile, yet will likely have a lower rate of return on incremental invested capital than the former?[18] 


Leaving valuation considerations aside, I think the answer for long-term fundamental investors is very clear: is the better bet.


Major Direct-Sales Competitors

Globally, the business model of brick-and-mortar retailing across broad product categories is melting away, with the internet and the convenience of online shopping as the main catalysts. This phenomenon is even starker in a developing market such as China, where the lack of a sophisticated offline supply chain network and high rental rates have advantaged online platforms greatly and allowed them to reach critical mass to the detriment of offline retailers.[19] Due to the massive lead of platforms such as Tmall/Taobao and JD, China will likely experience structurally higher e-commerce penetration levels than developed markets.[20]

JD’s direct-sales business is already substantially larger than any direct competitor, including any third-party merchant on JD, Tmall or Taobao’s platform. As a 1P retailer, JD’s scale advantage in product procurement from suppliers allows the company to implement higher mark-ups or price lower than competitors, which drives higher volumes and thus higher cost efficiencies in the supply chain. This successful playbook is nearly identical to the one Walmart used to become the world’s largest retailer.

Given JD’s massive share lead, I believe the “game” is already over for all of JD’s direct-sales competitors, whether offline or online, with the possible exception of and a few other niche vertical players.

Suning and GOME are the closest direct offline competitors to JD, as selling home appliances and electronics make up the majority of their sales mix. Despite being the largest offline retailers (excl. groceries) in China, they have been pressured by online competitors such as Tmall and JD to restructure their businesses[21]. Offline pricing integrity has suffered greatly as Suning, for example, has adopted a same-price policy for online and offline stores. The most relevant comparable to Suning and GOME is Best Buy, which has been in a death spiral of continually being pressured to consolidate its store base with a less efficient cost structure and compete against Amazon.

Amazon entered China in 2004 but despite an initial market share advantage, has yet to gain any real traction (Amazon China at its peak owned 20% of the B2C market and has since shrunk to less than 1%). I believe Amazon has largely failed in China because all of the key decision-making was deferred to HQ overseas, instead of empowering the local managers on the ground; this led to inefficient decision-making processes and an inability to respond agilely to the fast-evolving challenges and demands of the local Chinese market.


“Global companies tend to push one-size fits all solutions while to succeed in China you need to localize your strategy.”

– Krzysztof Werkun, Partner, China Renaissance Partners


“They (Amazon) rely heavily on the system, the technology. But their policies, local strategies, and local marketing are kind of not flexible enough. That’s why they are behind us in China. We make a very quick decision based on the market challenge. But I don’t think Amazon is doing that. What Amazon does in China is follow its global model and global process. If they apply the model in Germany, France or Japan, they also do it in China. They don’t consider if there are specific challenges and customer needs. That’s the difference between us and Amazon.”

– Shi Tao, Vice President & GM of Global Business,


Another one of the smaller B2C competitors, can be thought of as the online version of TJX. It is a flash sales website that adheres to an off-price, off-season retailing model with apparel as the major category. In essence this business occupies a niche within Chinese online shopping by targeting a certain customer demographic that primarily shops on mobile and buys on impulse.

I don’t have a strong opinion on the future success of this business, but search costs online are lower than offline retailing; a price comparison between websites is quick and convenient. This appears less of an issue for TJX where their core customer demographic are middle-aged, higher-income women who are typically in the habit of going to a TJX store and expecting discounted branded goods.[22] Given that both JD and Alibaba have fast-growing flash sales sites, along with JD’s low-cost advantage in fulfillment and having a substantial overlap in customer bases with Vipshop, Vipshop’s already narrow moat could erode further longer-term. JD’s flash sales site in particular has been growing rapidly at 200-300% per annum and will continue to be a focus for the company as they continue to expand aggressively into apparel.


Beginning of the End of Major Pricing Wars

As mentioned above, JD’s retail competitors are at a major competitive disadvantage.

On its path to success, there have been several multi-year price wars where JD has largely crushed its rivals such as Newegg (private), Amazon China, and With the three and a half year old pricing war against Suning and GOME centered on home appliances and electronics[23] potentially drawing to a close near-term, I believe we are near the beginning of a multi-year runway for JD to steadily price major categories at higher mark-ups relative to competitors, creating additional room for 1P gross margins to inflect upwards.

I’ve compared prices across several popular electronic and home appliance items on’s and Suning’s online websites.


Please see Appendix 2 for the price comparison results.


The results of this project suggest that, for the moment, average prices for JD and Suning are listed within a narrow band. However, for the JD buyer, in addition to benefiting from competitive prices, the buyer gets a faster and more reliable delivery service, best-in-class customer and post-sales service[24], and an option to conveniently return items for no incremental fees.


“There are two kinds of companies – those that work to raise prices and those that work to lower them.”

– Jeff Bezos, needs no introduction


Suning generated total sales of ~Rmb135.5bn during 2015, and GOME is a smaller business than Suning. For reference, JD reported net direct-sales of ~Rmb134.3bn for 2015 for its electronics and home appliances category, but this revenue stream alone will likely grow 3x-4x faster than either Suning or GOME’s entire business over the next several years. Having less efficient cost structures, Suning and GOME have seen their operating profit margins erode significantly over the past few years and have little to no more room going forward to sustain a major price war with JD.

Even if Suning and GOME decide to irrationally price at 0 to negative gross margins, they are doomed to fail. Advantaged with its greater scale to squeeze lower prices via larger volume rebates from suppliers, JD can easily afford to continuously match or even price slightly above Suning or GOME’s listed prices and still achieve higher relative mark-ups and thus higher product margins.[25]


Category Mix-Shift

An additional leg to my overall 1P gross margin expansion thesis is that JD is quickly diversifying its product sales mix away from low-margin electronic items; general merchandise gross margins are 2 – 2.5x higher than electronics and home appliances, but are likely growing twice as fast, leading to sizable overall gross margin expansion.[26]

Richard Liu has made it a priority to be the number one direct vender of home appliances by the end of this year, and to be a market leader in apparel within 3 years. Part of the strategy is to shift more apparels out of the third-party marketplace into direct-sales as JD believes it can achieve incrementally more scale efficiencies than third-party merchants selling these products directly over time.[27] Apparels are also among the highest gross margin category in all of e-commerce. Given JD’s additional advantage in being able to leverage its scalable logistics network over higher levels of SKUs/volume, this strategy appears sensible.

Currently, JD’s 1P business is earning 6-7% gross margins, and assuming general merchandise products grow to 40% of the total 1P mix vs 20% today, along with higher mark-ups, 1P gross margins can potentially expand closer to low-double digits, or by more than 500bps by 2020.[28]


2015 – 2020 Total 1P Gross Profit Bridge:

In my most likely scenario, I model JD’s direct-sales business to grow at a ~31% CAGR over the next 5 years. I will discuss my forward growth projections in greater detail in the valuation section, but for reference, this business has grown at a ~71% CAGR over the past 4 years. Under this scenario, overall 1P gross margins expand by a total 300 – 400bps over the next 5 years, contributing ~52% of the delta to the 2015 – 2020 1P gross profit bridge. Product category mix-shift and volumes account for the rest of the delta (~48%) in total gross profits.


Critical Mass, Pricing Power, and Completing the Flywheel

As previously mentioned, Tmall and JD combined control ~82% of China’s B2C market. Given that both platforms have already achieved a critical mass of merchants/suppliers and market share, both platforms should be able to continue to grow their respective market share well into the future.

Despite Tmall’s advantage in product selection and its competitive prices, neither vendor may ever satisfy the needs of all consumers. However, I believe JD has the greater potential to grow its incremental customer share at a higher rate than Tmall.

How I think about this issue is this: A company’s reputation, brand and mindshare with consumers are relatively difficult to change over time. Consumer shopping habits are typically very hard to change. JD has already demonstrated that it places the customer first primarily by selling only authentic products and offering the highest-quality delivery service in the industry, and this advantage is not easily replicable.

If selection and to a lesser extent, competitive prices, are the two areas where JD has the most room for further improvement, then JD has massive potential to grow beyond its core customer base. These variables, in my view, are “low-hanging fruit”, compared to the time and investment needed to build a superior customer service and trust.[29]

As mentioned, search costs in online retailing are generally lower than in offline. A shopper can easily compare prices and product selection across multiple shopping sites quickly. As JD continues to leverage its flywheel to expand into under-penetrated categories such as apparel, baby, cosmetics, and groceries, and grow its third-party marketplace, its platform becomes more attractive to buyers.

As its scale in procurement grows faster than any other vender, JD’s pricing power will only get stronger over time. And there are already signs that this is happening.


1) Delivery the product to the end customer is an integral piece of the e-commerce value proposition. Steady raises in the minimum order value threshold for free delivery are de facto hidden price increases, which has been a recurring practice for JD over the years. In fact, JD recently increased its minimum order size from Rmb68 to Rmb99 for free delivery.[30]


“We’ve raised the minimum purchase amount that qualifies for free delivery in each of the past three years. We started with zero – even if you bought something for five yuan, we delivered for free. Then we raise the amount to 29 yuan ($4.64), 59 yuan and then 79 yuan this year. Next year we’ll raise it to 99 yuan. We may charge for all deliveries in 2017.”

– Richard Liu, Founder & CEO


This is brilliant as it naturally forces consumers to lump their purchases into larger orders (leading to higher average GMV per order/average transaction values, all else equal) and also potentially reduces order splitting. In the future, price discrimination via offering different shipping speeds is also a possibility. JD is also currently experimenting with an Amazon-like Prime membership service with a small group of consumers, which could help further increase customer stickiness.

2) Prices for third-party marketplace-related services are increasing. The annual service fee for a 3P merchant doubled from Rmb6,000 in 2014 to Rmb12,000 in 2015. Take rates for certain categories such as jewellery have also increased.[31] JD already charges higher take-rates of between 2 – 10% relative to Tmall at between 0.5 – 5%.

As JD’s active customer base grows over time (currently at 155mm), merchants will become more captive to JD’s platform. Most merchants would be incentivized to have a presence on both Tmall and JD to maximize their sales, leaving JD room to increase take-rates.

3) Finally, certain product categories such as baby and fresh groceries/food have stronger inelastic demand profiles on JD’s trusted platform, and thus sell at premiums. These categories are particularly health-sensitive to Chinese consumers; in consequence, consumers are willing to pay a premium for these products on for the perceived safety and peace of mind.[32]

I think JD’s flywheel is already complete: despite relatively higher prices than competitors, JD continues to grow its GMV (both 1P and 3P) at the highest rate.


Core E-Commerce 2015 – 2020 Blended Gross Profit Bridge:

Over time, steady growth in penetration rates and prices across value-added services such as advertising, cloud-based software & data analytics, marketplace commissions & fees, and warehousing & delivery[33] is likely as JD’s closed-loop ecosystem becomes more attractive to suppliers and third-party merchants. JD’s 3P monetization rate is currently 10.5% as a percentage of net 3P GMV; I think their 3P take-rate/monetization rate can expand closer to 14%, or by 350 bps, by 2020.

JD currently delivers ~25% of its 3P parcel volume, and sorts a single-digit percentage point of 3P parcels in its warehouses. The 3P warehousing service is relatively new – introduced only recently in mid-2015 – hence the current low penetration rate. According to IR, JD’s penetration of third-party last-mile delivery services hasn’t meaningfully ticked higher because JD would incur too large of a loss to deliver merchandise for many of the lower volume 3P merchants on its platform.[34] However, as JD grows its warehousing capacity, penetration rates across both 3P warehousing and delivery services should increase.

With the exception of the warehousing & delivery services[35], the 3P services are all very high-margin revenue streams, (likely 100% gross margin excluding any traffic acquisition costs) and are among the fastest growing service lines on JD’s platform.

I am modeling core e-commerce blended gross margins to expand to the low 20’s percent range by 2020 from 13.4% in 2015, with 1P gross profits and 3P gross profits driving ~47% and ~53% of the total change, respectively.[36] The improvement in overall gross margins should fall straight to the bottom line.


Unit Economics of JD’s Logistics Business

“Distribution and transportation have been so successful at Wal-Mart because senior management views this part of the company as a competitive advantage, not as some afterthought or necessary evil. And they support it with capital investment. A lot of companies don’t want to spend any money on distribution unless they have to. Ours spends because we continually demonstrate that it lowers our costs. This is a very important strategic point in understanding Wal-Mart.”

– Joe Hardin, Former Walmart executive vice president, logistics and personnel



The cost structure of a fully-integrated logistics business can be broken down into three main parts: Fulfillment Center[37] (“FC”), Line-haul transport (“LHT”), and Last-mile delivery. Last-mile delivery constitutes ~50% of the total cost per parcel/order, and line-haul makes up ~37%.[38]

Since JD is currently pricing its 3P delivery service around marginal cost, I think it would be instructional to compare JD’s average delivery cost per order vs. industry ASPs. JD’s total fulfillment cost per order was ~$1.70 in 2015, the lowest amongst all major B2C platforms in China.[39] Shipping cost (or last-mile delivery cost) per order was half of this, at $0.85.[40] Industry ASPs for 3rd party couriers are currently around Rmb10 per parcel, or $1.50. Note that this service doesn’t include storing inventory for the merchant, and last-mile courier firms are currently already earning very thin margins.

Conservatively, JD’s current net GMV per 1P order is around $21. Out of that $21 they make an average 6 – 7% gross margin, or ~$1.40 per order. Contribution losses per order are around $0.30 if we fully expense fulfillment costs.[41] By 2020 I think JD’s fulfillment and shipping cost per parcel can easily get below $1.50 and $0.75 respectively, driven by robust parcel volume growth and increasing order density in lower-tier cities. In consequence, by 2020 JD should easily be profitable on a contribution profit basis[42] as 1P gross margins expand, and should also be able to earn a positive contribution margin on third-party delivery and warehousing services.


For more details on my fulfillment unit economics assumptions, please see my model in Appendix 6.


So despite owning its logistics assets in-house, JD’s cost structure is already very competitive vs. third-party couriers (who typically have a lower-quality service), and the company is well-positioned to leverage more cost efficiencies over higher levels of parcel volumes over time. Morgan Stanley estimates that China’s total express delivery parcel volume will reach ~48mm in 2020 from ~19mm in 2015. JD will likely expand its volume share of this market from 6.5% in 2015 to 13% in 2020.


Brief Overview of 3PL Operators with Franchise Models

China’s logistics industry remains highly fragmented and inefficient[43]; it is unlike the oligopolistic competitive structure that exists in the US, where UPS and FedEx ensure a consistent and timely delivery service with nationwide coverage.

The largest 5 – 6 private express delivery operators in China primarily use the franchise business model. These operators make up the lion share (76% in 2015) of the China express delivery market in terms of parcel volume, and deliver the vast majority of parcels ordered on Taobao and Tmall.


For a brief overview of China’s major 3PL firms and Cainiao, please see Appendix 4.


How the franchise business model works is this: the franchisors invest in the line-haul network assets – trucks, planes and regional sortation centers – typically via leasing these assets, and in turn, charge their franchisees for using them.

Franchisees either focus their business on first-mile pick-up or last-mile delivery. First-mile pick-up is the process of moving merchandise from the merchant’s warehouse to the centralised sorting stations controlled by the franchisor. Last-mile delivery is the process of shipping the order to the customer from local delivery stations. Note that this model has spawned thousands of local franchisees/entrepreneurs.[44]


JD’s Advantage over Third-Party Logistics Firms

“When you own and manage your distribution and logistics channel, you have a great competitive advantage over companies that rely on third-party suppliers. It automatically shortens your lead times, but also you can constantly look for ways to improve your operation and try to make it more efficient. You never have to rely on what’s going on in somebody else’ shop. In our case, we generally know where things are in relationship to when we want them to arrive, so we can schedule and plan to move goods into the stores at the right time. That maximizes our in-stock positions, which is vital. You can’t generate sales unless you have the product there when the customer wants it.”

– Joe Hardin, Former Walmart executive vice president, logistics and personnel


JD’s nationwide fulfillment and delivery infrastructure allows it to provide same-day delivery to 137 cities and next-day delivery to 884 cities in China. Currently over 85% of orders fulfilled by JD are delivered on the same-day or the next. No other logistics or e-commerce company in China is able to offer such coverage.

JD’s logistics business is an end-to-end solution; this means that JD controls the entire value chain from procuring and storing the inventory, all the way to last-mile delivery. The only piece of the logistics process that is outsourced is the inbound shipping of goods from the supplier/manufacturing to JD’s fulfillment centers.[45]

Order Cycle Flow Chart for JD:

As shown above, the typical order for JD moves through two to three distribution layers: Warehouse/Fulfillment Center -> 1) Regional Sortation Center -> 2) Delivery Station -> 3) End Customer, or straight from sortation center to a pickup station or to the end customer. Unless cross-regional line-haul is required (an additional layer)[46], this is the typical logistics process for an order fulfilled by JD.


Here’s the typical transaction cycle for an order on Tmall or Taobao:

As shown, the order moves through at least 4 – 5 distribution layers (transitioning from the merchant’s warehouse or a Cainiao-owned warehouse to the 3P courier). Since most sellers on Taobao or Tmall are too small to have a national warehouse network, cross-regional line-haul is inevitable for orders going to regions without inventory.

This inefficiency stems from the fact that merchants operating on marketplace platforms typically manage inventories on their own, but lack the scale to build out their own in-house nationwide logistics network. With lesser overall volumes, a merchant may not have the right inventory available in the region close to the final destination; in consequence, an order usually takes longer and is more costly to deliver if line-haul services are required. 3PL firms that use a franchise model can only leverage the volumes they receive on their part of the value chain, which ultimately limits their scale longer-term as order volumes increase.

JD simply has a superior hub-and-spoke model with fewer layers of distribution and higher cost efficiencies; local economies of scale are achieved via a dense network of delivery stations that are strategically located around its self-owned fulfillment centers. As JD’s direct-sales volume increases, higher order density helps justify the economics of a denser warehouse network, higher line-haul frequency and a shorter last-mile delivery radius. Once order density reaches a critical mass within a local market, JD can group multiple orders together into a single route (since they have the SKUs available) with increased frequency vs. last-mile franchisees.



“We do not believe the franchising or subcontracting models for logistics, which tend to have limited value-added services, are able to provide the type of customized delivery services that JD can provide.”

– Richard Liu, Founder & CEO


The main weakness of the franchise model is that franchisors have limited quality control over their franchisees; service quality, as a result, is lower (Please see Appendix 3 for customer service scores for major 3PL firms). This is important because customers generally have direct contact with last-mile delivery staff.

Another issue with the franchise model is that the incentives are misaligned between the franchisor and franchisee. It appears that last-mile delivery franchisees are incentivized to generate greater volumes even by sacrificing profitability since there is a possibility that they could sell the franchise a few years later for a good ROI. JD management has stated, for example, that in some rural cities, last-mile franchisees are charging Rmb2-3 per parcel as promotions, which should be well below their break-even levels. The franchisors, however, care more about having a sustainable business long-term. Whether the franchise model will be sustainable over lower industry price-points remains a mystery, as the economics for the franchisees appear to be deteriorating in a highly commoditized environment.

Finally, third-party couriers do not use ‘open-box’ services or cash-on-delivery (COD), which is a service that Chinese shoppers love.[47]  In contrast, JD’s delivery personnel are extremely well trained, are paid higher than average market salaries with generous benefits, and employee turnover is lower.[48] In fact, if you under-perform (too many late deliveries or customer complaints) as a delivery personnel at JD, you are likely to get fired promptly.

Overall, the barriers to entry in building a nationwide logistics network are substantial; it would take a lot of time, logistics know-how and capital for anyone who attempts to replicate JD’s network. Compounding the challenge is the fact that land located near strategic logistical hubs is difficult to secure due to misaligned local government incentives.[49] At the same time, a solid ROI is questionable as industry ASPs for express delivery services continue to decline while major input costs (labor, fuel, rent) are all rising well above the rate of inflation.

Given these challenges, and the fact that Alibaba/Cainiao’s strengths are not in managing asset-heavy businesses such as logistics[50], the probability of them expanding into last-mile delivery in any meaningful way is low. Instead, Jack Ma will likely stick to his strategy of taking minority stakes in companies with strategic logistics assets.

As JD continues to expand and densify its own network in lower-tier cities, it is well positioned to roll out a 2 – 3 hour delivery service in several years’ time, and thereby increase its overall lead in logistics.


Asia No. 1s and Fulfillment Leverage:

“Over the next 15 to 20 years, the real cost of building warehouses is going to be staggering.”

– Jeff Schwarz, Global Logistics Properties Co-founder


JD is currently operating around 213 warehouses (a majority of which are locked into long-term leases and have an average GFA of 25 – 35k sqm) with a total GFA of 4mm sqm. To meet future parcel volume demand, Richard Liu intends to expand JD’s GFA to at least 10mm sqm, likely over the next several years.

JD’s new Asia No.1 warehouses will drive this expansion. These are custom-designed, hyper-scale, and self-owned standalone warehouses, similar to Amazon’s modern day fulfilment centres.[51] The main benefit of these hyper-scale FCs are the incremental cost savings, (namely labor costs due to high automation) such as being able to sort more packages per hour.[52] More specifically, owning self-built warehouses will also help reduce long-term rental and labor inflation risks, and reduce order splitting.

JD currently has 7 self-owned fulfillment centers each providing a GFA of ~100k sqm. Management has stated that they intend to have a footprint of at least 25 Asia #1 fulfillment centers (“FC”)[53] longer-term.

A picture of JD’s new Asia No.1 in Shanghai

     A picture inside JD’s Asia No.1 in Shanghai

The first phase of JD’s Asia No.1 FC in Shanghai (GFA of ~100k sqm) incurred total CapEx spending of around Rmb0.8bn. To be conservative, I assume JD will spend an average of Rmb900mm for every 100k sqm of GFA for its Asia No.1 capital budget.[54]

JD will need to construct 6mm sqm in GFA to reach their 10mm goal. In aggregate, I am modeling total cumulative CapEx spending of $5.5bn over 2016 – 2020 budgeted for Asia No.1 construction. This is well below the cumulative cash flow they will generate from working capital alone.


Core Business EBIT Bridge 2015 – 2020:

I am conservatively modeling flat to slightly positive leverage from fulfillment due to the heavy investment phase and aggressive expansion into lower-tier cities over the next several years. There is potentially meaningful long-term upside to my EBIT margin assumptions by as much as 100 – 200 bps as fulfillment[55] costs as a % of net GMV steadily declines. A scenario that captures a more automated fulfillment process (use of fully-automated, unmanned warehouses and an increased usage of flying drones, for example) is not difficult to imagine.

Most of the upside in operating margins will be driven by gross margin expansion. Base case, I think JD’s operating margin as a % of total net GMV can reach 5% by 2020.


JD Finance:

“In ten years, 70% of JD’s net profit will come from financial business.”

– Richard Liu at Growth Forum held by ZhongGuanCun 100 Club, March 2014


Business Overview

JD Finance began as an independent operation in July 2013; business lines include consumption loans (Baitiao), supplier and merchant loans (Jingbaobei and Jingxiaodai), Online Payments (JD Payments and JD Wallets), Crowdfunding and Wealth Management services. The business is currently making losses but the top-line has been growing in the triple-digit range.


Supply Chain and 3P Merchant Financing (~19% of total revenue) – Provides credit to 1P suppliers and 3P marketplace merchants. The total outstanding loan balance for supplier and merchant financing combined is around Rmb5.1bn as of 2015Q3, with average loan sizes at Rmb6mm and Rmb200,000, respectively.

I believe investors are overly concerned about the credit exposure of this business. Credit risk for 1P suppliers is de minimis, as the supplier’s inventory in JD’s warehouses collateralizes the loan.[56] Over 80% of the total outstanding loan mix for this segment is supplier financing. Supplier loan periods are very short: under typical industry payment schedules, JD pays the supplier right away; but instead, it offers supplier financing by charging the supplier interest over a 30-day period.

Rates for supplier and merchant financing are around 10% p.a.[57], which are very favorable compared to 18% for Ali Finance and 20 – 30% for comparable services.


Consumer Credit (~23.5% of total revenue) – Currently has around 2.5mm active burrowers, which is a very small percentage of JD’s total annual active customer base (155mm in 2015). At an effective interest rate of 11%, rates are typically much lower than comparable rates offered by state-owned banks; this service is particularly attractive for consumers who cannot get credit cards from the banks such as students.

Premium consumers are targeted where NPL is low at around 0.6 – 0.7%. But as this segment’s credit-evaluating system becomes more sophisticated, and as its database of consumer data expands, it could extend financing services to a wider consumer group. Credit risk could also be borne by a third-party via securitization.

At YE15, ending balances of consumer financing were around Rmb10bn, and the average loan size should be around a few hundred dollars USD. Non-performing assets (defined as receivables or loans more than 90 days overdue) accounted for only 0.2% of total volume, and coverage ratio was well over 300%.


Online Payments (~48.5% of total revenue)Revenue model is a commission out of total transaction value. JD payments currently has around 500,000 merchants and 70mm active customers on its platform. The platform had a GMV of Rmb105bn in Q32015 (Rmb60bn on JD’s platform and Rmb45bn outside); this is around 50% of JD’s annual GMV.

This service is currently priced at zero percent commissions as a promotion to third-party merchants. Alipay and Tenpay dominant the online payments market with 50% and 20% share, respectively. Alipay charges 0.7% – 1.2% and Tenpay charges 0.6%.


Valuation Post IPO: Massive Upside Potential

The future growth potential of this business is very attractive as it benefits from a massive total addressable market; China’s SME and consumer financing markets remain in their infancy as the state-owned banks are highly risk averse. Most of the Chinese population is severely under-banked; only 20% of Chinese adults have a credit score from the PBOC.[58] Moreover, the state-owned banks are widely hated, as service in general is atrocious (line-ups at certain bank branches can easily last up to 30 – 60 minutes).

JD Finance’s lower customer acquisition cost (via online distribution) and its rich database of transactions are its main competitive advantages over China’s state-owned banks. Having a longer transaction history with its customers allows JD to better assess credit risk than the banks.

I think we are only in the early innings of the internet disrupting traditional banking in China. Similar to how mobile has leapfrogged PC/desktop, and e-commerce has leapfrogged offline retailing, online banking will eventually leapfrog traditional banking in China. Why is there a need for any physical branches at all if consumers are comfortable with banking online and if the services offered by financial technology companies such as JD Finance have a superior value proposition?[59] The only major roadblock could be stiff regulations; but over time, the rationale for banking services to shift online appears sound.


Lending Segment Growth:

Both the supply chain and consumer financing segments should continue to grow rapidly, driven by increasing customer penetration, larger average loan sizes, and the overall growth of JD’s e-commerce business. Management’s focus right now is on improving risk management over short-term profitability.

In terms of the growth potential of the consumer lending business, Rakuten is a potential benchmark. Rakuten is the largest e-commerce platform in Japan has around 40% of its shoppers using credit cards and outstanding consumer loans represent 30% of its total GMV. I have modelled much more conservative long-term growth and penetration rates for all of JD Finance’s lending segments.[60]

In addition to traditional interest revenue from loans to suppliers, merchants, and consumers, as JD Finance’s customer database grows there is also the potential to expand into third-party credit rating services, which is typically a very attractive, asset-light business with high barriers to entry.


Online Payments Growth:                                                      

This segment also has massive potential as online payments can be a great business with fantastic incremental margins once a critical mass of merchants and payers is achieved. I expect in-house GMV penetration to increase modestly as it is already around 50%.[61] Given JD Payment’s relatively small market share, it is conceivable that once JD Finance is IPO’d out of JD, a partnership or JV with Tenpay could be considered, which would leverage additional synergies from data sharing and greater incremental market power.

Independent Company Valuation:

JD Finance’s business is currently quite synergistic with the core e-commerce business. However, due to the inherent conflicts of interest between the payments division and e-tailing[62], I think it’s inevitable that JD Finance will become an independent, publicly-traded company. Another benefit of separating JD Finance from the holdco is the elimination of the negative drag on JD’s operating cash cycle.

In the event that JD Finance goes public, the value discount assigned by public market investors on this business will likely collapse. I think JD Finance will be a very high multiple business if freely traded, especially if management decides to pursue a more asset-light lending model.[63]

Whether management eventually decides to pursue an asset-light or a pure lending model[64], this business will become more valuable over time. PayPal as a publicly-traded comparable is a dominant online third-party payments operator with a more mature growth profile; it trades at 4x 2016E revenue. I think JD Finance is much better managed than PayPal, and has a much more attractive long-term growth profile. At 5x 2020E sales of $2.9bn, JD Finance could potentially be worth closer to $14.5bn by 2020, or $12.3bn post-dilution to JD equity holders.[65]


Management & Corporate Governance:

  • Founder & CEO Background: A Rare Breed

“Investing in a project is primarily investing in a person, and I have spent a lot of time looking for a Killer entrepreneur. For my first meeting with Liu Qiangdong (Richard Liu), I noticed his computer whereon he had written “The Best or Nothing”, which convinced me that he was just the person I had been looking for. Liu Qiangdong started up his (first) business ever since his campus life. In my eyes, one that starts up business on campus is rarely driven by his own desire for fame or money but by his born nature of entrepreneurship. Furthermore, an entrepreneur on campus must be brave and good at personnel management. Liu Qiangdong was a social science major and taught himself programming. Having no computers of his own at that time, he had to take a bus for one or two hours to a relative and waited for an opportunity of doing programming exercises on the computer until the evening when the workers came off duty. After he learnt it he programmed for others and made profits thereby. Later he opened a shop at Zhongguancun where he sold more CD writers than any other peer, and the situation was likewise good for his CD business later. His experiences impress me with his cleverness and entrepreneurship. In addition, he is also an honest man who tells you everything instead of the flattering remarks only, which pleases me a lot.”

– Kathy Xu, Capital Today


In a market with a reputation for spawning frauds and atrocious corporate governance, JD stands out with an exceptionally high-integrity CEO with great respect for the interests of minority shareholders. I believe the best way to illustrate Richard Liu’s character is through sharing stories that revolve around how Liu has dealt with JD’s major stakeholders in the past. Many of the stories below are rough translations from the book “The Founding of JD.COM”, a biography on Richard Liu and the JD story (the English version of the book, “The JD Story: An E-Commerce Phenomena”, is coming out in September and available for pre-order on Amazon).


High Integrity:

Early CD business

When Richard started his CD business, he had no supplier relationships, no capital, no customers and no team. He started everything by himself, insisting on selling genuine, branded products, and refusing to bargain with customers. The business grew mostly through word of mouth as the customers felt his prices were reasonable and he was one of the very few vendors who did not sell knockoffs, even though at the time it was very easy to produce knockoff CDs – all one had to do was print a logo on an empty disk and replicate the cover. The gross margin of selling knockoffs was multiples of that of retailing the real product.

One of the early practices that he insisted on was issuing receipts to customers (which the counterfeit sellers never issued for fear of being busted by the police). Every order would be followed up with a receipt to prove to the customers that they were getting the real deal. When the company was once audited by the government for three days, officials were surprised to find not a single dollar of evaded taxes (VAT), zero knockoffs and zero counterfeit CDs.


Private Round with Tiger Global

In 2009, Tiger Global offered to invest in JD at a $200 million valuation. Richard took the proposal to the board, and after some discussion decided to counter propose with a $250 million valuation. After Tiger immediately took the offer, Richard realized that they got lowballed and Tiger must have had much better expectations for the business.

At the time JD was in discussions with another fund for the financing round. That fund offered to invest at a $300 million valuation; if JD accepted that offer instead, the dilution would be less severe than Tiger’s deal.[66] One of Richard’s executives argued that since the agreement with Tiger was only a verbal promise and had not been set in formal writing, they should take the superior offer instead. Richard refused: “Great leaders must all fulfill their promises. If your words mean nothing, how can you lead a company?” At the end, JD took Tiger’s investment.

Tiger learned about this episode shortly after, and proposed an additional investment at a $700 million valuation (presumably because they felt bad and to make up for the difference). Richard replied by saying that JD didn’t need any more money and if Tiger wanted to increase its stake they would have to buy shares from other shareholders instead.


Capital Today

In 2008, some people (presumably investment bankers?) proposed to Richard a scheme to push out Capital Today as a minority shareholder, which would deliberately lower the valuation of JD and allow Richard to issue a ton of stock to enrich himself. Richard again refused: “Capital Today helped JD get through its most difficult period. I must honor the agreement I signed.”

Capital Today was JD’s first outside investor. Kathy Xu, Capital’s Today’s founder, once told Richard that she would be happy to make 10x on her JD investment. Richard told her that he wanted her to make at least 100x. Upon JD’s IPO in 2014, Capital Today ended up realizing a 160x return on their investment.


Hillhouse Capital

Hillhouse’s Zhang Lei and Richard Liu met at an Internet conference in late 2009. Both had been graduates of People’s University in Beijing. After Richard gave a talk at the conference, Lei approached him asking if he needed capital. “Of course, but most venture capitalists don’t understand me.” At the time, investors favored businesses that were capital light (like Alibaba’s marketplace model), and most internet entrepreneurs built their businesses that way to appeal to investors. Richard refused to characterize JD that way: “JD is capital heavy. The only way to ensure that the customers can get the best service quality is to be capital heavy and control the delivery process.”

Lei found Richard’s candidness to be rare, and decided to make an investment after chatting with him for just two hours. Lei asked Richard how much cash he needed; Richard asked for $50-$75 million. “Either you let me invest $300 million, or I won’t put in a cent,” Lei replied. Allowing Hillhouse to make that large of an investment would make the hedge fund JD’s largest shareholder. The end solution was to allow Hillhouse to invest $265 million, and Richard would retain control over the board through super voting rights.


Conservative, but also Ambitious:

Capital Today Investor Agreement

In the original Capital Today investor agreement, there was one contingency term where if JD achieved certain growth targets, Capital Today would give away some of their shares to JD executives as a bonus. A partner at Capital Today phoned up Richard asking to set near-term sales targets. Richard’s original proposal was this: Rmb 350 million in sales by 2007, and Rmb 1 billion by 2008.

These were almost unthinkable milestones at the time because JD had only generated Rmb80 million of revenue in 2006 and the targets effectively implied that they would grow 4x in one year and another 3x the following year.are you kidding me?” The partner thought.

Capital Today became concerned that the company wouldn’t achieve those targets and would in the process hurt morale, and therefore negotiated a more reasonable plan whereby JD would aim to double its revenue consecutively every year for the next four years. In reality, JD achieved Rmb 360 million of sales in 2007 and Rmb 1.3 billion in 2008, handily exceeding both of the original targets that Richard proposed.


“Even if JD can get 100 points (in performance), we would tell our investors that we forecast 80, 90 points. It’s better to be a little conservative, even if that means in the short run our stock only reflects 80, 90 points. We will know that the company is really 100 points when our results come out and speak for themselves. Conservative communication is key to building investor trust and confidence. The only thing we care about is maximizing the long-term value of the company, not maximizing the short-term stock price.”

– Sidney Huang, CFO


Reported Numbers Unlikely Overstated:

It can never be guaranteed to non-insiders, but based on these stories, I find it highly unlikely that JD is a fraud. What’s more likely is that Richard is one of the most impressive entrepreneurs and CEOs in China, and has higher ethical standards than the vast majority of Fortune 500 or S&P 500 company CEOs.

Moreover, now that JD is a publicly-traded, SEC-registered company, any shareholder unfriendly actions would be much more heavily scrutinized and likely a greater blow to Richard’s reputation than if the company was still private.

In fact, even during the company’s early days, in order to ease investor concerns over the company’s finances, Richard would let investors pick a random week and mail all of that week’s reports to the investor straight from the ERP systems. The logic was that no company could fake data 365 days a year and it was extremely unlikely that Richard would get weekly reports containing fake data. JD had no audited financials during that period as they couldn’t afford an auditor yet. PWC is now JD’s auditor, and they are by far the best auditor in China.

JD’s direct-sales competitors (Dangdang, Suning, Gome, and Amazon China) are all struggling in terms of performance (and they have no incentive to report bad numbers), suggesting to me that someone else has to be doing well. In contrast to Amazon, there is a lot more disclosure of KPIs and relevant operational metrics contained in the 20-Fs, including: reported GMV, the number of merchants, suppliers, SKUs, orders, and annual active customers.

Finally, Richard is not an empire-builder. He cares deeply about maximizing shareholder value per share given that he respects the company’s minority shareholders as illustrated by his past actions. He certainly cares about growth, but not growth at any price. And he definitely cares a lot about profitability.[67] As a result, I think he is less likely to pass on an excess of economic surplus to consumers like Jeff Bezos of Amazon and Costco may have, for example.


  • Company Culture: Militaristic, Familial, and Performance-Oriented

“If we don’t work hard today, tomorrow we will go bankrupt.”

– company saying


Part of understanding how JD was able to beat its early competitors such as Amazon and Dangdang (who were among the earliest entries into China e-commerce) is by studying its culture.

First of all, hiring the right people is extremely important. Hiring the right people, and training them well reduces employee turnover, which in turn reduces costs. JD specifically looks for recruits from a working class background who are fresh out of college for their management trainee program (candidates are not allowed to have prior work experience). Management trainees are actually sent to military school for their first week of training, and must perform delivery duties for their first six months to learn the basics of the business.

Fast execution, and accountability are very important. Similar to the key ingredients of success at FedEx and UPS, (which are both asset-heavy, logistics businesses with large express delivery divisions), perfecting a supply chain requires timely execution and an employee workforce that operates like a military unit. In addition, other similar aspects between FedEx/UPS and JD include the fact that these companies almost always promote from within (lifetime employment is common), employees hold a lot of stock and everyone has equal respect, regardless of rank.

Layered on top of JD’s ruthless efficiency is a maniacal focus on customer experience. JD has a delivery policy labelled “211 program” where the company guarantees that items placed before 11 AM are delivered before 6 PM on the same day, and items ordered after 6 PM (before 11 PM) must be delivered to the customer by 11 AM the next day. There is no E-Commerce company anywhere in the world (including Amazon) that is able to match JD’s delivery speed. Delivery personnel are required to build relationships with customers; receiving over a certain number of complaints would result in automatic dismissal for the delivery person. Likewise, if a customer complains about receiving counterfeit products, when verified, the purchasing manager responsible for sourcing the product is automatically fired.


“ features strong execution….Once we attended a meeting lasting from 9:00 am to 6:00 pm. After the meeting was over, everybody rushed to the front of the meeting room to see a PC screen. I wondered what they were looking at and then found out that all the 68 issues discussed during the meeting were shown on that screen, attached with the respective persons in charge and deadlines. I think that this is what makes outstanding. While Liu Qiangdong was studying at Columbia University, his team was still as efficient as before during telephone conferences.”

– Kathy Xu, Capital Today


Having the right system and culture in place has allowed JD to scale up its operation at an astonishing speed without compromising quality. In the last eight years alone, JD has expanded from a 50-personnel company to an 110,000-employee powerhouse. I am aware of no large company in the world that has expanded so fast in such a short a period of time, especially when the task involves the complex integration of large white-collar and blue-collar workforces into one cohesive, high-performing unit.

A picture speaks a thousand words…

A picture speaks a thousand words…


  • Track Record: Strategy and Capital Allocation

Up until this point, Richard has largely made all the right long-term strategic decisions for JD, despite some of these decisions not being very easy to make, or even against the view of major investors. Here’s a summary of some of the key events/decisions made by Richard throughout JD’s history:

-The decision to shift the entire business online in 2004. This was done in spite of the fact that 95% of the revenue of JD at that time were in brick & mortar electronics wholesale. I think the decision to forgo all that short-term profitability and have the vision to see where retailing was ultimately going to is incredibly impressive.

-The decision to invest heavily in logistics starting in 2007. This decision was against the advice of a major investor, but Richard saw the need to own an in-house logistics network in order to provide a higher-quality delivery service to customers. The logistics business has turned out to become a great asset and a key competitive differentiator.

-The decision to expand JD’s product categories beyond electronics in 2008. This was also against the advice of a major investor, likely because of the executional risk of holding new inventory in additional categories that have non-standardized SKUs.[68] In retrospect, diversifying the overall product sales mix away from electronics was a very wise decision, and this shift remains on-going.

-The Strategic Partnership with Tencent completed in 2014. I will discuss this deal in greater detail in the valuation section. In general this was a fantastic deal that just made all the right sense in the world, and was brought up originally by one of JD’s large investors.


“Over a decade since the inception of the company, Liu Qiangdong’s most correct strategy was to increase stock keeping units (“SKU”). Particularly, selling books was a very shrewd move, which cut down the average transaction value (“ATV”) at not too much cost, and thus lowered the threshold for the first shopping experience of a new customer to The ATV for IT product sales is around RMB 800, which makes a new customer hesitate as he might doubt the authenticity of the product. However, if the customer buys a book at about RMB 80, he faces a lower threshold. Besides, if he feels highly satisfied with the extremely fast delivery of the book, he will immediately make his second purchase.

When increasing SKUs, we worried about the adequacy of our capital. However, Liu Qiangdong stuck to the strategy rather determinedly. At that time, although I agreed with him, I was still afraid that our capital chain might break, because our money was not that much and a loss was to be initially suffered for each SKU added. Finally, Liu Qiangdong insisted on increasing SKUs before we ran out of money. The second correct strategy was Liu Qiangdong’s inception of warehousing logistics business when the company received its second investment. At the time, Ma Yun, Executive Chairman of Alibaba Group, was not willing to be engaged in any capital-intensive asset business like warehousing logistics. Therefore, embraced a three-year non-competition period. Liu Qiangdong implemented this strategy very persistently, because 70% customers were not satisfied with delivery services. At the beginning (of the company’s warehousing logistics business), we were suffering huge pressures, because a delivery center was to be set up for each city newly covered by our network. As a matter of fact, the company was suffering losses for only 20 orders per day in a city. It would not break even until 2,000 orders were received per day in a city. Nevertheless, it took a long time from 20 to 2,000 orders per day in a city. Being suffered for six months in some cities and for a couple of years in some others, the losses totaled a tremendous amount when 30 cities were covered. Liu Qiangdong, with firm conviction and really far sight, has realized the necessity of warehousing since very early.”

-Kathy Xu, Capital Today


I think these decisions indicate that Liu is open-minded and willing to listen to the advice of JD’s long-term investors, yet he is also intellectually independent in being able to exercise his own judgement when making the right decisions for the business despite when at times hearing differing views from his investors. In my view, this is a rare combination of traits in the business world.


  • Compensation Structure / Incentives:

Richard’s incentives are properly aligned with shareholders and for long-term value creation. He founded the company and is an owner-operator who holds around a 20% stake of the equity (valued at ~$6.7bn). Richard has sold very little stock since the IPO in 2014.

In 2015, Richard was granted 13mm ADR options at a $33.40 strike price, subject to a 10-year vesting schedule with 10% of the option values vesting every year. A 10-year vesting schedule is quite a long time-horizon in the realm of typical executive compensation, and indicates that the CEO and the board, like they have been, are focused on long-term value creation. In addition to this option grant, Richard virtually gave up all his cash compensation for the next 10 years. He now takes an Rmb1.0 annual cash salary with no annual bonus. Employee compensation is also heavily tied to the long-term performance of JD shares.

Interestingly, JD recently introduced two new KPIs for 2016 – operating profit and cash flow days (AP – days inventory days). Prior to these new KPIs, net GMV and total revenue were the main KPIs in which managers were incentivized on as part of their annual compensation package. The new KPIs for 2016 potentially mark a shift from focusing on top-line growth to profitability.


Valuation & Key Growth Drivers:

TAM is Massive:

Big picture, the overall macro themes driving this story are simple, powerful and inevitable:

  1. Chinese consumption is growing 10%+ per year. Savings represent a whopping 50% of China’s GDP, by far the highest of any major economy in the world. Consumption, which is the inverse of savings, is only 37% of GDP. As was the case with Japan in the early 1970s and Korea in the early 1990s, when middle-income countries start making the transition into developed economies, consumption growth generally accelerates on the back of slower overall GDP growth. China is no exception to that trend. While consumption is less than 40% of total output, incremental consumption growth currently accounts for 60-70% of incremental GDP dollars.
  1. Online shopping penetration is increasing. Unlike most developed economies where brick and mortar retail had a 50-100 year development lead over E-commerce, China’s brick and mortar retail industry started at the about the same time as E-commerce (late 1990s vs. early 2000s). Critically, this means offline retailers never had the chance to build up significant scale and supply chain advantages over their online counterparts. This has allowed E-commerce to leapfrog at a speed that far outpaces the West. China also has a number of idiosyncratic characteristics that greatly benefit E-commerce, such as a high urban density (everyone lives in apartments which lowers delivery cost dramatically), urban pollution (discouraging people from shopping outdoors), and infrastructure imbalances (much worse traffic, huge shortage of urban parking space). Over the next 15 – 20 years, I expect the great majority of Chinese retail consumption to move online.
  1. Barriers to entry in online retail are much larger than offline. Alibaba and JD on a combined basis control close to 90% of the E-commerce market and are gaining share at the expense of tier 2 players. On top of that, JD is taking share from Alibaba (especially Taobao), having grown its GMV at roughly 2-3x the speed of the larger rival.


Internet penetration in China is around 50%, and online shopping penetration is around 60%. With nearly $70bn in reported GMV in 2015, whether you use total online shopping GMV[69] ($640bn in 2015), total retail GMV[70] ($4.6 trillion in 2015), or B2C GMV ($342bn in 2015) as a proxy for JD’s TAM, the growth runway is enormous.

If we take China’s B2C GMV as a proxy for JD’s TAM (most conservative), JD’s current market share is 20%. By 2020 I think total B2C transaction volume can top $1 trillion USD (assuming a mid-20’s 5-year CAGR)[71], and JD with its higher growth profile can increase its total share closer to 27%. At the same time, it should be able to extend its existing massive lead on the direct-sales side.


Key Operational Metrics:

Robust annual active customer growth and an increased frequency of annual orders per active customer will be the main drivers of JD’s net GMV growth. I estimate that customer-level IRRs are already well into the triple-digits.

As new customers develop stronger online shopping habits over time, their annual frequency of purchasing online gradually increases. JD’s 2008 cohort of active customers, for example, have ramped-up their annual frequency of orders from 3.7 annual orders in 2008 to 21.8 in 2015. In addition, an expanding selection of products on JD’s platform will likely lead to an increased frequency of purchases. It isn’t difficult to imagine JD’s total active customer base making online purchases at an average of once per month (or 12x per year) by 2020 from 8.1 annual orders today.[72]

Assuming that JD’s annual active customer base grows at a mid-20’s CAGR over the next 5 years, (from 155mm in 2015 to 450mm – 500mm by 2020) JD’s penetration of total internet users and online shoppers in China will remain at relatively modest levels of 45 – 55%.


Strategic Partnership with Tencent[73]: Mobile-driven Customer Growth

The strategic partnership with Tencent completed in 2014 has accelerated JD’s GMV growth profile by providing convenient access[74] to JD’s shopping app for Tencent’s large base of WeChat and Mobile QQ users.

Mobile application technology has revolutionized the way people communicate and Tencent owns the premiere online communications/social media properties in China. WeChat in particular is a rapidly growing, mobile-only, ubiquitous social media/communications app with nearly 700mm MAU as of 2015YE. As mobile’s total share of internet usage continues to grow, more time is increasingly spent on “Super Apps” such as WeChat that have considerable consumer mindshare. WeChat has brilliantly integrated a highly frequent[75], high-utility activity (communicating online) with local life services[76] within its own app. In essence, WeChat can be thought of as a portal to the mobile internet since it has its own set of integrated third-party apps on its sticky platform – or an app within an app.[77]


I expect JD’s penetration of WeChat and Mobile QQ’s users to continue to increase over time on the back of increasing mobile penetration, which should help drive robust customer growth for JD.[78] In Chinese rural/lower-tier cities, mobile adoption has largely leapfrogged PCs, and these under-penetrated markets will be large growth avenues for JD.[79] Over the past few quarters, WeChat and Mobile QQ accounted for roughly 20%-25% of the incremental growth of JD’s customers.


For a summary model of the relevant top-line projections, please see Appendix 8.


Valuation Summary:

Valuation Summary


At $24.22 per share, JD has a market capitalization of $33bn and a TEV of $28bn with a strong net cash position. If we back out JD Finance’s valuation based on its latest PMV, JD’s TEV is closer to $22bn.[81] JD also holds a portfolio of non-core, hidden growth assets and stakes in publicly-listed equities.

The public cloud infrastructure business remains at a nascent stage. Richard hopes that this unit becomes a meaningful revenue and profit stream in a couple of years. Given the massive economies of scale required, it is possible that JD will eventually form a JV or partnership with Tencent’s much larger cloud service unit. The industry itself is attractive for scale players such as Alibaba, and given its early stage will likely grow at 100-150% per annum over the next several years.

JD Home/Daojia is also an early-stage growth business and has an Uber-like, on-demand business model. Launched in April 2015, JD Daojia is an online-to-offline (O2O) delivery platform that provides consumers with two-hour delivery of goods from local supermarkets with its location-based app. A few weeks ago, Daojia and Dada Nexus (China’s largest crowdsourced delivery network) agreed to merge, which will further increase local economies of scale as the two delivery networks combine assets. JD will hold a 47.4% stake in the new pro-forma company. Please see Appendix 5 for a brief overview of my notes on JD Home/Daojia.


Summary of my estimates of the current value of public equity stakes and privately-held “non-core assets”:


Model Drivers: Net GMV Growth and EBIT Margin

In 2015, JD’s core business reported $69bn in reported/gross GMV, which equates to roughly $47bn in net GMV assuming a mid-teens combined return and cancellation rate and 15 – 17% VAT taxes. I am modelling a net GMV[82] range of $175 – $225bn by 2020 (assumes a 30 – 37% 5-year CAGR range, with 3P GMV growing faster than 1P).

The great thing about this idea is that as long as I’m directionally correct on the key business drivers, I believe a permanent loss of capital over a 5-year time horizon is a remote possibility; whether JD turns out to be a $100bn or $300bn net GMV business in 2020, the margin of safety afforded by the current valuation is massive. To highlight how ridiculously undervalued the equity currently is, just the total FCF generated over the next 5 years alone could make up more than 120% of the total current enterprise value today. This is a great benefit of owning a business that operates with an increasingly favorable working capital position over time.[83]

Richard Liu has stated that he hopes to achieve a similar margin profile to Walmart long-term. I think a 3 – 5% operating profit margin range as a % of net GMV would be a very realistic margin profile for JD 5 – 7 years from now.


Base Case:                                                                                                          

JD is a $200bn net GMV business by 2020, and earns a 5% operating profit margin on net GMV (~$10bn in EBIT). At an 18x EBIT / ~25x maintenance FCF exit multiple[84], along with adding the current value of all the public investment stakes/non-core assets, (with the exception of adding the projected 2020 value of JD Finance) and summing the incremental FCF that will be generated in the interim, JD shares could potentially be worth $160 by 2020, providing a total return of 570% and a 45% IRR over a 5 year period. Note that this valuation assumes that all the FCF generated over the next 5 years (around $26 – 27bn) will accumulate on the balance sheet at a 0% reinvestment rate.


Please see Appendix 7 for my detailed base-case modelling assumptions.


This target valuation implies an EV / net GMV multiple range of 0.8x – 1.0x in 2020, which appears quite reasonable relative to offline and online retail comps that frequently trade at similar or even higher multiples even though they may be operating in shrinking or very mature growth environments. Post terminal year, JD’s GMV can easily double again over the following 5 successive years given the massive growth runway.

JD’s return on incremental invested capital is also improving over time.[85] If we back out the excess cash that will build on the balance sheet, returns on capital approach infinity.


Cyclical risk is also minimal as growing internet and e-tailing penetration will greatly outweigh any short-term economic weakness, along with JD being able to take market share from weaker competitors in a more challenging economic environment. The balance sheet is also very conservatively managed.

These factors alone suggest that a 25x multiple on 2020 earnings power could be severely undervaluing the equity.


My Base Case Numbers vs. Street Consensus:


Grand Slam Scenario:

For a business operating with huge barriers to entry, high returns on invested capital, and a secular growth profile more attractive than all of its relevant publicly-traded peers, I don’t think a 50x multiple on 2020 earnings power is an unreasonable assumption.[86] Assuming a 6% margin on net GMV of $225bn, JD could be earning $10bn in maintenance FCF by 2020. On a 50x multiple or 2% yield ($500bn valuation or 37x 2020E EBIT), JD shares could be worth $400/share by 2020 for a total 5-year return of 1,500%.

Maybe this isn’t a 50% probability, but it’s definitely not zero either.

The highest-quality compounders (led by the top management teams) are typically perpetually undervalued by the market because investors fail to price-in future value creation from leveraging a powerful flywheel or sustainable competitive advantage to expand into untapped and adjacent markets with considerable TAM potential. Customer and transaction data, for example, are typically under-appreciated intangible assets that high-quality compounders use to expand into new markets.


Downside Case:                                                                                                                         

If JD only earns a 3% operating profit margin (low-end of Liu’s target) on $175bn of net GMV, (around $5bn of EBIT by 2020), the stock trades at less than 5x 2020E EBIT. I think JD will still likely generate at least $15bn of FCF over the interim years in such a scenario. As a result, the shares could still compound at 25% per annum on a reasonable 15x exit multiple on EBIT.


What can go wrong? / Key risk factors

  • Political Risk / Adverse Regulations. JD shares are listed on the NASDAQ as an ADR via the VIE holding structure, which is essentially a legal loophole used by domestic Chinese companies to allow foreign investors to invest in their securities. The concern here is that the Chinese government may potentially nationalize the value of foreign investors’ holdings in these securities.


First of all, let’s think about what would happen to China if they actually wiped out foreign investors by eliminating the VIE structure and not replacing it with an alternative: 1) It would cause permanent collateral damage to China’s international reputation, 2) All domestic Chinese companies will likely become uninvestable for foreign investors, which means they won’t be able to ever raise any foreign capital (this would likely cause considerable damage to domestic financial markets and the general health of the Chinese economy), 3) Since this is akin to seizing the assets of foreign investors, there will likely be a massive retaliatory response from major economies globally; this could range anywhere from a trade embargo to more serious measures. With such adverse potential outcomes, why would President Xi even consider such a move?

It is also important to note that this structure has been around for well over a decade, which suggests that the Chinese government has de facto endorsed it. So unless you think WW3 is going to happen (which means you probably don’t want to be invested in any Chinese ADRs), I don’t see forced nationalization of foreign capital as a viable solution, and likely an extremely remote possibility.

What’s more likely is that the government will either eventually formalize the legality of the VIE holding structure, or reform it (propose an alternative structure whereby foreigners can legally invest in Chinese ADRs), or simply leave it alone. The reason the VIE structure exists in the first place is because the Chinese government doesn’t allow foreigners to have control over domestic technology companies (the internet sector is deemed critical to national security). Public opinion is currently being gathered regarding the treatment of VIEs, and progress towards a favorable solution to all parties appears promising.

JD’s business is also not a politically-sensitive one. In fact, adhering to a business model of only selling authentic products to consumers seems like a very honorable one, particularly in China. JD’s value proposition to Chinese consumers is massive. Customers in general love the business, and as a result, the company has substantial political capital. In fact, JD could be the perfect role-model for how a business should be run in China from an ethics point of view.


  • Massive tail-risk event of major Rmb Currency Devaluation. (If your base currency is not Rmb.)

Mitigant: This risk could be easily hedged out (at a relatively low cost) by shorting the entire Rmb exposure proportional to the size of the investment.


  • Key Man Risk – Richard Liu is very important to the business.

Mitigant: Liu is only 42 years old, which means he can potentially be CEO for a very long time to come (though at 42 he already has more than 20 years of business experience). As such, his youth is a massive advantage, similar to how a young investor has a long runway for compounding knowledge and capital.


  • The share price is depressed, and insiders know it. There is always the risk of a management buyout to take the company private at a depressed valuation, and then re-list in the A-share market (at a presumably higher valuation) in an arbitrage-style transaction. Competitor Dangdang, for example, is looking to go down this route.

Mitigant: Given his track record, I trust Liu to not screw over minority shareholders. He has stated specifically that he understands the stock may be undervalued from time to time, and that easy money can be made by going-private and engaging in valuation arbitrage, but he rather focus his time on improving the business.


“Real entrepreneurs build value by creating real products, not by financial engineering.”

– Richard Liu, Founder & CEO


Event Path / Catalysts:

Timing is always tricky, but I think the set-up looks particularly attractive post the next 6 – 9 months. My numbers are materially higher than Street estimates over the next few years, and the shares should re-rate and compound accordingly over time. Over the very near-term, if you care, the stock will likely trade on reported Revenue/GMV figures, and along with general Chinese equity market volatility, but really, who knows?

Richard has stated that he expects to spin-off at least 2 listed companies in the future (most likely JD Finance and JD Daojia in my view). A good portion of shares in these subsidiaries will be allocated to employees.

  • Early 2017 timeframe: IPO of JD Finance in the A-share market. This would provide a clean set of reported financials for investors to value JD Finance independently. Separating JD Finance will also remove its associated losses off JD’s reported earnings and remove the negative drag on working capital.
  • By the end of Q2, de-consolidation of the O2O unit JD Home/Daojia post-merger with Dada, which will remove current losses off the reported PnL statement. In the event that this business gets separated from the holdco, it will likely trade at a very high multiple.[87]
  • Eventual de-coupling of the performance of share prices between large-cap Chinese internet stories vs. the general Chinese equity market. Recently reported earnings from large-cap, high-quality, internet-based growth stories (eg. JD, Baidu, Tencent) have remained very strong and above Street expectations in light of a slowdown in Chinese economic growth, indicating that the Chinese service economy and consumption spending remains robust. The market may eventually better appreciate the resiliency of these earnings as they continue to roll-in over the next several Qs, and appropriately re-rate Chinese large-cap internet names higher.
  • My belief is that one of the best times to generally own a stock (especially one that reports negative earnings) is when margins are on the verge of a major inflection point.[88] Starting in 2017, I believe JD is on the verge of a prodigious multi-year ramp-up in free cash flow generation.


Summary Conclusion

JD carries the rare, perfect trifecta of characteristics that are typically highly sought after in an investment idea: a phenomenal CEO/management team, a stock price reflecting severe undervaluation, and a fantastic business model with earnings power growing at an attractive rate over time. As a bonus, it has a patient, long-term fundamentally oriented shareholder base that is able to provide smart strategic advice to management.

I am extremely challenged to find a more attractive long-term investment opportunity in the markets today, and suspect I won’t for a very, very long time.

Buffett has talked about facing the choice of investing only in a handful of opportunities within one’s lifetime. For long-term fundamental investors, I think JD qualifies as a real punch card investment.



  1. Chinese Online Shopper Survey


  1. Price Comparison Results


  1. Third-Party Logistics Customer Satisfaction Score


  1. Brief Overview of Main 3P Logistics Competitors


China Smart Logistics/Cainiao:                                              

Cainiao was established in May 2013 and is a joint venture between Alibaba, Intime Retail, Fosun International and several other 3PL firms. It aims to provide up to 24 hour nationwide delivery once the order is placed online in 2,000 Chinese cities. Cainiao is a bit misunderstood by most investors; the business does not provide any line-haul or last-mile delivery services. Instead, Cainiao is essentially a 4P logistics business: it leverages big data from the Alibaba ecosystem of customers and merchants to improve logistics efficiency with third-party logistics firms.


Recently, Cainiao has started investing more heavily into fulfillment centres/warehouses to meet the growing e-commerce demand. On average orders on Tmall can take from 2 days to 1 week to reach the customer.


Cainiao assets:

Provinces covered: 31

Delivery stations: 97,000

Delivery personnel: ~1.5mm

Collection points: 25,000


Premium Express Operators: SF Express

SF Express dreams to become a Chinese FedEx, trying to build a ‘premium quality’ image. SF Express offers free shipping for any order over Rmb199, for orders below Rmb99, delivery fee of Rmb10 per order is charged.



EMS has the broadest nationwide logistics coverage; however, due to its state-owned background, it is not very service friendly and is the most expensive.


SF Express assets:

Workers: 340,000

Transport vehicles: 12,000

Service centres: 12,000

31 provinces, 900+ cities, 1,900+ counties

2014 express volume (mm): 1,200 (1.2bn orders)

Market share: 9%

Customer satisfaction score: 83.9

-building four cold-chain warehouses in Beijing, Guangzhou, Jiaxing, and Xiamen


EMS assets:

All cities and counties covered

45k storefronts, 105,000 employees, 36k vehicles; 2014 express volume (mm): 1,200, 9% market share, customer satisfaction score: 80.1


“Four tong one da” – Shentong Express, Yuantong Express, Zhongtong Express, Best Express (Chinese name contains tong) and Yunda Express are a group of second tier express delivery firms with a focus on e-commerce orders. They are similar in scale and strategy and each operator employs 50-200k workers with 7-15k service centres. logistics assets: (as of Dec 2015)

Fulfillment centers: 7

Nationwide coverage: 31 provinces, 2,356 counties and districts

Delivery / pickup stations: 5,367

Next-day delivery as % of direct-sales: 85%+

Over-the-road vehicles: 58,000

Warehouse GFA: 4mm sqm

Warehouse staff: 15,765

Delivery Staff: 59118

Total Warehouse and Delivery personnel: 74,883


  1. JD Home/JD Daojia

“In the past, we changed the way our customers shop; in the future, we want to change the way our customers live.”

– Richard Liu, Founder & CEO


Brief Notes on JD Daojia:

-Daojia is a location-based services (LBS) enabled O2O app which provides local services including supermarket, food delivery, flower delivery, laundry and home cleaning services and uses crowd-sourced delivery network

-Daojia serves 12 cities, and its GMV is less than 1% of JD’s total GMV

-This is a high frequency volume generating business, which create cross selling -opportunities as well as provides JD an opportunity to strengthen its big data capabilities

-Valuation proposition for merchants is to help them increase sales via O2O channel

-company will have a revenue sharing model with supermarkets in the future

-JD announced partnership with Yonghui Superstores and have subscribed for ~10% of Yonghui’s shares for Rmb4.3bn

-they also have a small stake in, a food delivery service

-JD Daojia does not own the products or services provided by 3P merchants, and only handles the fulfilment portion of the service

-JD is currently building its own cold chain supply network

-premium/high-end groceries are sold and fulfilled by 1P/cold chain logistics (similar to Amazon Fresh)

-Google Express is a similar O2O service that partners with large B&M such as Walmart, Target and Costco

-The average Chinese city is quite dense with heavy traffic; for eg. Shanghai has a population of over 20 million, which is greater than the entire population of greater New York

-Dada specializes in last-three-kilometer delivery


  1. Key Operating Drivers and Unit Economics


  1. Long-term Financial Model


  1. Top-down Projections


  1. Working Capital Schedule



In the production of this paper I’ve taken either quotes, information, or insights from the following books:

  • Kissinger: On China
  • The End of Copy Cat China: The Rise of Creativity, Innovation, and Individualism in Asia
  • China’s Super Consumers: What 1 Billion Customers want and how to sell it to them
  • China’s Disruptors: How Alibaba, Xiaomi, Tencent, and Other Companies are Changing the Rules of Business
  • Changing how the world does Business: FedEx’s incredible journey to success
  • Leadership Lessons from a UPS Driver
  • Alibaba: The House that Jack Ma Built
  • Sam Walton: Made in America
  • East-Commerce, A Journey Through China E-commerce and the Internet of Things: A Journey Through China E-commerce and the Internet of Things
  • The Founding of JD.COM (Liu Qiangdong’s Entrepreneurial Journey)



[1] A term coined by Jim Collins, think of Amazon as an example

[2] Net GMV is reported/gross GMV net of returns, order cancellations and VAT related charges

[3] General merchandise items such as apparel, baby, cosmetics and home products likely exhibit gross margins closer to the mid-teens range, or at least 2-3x electronics GM

[4] Suppliers/wholesalers tend to purchase branded display ads, whereas third-party merchants tend to purchase performance-based ads; advertising revenues are roughly split 50/50 between merchants and manufacturers/wholesalers/re-sellers

[5] JD Finance also provides online payments services to customers outside JD’s platforms

[6] Average inventory days is for the core e-commerce business, which includes any effects from JD Finance

[7] To ensure product authenticity, stringent background checks are conducted on each 3rd party merchant or supplier which includes, qualification certificates for products, examining business license and on-site visits

[8] Packages delivered by low-tier third-party logistics firms are generally at greater risk of being damaged or late

[9] According to a recent customer survey conducted by RedTech Advisors, approximately half of Chinese online shoppers have experienced purchasing a fake product

[10] JD started investing in its logistics network in 2007 after Richard Liu learned that 70% of JD’s customers were dissatisfied with subpar quality delivery services from third party logistics firms.

[11] Alibaba has decided to outsource last-mile delivery to third-party logistics firms via their JV Cainiao

[12] JD as an online shopping platform has built substantial consumer mindshare as a trusted site that sells authentic products

[13] RedTech Advisors, a reputable research firm, conducted surveys to weigh the importance of price, product authenticity, delivery service quality and selection in online shopper’s minds

[14] Morgan Stanley also recently conducted a global survey of over 10,000 online shoppers indicating that free shipping is the biggest attraction to shopping online. According to a global survey by PayPal, Chinese online shoppers are among some of the most demanding in terms of delivery time, averaging a “delivery tolerance period” of about 5.5 days



[15] According to a recent survey conducted by research firm RedTech Advisors, Taobao was the source of nearly 80% of fake products purchased by online shoppers, and the source of 73% of products which were returned

[16] RedTech Advisors recently conducted a survey of Chinese online shoppers showing that Tmall was the source of 19% of fake products

[17] I am aware Alibaba has other businesses outside of e-commerce such as cloud computing services and internet finance

[18] Buffet as stated that “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

– 1992 Berkshire Hathaway Annual Shareholder Letter

[19] For example, the top 20 B&M retailers in China have a 12% share vs 40% for the US

[20] In fact, e-commerce penetration levels are already higher in China than the US

[21] Suning and GOME have been closing down stores and pushing aggressively into online sales channels

[22] This has allowed TJX to scale a repeatable business model over higher volumes and achieve significant cost efficiencies over time

[23] Richard Liu tweeted on Weibo in late 2012, translated: “Tonight, once again I made the decision to sell big home appliances at 360buy at zero gross margins for the next three years… Within these three years, any employee found to sell at marked-up prices will be fired… I assure you that the prices of large home appliances sold on Jingdong will be at least 10 percent lower than those in the Gome and Suning stores… Starting 9 am tomorrow morning, all big home appliances at 360buy will be sold at cheaper prices than those from Suning, both online and offline. There will be no bottom line. If Suning dares to sell at 1 yuan, then 360buy will surely sell at 0 yuan. To those who plan to buy big home appliances, you will lose money if you don’t follow 360buy.” 

– Richard Liu, Founder & CEO

[24] JD has a “100-minute policy”: If a customer has any complaints about a product, a delivery person will be back at his doorstep within an hour and 40 minutes after the complaint is lodged.

[25] JD can also hold a greater number of SKUs, and have faster inventory turns than offline competitors; this contributes to JD’s lower cost structure

[26] JD started off primarily selling electronics items online, and now as a more mature category it is growing at a slower rate. Coming off a lower base, home appliances and general merchandise categories have higher growth potential and were introduced to the platform several years after electronics around 2010.

[27] Products with less seasonality and inventory risks such as socks, for example, are sold on the 1P platform and non-standardized, long-tail products[27] are typically sold on the third-party marketplace.

[28] This long-term direct-sales gross margin estimate is in-line with JD CFO’s recent comments; he expects JD’s long-term direct sales gross margins to be in the mid-range between its current levels and the average of offline retailers (~19%).


[29] It is not difficult to add an incremental product category to your platform once you have built a sticky customer base

[30] Under Rmb99 per order, delivery fee appears to be Rmb5

[31] Source:, February 12, 2015

[32] In the past, JD’s 1P business priced its products lower than offline competitors and Alibaba’s platforms but this spread has narrowed as price is no longer the most important purchase criteria for shoppers; convenience is now the most important factor.

[33] Third-party marketplace services such as fulfillment (warehousing) and delivery are currently priced around marginal cost in order to drive higher volumes.

[34] If the merchant’s business volume is very small, they may only have fulfillment/warehouses in certain regions, meaning that for fulfillment/delivery JD will have to pick-up a smaller number of SKUs from that merchant, and potentially deliver it cross-region to another regional sortation center, closer to where the final destination is; this adds too many layers of distribution and costs that make the third-party fulfillment business unprofitable for lower volume merchants

[35] CLSA estimates that Amazon earns a 10% contribution margin for its fulfillment services

[36] This long-term gross margin estimate is in-line with JD CFO’s recent comments; he thinks JD’s overall gross margins could eventually improve to 20%

[37] Payment processing fees and customer service center costs are also included in JD’s fulfillment expense line item

[38] According to AT Kearney, and also confirmed by JD’s current fulfilment cost structure

[39] CLSA estimated that the average fulfillment cost per order for large B2C platforms with 1P businesses are typically Rmb20-22 (US$3.2-3.5).

[40] According to CLSA, JD’s average delivery cost is Rmb5.2 (~$0.8) per order in tier-1 cities such as Beijing and Shanghai. For cities with at least 2k+ orders per day, JD’s cost per order would be on par with 3P courier firms.

[41] This expense pool also includes all of JD’s customer service related costs, such as call centers and employees, which is a service not provided by third-party couriers

[42] I estimate the contribution profit margin to be MSD margin as a % of Net 1P GMV per order

[43] For every 8 complaints of online shoppers, one is related to delivery. Labour productivity, in particular, is very low as the average number of parcels delivered by express delivery personnel was 23 per day in 2014 vs >50 in the US.

[44] Some of the delivery franchisees in lower tier cities offer promotions as low as Rmb2-3 per delivery; JD believes these local franchisees either make no profit or incur losses

[45] Based on my knowledge, every Chinese e-commerce firm outsources this part of the value chain. In some remote Western Chinese regions, some logistics processes are outsourced.

[46] Given JD’s growing direct-sales volume and GFA to hold more SKUs, cross-regional line-haul is becoming less common

[47] 30% of JD’s annual active customers still prefer COD services

[48] Pay-for-performance is also used to incentivize delivery staff to meet daily targets.

[49] Local governments rather approve land for non-logistical purposes in order to generate more tax revenues

[50] Alibaba has a modus operandi that adheres to an asset-light approach

[51] Most traditional warehouses (~6k sqm) in China do not meet modern logistics requirements in terms of location, height, spacing, lighting, vehicle accessibility, loading docks and safety standards. Modern warehouses typically have wider column spacing, higher floor to ceiling, larger floor plates and truck docking bays compared to traditional warehouses.

[52] Warehouse personnel can account for nearly 50% of the fulfilment cost of storing inventory. JD’s new Asia 1. FC can sort up to 16K packages per hour

[53] JD has already acquired land use rights to over 3mm sqm in 12 cities

[54] The typical all-in cost for a warehouse in China is Rmb5,000 per sqm in tier 1 cities and Rmb3,000 per sqm in tier 2 cities

[55] Fulfillment costs make up around half of JD’s total cost structure

[56] JD’s inventory days is relatively low at 32 – 33 and they have sufficient transaction to appraise the value of this inventory, helping reduce inventory risk

[57] Rates for merchant financing may be closer to 15%

[58] People’s Bank of China

[59] Alibaba recently launched MYbank, and Tencent has WeBank, which are essentially online banks.

[60] For detailed JD Finance modelling assumptions, please contact the Author directly

[61] 30% of JD’s customers still prefer CoD services

[62] A similar phenomenon occurred between the relationship of PayPal and eBay, for example, when PayPal clearly should be its own independent company. Ant Financial will also likely be fully spun-out of IPO’d out of the Alibaba holding structure

[63] The company can tap the ABS market for more wholesale funding with third party financial institutions. In fact, JD Finance recently offered a 4.7 – 6.9% rate during a Rmb2bn securitization round in Q42015.

[64] JD Finance has an advantage in an attractive customer acquisition cost via online distribution if it needs to build a large customer deposit base

[65] Not counting any cash accumulated on the balance sheet.

[66] Richard Liu said in an interview: “… two other investment groups from Shanghai and Hong Kong travelled to Suqian to propose investing in the company, both at prices that were a third higher than Tiger had offered. Both my CFO and executive assistant were sitting in my office, watching over how I planned on handling the situation. I asked them what ranks first on our company’s set of values? Easy, integrity! If integrity is what we believe in, then we don’t even have to spend time thinking about this. Not just for a 30% premium, even if they had offered 300% higher, we would never entertain their proposal. So overnight we lost over 100 million RMB (in dilution – worth billions at today’s stock price), but I don’t regret that decision once.”


[67] Liu said in an interview with the WSJ during JD’s IPO that he would not rest until JD was the most profitable company in China

[68] DangDang, pitched as the “Amazon of China”, has largely failed to meaningfully expand its category mix outside of books

[69] B2C + C2C

[70] Offline + online

[71] CLSA and iResearch, two the most well-respected Asia/China focused research firms are assuming total China B2C market growth of just under 30% per annum over the next several years.

[72] For reference, currently BABA has 50 orders per active customer per annum vs. 8 for JD

[73] In a nutshell, Tencent sold its e-commerce properties to JD, provided level-1 access to Tencent’s online communications/social media properties to JD’s mobile app, and entered an 8-year non-compete agreement with JD. In exchange, Tencent received a ~20% equity stake in JD.

[74] WeChat and QQ users will have Level 1 access to JD’s mobile shopping app; Level 1 access means there will be a link to JD’s app on the app’s homepage so that WeChat or QQ users don’t have to leave the app or directly go on JD’s website or mobile app to shop.

[75] Some would say addictive

[76] Hailing a cab, buying movie tickets, and paying utility bills, for example, are some activities you can perform on WeChat in China

[77] Users can access daily services on WeChat, and make a payment on the app in a closed-loop transaction.

[78] I model JD’s customer penetration of WeChat to be around 46% by 2020

[79] According to Alibaba’s COO, internet penetration is ~60% in urban cities but only 27% in rural villages.  “The future of e-commerce in China is smaller cities” – Richard Liu, Founder & CEO.

Note that I already model lower a GMV per order based on outsized growth from lower-income, rural-based customers. The net effect to GMV per annual active customer, however, remains positive over time, as purchasing frequency increases.

[80] Acquisition-related amortization of intangibles is added back to non-GAAP EBIT and PE. SBC is fully-expensed. Maintenance FCF assumes 0 capitalizing FCF at a non-growth state, so no cash flow generated from working capital is capitalized; Full CapEx is also assumed

[81] Note that all the USD/Rmb fx rates used in this report are based on 6.4778 rate.

[82] I estimate Net GMV will be 68% of reported/gross GMV

[83] Cash conversion cycle was around (10) days in 2015, which I expect to further decrease to (20) days in 2020

[84] This implies a 4% terminal growth rate and 8% cost of capital

[85] In reality this figure is actually much higher if we subtract the excess cash on the balance sheet

[86] 6% growth into perpetuity with a 8% cost of capital

[87] Uber is a business with a similar business model (local economies of scale, reliant on order density, benefits from network effect, disruptive to traditional large industry, large TAM, etc.)

[88] Amazon is a prime example, pun intended

Amazon and World Domination

“I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.”

– Jeff Bezos, 2014 Annual Letter to Shareholders



Since the summer is clearly over and it has recently started snowing here in Toronto, I’ve been more in the mood to write about another investment idea. In general I’ve been finding more interesting names to potentially short than go long in the US. I don’t believe I’m a great short seller. In fact I think it’s probably the hardest skill to master in this business, and making money consistently with an absolute return mandate and high risk-adjusted returns is extremely difficult. For now I view it more as an intellectual exercise which should augment my analytical skills until it has become apparent I’ve mastered the art of short selling. In general my view on short selling is that it’s a relative return business, and concentrated positions are not justified unless one believes the idea is more attractive than an idea on the long side; even if that were the case, due the leveraged nature of short selling, the vast majority of positions should always be sized smaller relative to long ideas. Just my 2 cents.


Moving on, I think some interesting long opportunities have been developing across the “large-cap information technology/media growth conglomerate” space.[i] I believe that some of these “conglomerates”, if I may call them that, have a dominant existing core business which generates relatively predictable cash flows; however, due to limited financial disclosure, they each also possess extremely valuable, but largely hidden growth assets which I believe have largely been under-appreciated or misunderstood by the market. Some notable examples include Google’s intention to reorganize its various business units into the “Alphabets”, which should provide increased financial disclosure to one of the most valuable assets in all of media – YouTube – or Facebook’s largely under-monetized social media portfolio which include hyper-growth assets such as Instagram, and private messaging apps such as FB Messenger and WhatsApp; did I also mention that Facebook owns one of the leading virtual/augmented reality businesses which could turn out to be a massive home-run investment? It is also worth noting that Google, alongside top VC firms Andreessen Horowitz and Kleiner Perkins have invested in the very secretive augmented reality start-up Magic Leap. It appears that the smartest money in the Valley are betting big on virtual reality as potentially the next major computing platform. One day soon, we could see a Minority Report-like future, and the potential applications of this technology certainly excite me! Even Microsoft stock which has had a largely uninspiring share price performance over the past decade or so, now looks kind of interesting from a sum-of-the-parts basis. Having looked rather closely at some of these names, if I had to buy one mega-cap US stock today, it would likely be Put simply, Amazon is a collection of two high-growth, excellent businesses, run by a proven value creator and serial monopolist. In its Q1 filing this year, Amazon broke out some of the financials for its cloud computing platform, Amazon Web Services (AWS), which was the catalyst for me to take a deeper into this story. AWS is the undisputed industry leader in public cloud infrastructure services (IaaS) and will benefit from a massive multi-decade shift in IT resource spending from on-premise solutions to the public cloud. I believe it will be very likely that AWS will become the dominant public cloud computing platform of the 21st century, and we are only in the very first inning of this growth cycle.


A Trillion Dollar Valuation?

I believe the purchase of Amazon shares will be very rewarding for investors with a 5 year plus time horizon. My thesis on Amazon is centred around the AWS opportunity so the focus of this write-up will be on that segment; however, I do believe the retail segment is under-appreciated and materially undervalued on a standalone basis as well and I will further discuss this in detail below. In short, I believe the long-term profit opportunity for AWS is vastly under-appreciated by the market and that we are at a major industry inflection point in terms of the adoption of public cloud infrastructure services. My high conviction for this idea stems from my belief that AWS will be a much higher quality and valuable business than Amazon’s retail segment over time. AWS’ moat will only widen over time, and the total addressable market (TAM) that it is tackling is massive at conservatively $300bn+ and growing. In a couple of years, I think AWS’ standalone valuation (~$300bn by my estimate) will easily justify Amazon’s entire market capitalization today. Five years from now, both segments on a standalone basis should be worth well more than the entire current market cap. In fact, by 2020 and on a sum-of-the-parts basis, backing out the retail segment’s enterprise value at 20x 2020e EBIT or $470bn, we are getting paid to own the AWS segment for -5x EBIT and this segment alone could be worth more than $600bn or 2x Amazon’s current market-cap by 2020. The total future value from both segments plus the incremental free cash flow and working capital that will be generated over the next 4 years gives me a base case intrinsic value per share of $2,000 – $2,350 or a 4-year MoM of 3.0x-3.5x.


Key Points of Variant Perception

  • I believe the market is largely under-estimating AWS’ long-term secular growth profile. According to Gartner, just the cloud infrastructure market alone will be worth around $17bn this year, and I think will likely grow at a 5-year 50% CAGR to nearly $130bn by 2020. AWS is currently a $8bn+ run-rate business with a ~47% share of this market and I expect this business will grow to well over $50bn or 6x larger over the next 5 years; this is well above the majority of Street estimates I’ve come across. But the IaaS market is just the tip of the iceberg. If we look at broader global IT spending across enterprises[ii] which includes platform and application software, we should be closer to at least a $1 trillion+ total addressable market (TAM) which makes AWS’ current market share de minimis; there is no reason for me to believe that AWS will not slowly expand into adjacent IT markets such as PaaS (of which they are already doing, successfully, I might add), and SaaS applications over the next 5-10 years. Very conservatively, I believe somewhere between 40%-50% of total IT spending could shift over to the cloud over the next decade or so, which would translate into a market opportunity of at least half a trillion for AWS. At the same time, enterprise adoption of infrastructure cloud services appears to be at a major inflection point, as AWS storage and computing usage rates are accelerating to near 100% growth rates per annum. This strong operational performance from the clear market leader confirms the stated intentions of an increasing number of Fortune 500 CIOs to shift more IT spending over to the public cloud at an accelerating pace.
  • Operating margin ramp-up is vastly under-appreciated. Most of the Street is incorporating significant operational deleveraging assumptions or limited operating margin expansion forecasts for AWS over the next 5 years. My view is that long-term margins will be much higher due to a mix of 1) More muted IaaS pricing decline assumptions relative to expectations; I believe an attractive oligopoly industry structure will translate into pricing cuts being closer to 8%-10% annually on core IaaS computing and storage services instead of the 20%-30% implied by Moore’s Law, 2) A favourable sales mix-shift to faster-growing, higher-margin PaaS such as database application subscription services and most notably 3) Easily realizable benefits from massive economies of scale and fantastic incremental margins which should be much higher than current ~19% GAAP operating profit margins today. Due to its clear first-mover advantage and the massive entry barriers for this business, among the largest “hyper-scale” infrastructure cloud service providers, AWS is likely the only one that is currently profitable at a 25% consolidated segment operating income (CSOI) margins. The business is 10x bigger than the next 14 competitors combined in terms of computing capacity, and in terms of revenue, around 5x the size of the next largest competitor – Microsoft’s cloud computing business Azure. 5 years from now, I believe AWS’ operating margins could be closer to 40%-50%, with EBITDA margins ranging from 60%-65%.
  • The retail segment’s normalized profitability remains misunderstood by the majority of investors. Investors appear myopically focussed on the lack of or limited profitability of Amazon’s 1st party (1P) retail business on what is suppose to be a more efficient retail model than traditional brick & mortars (B&M). On this issue a couple of things come to mind: 1) Continued investments in the fulfillment and distribution network are necessary to support a superior customer service offering which in tern leads to continued share gains in under-penetrated product categories within a gigantic TAM; In the US alone Walmart has retail sales of well over $300bn, which is massive compared to Amazon’s entire 1st party sales which will likely be under $100bn this year. The highly successful Costco-like retail playbook of sharing scale efficiencies with the customer results in a superior service and a more loyal and valuable customer base, completing the virtuous circle that propels the Amazon Flywheel. Customer service and pricing levels are probably the two most important competitive factors in mass market retailing, and I believe that these universal truths have been overlooked or under-appreciated by investors who study Amazon and arrive at the conclusion that Amazon can simply pass less value to their customers in order earn a higher profit over the short-term without risking erosion of its moat longer-term.[1] In short, I believe that Bezos’ strategy to densify Amazon’s fulfillment and distribution network, in time, will payoff hugely for shareholders and allow them to continue to crush the competition. Although I concede that Bezos might be excessively over-investing in some areas at rather low rates of return such as the Fire phone, I am confident that most of Amazon’s investment programs will be highly accretive over time. Ongoing initiatives such as Kiva Robotics, the Drone program, Prime Now, Prime Fresh, and content investments that support Prime’s subscription video-on-demand (SVOD) service are multi-billion dollar bets that are depressing current profitability. 2) The second thing and undeniable truth is the rapid growth of very high-margin 3rd party (3P) marketplace sales and a faster growing mix of 3P Gross Merchandise Value (GMV) vs. 1P, along with growth in Amazon Prime membership subscription fees and Fulfillment by Amazon (FBA) services for merchants. I estimate that Amazon’s 3P GMV will grow at 30%+ per annum, and these services are accelerating retail gross profits, expanding gross margins and further propel the Flywheel. Because of these additional services, Amazon is no longer destined to the financial shackles of being a pure low-margin, (although extremely efficient) 1P fulfillment-based retailer. Due to these large investment programs, along with the under-appreciated growth of these higher-margin services, the market has consistently and unfairly accused Amazon of being a low-margin retailer that barely generates any real profits.


Why does this opportunity exist?

Amazon broke out revenue and operating profit figures for its AWS division during its Q1 results this year, which revealed a very profitable cloud computing business. After being thought of as a loss-making division, by now AWS’ profitability is well known to most investors. This event, along with a steadily improving margin profile for the retail business has catalyzed a substantial re-rating of Amazon shares year-to-date.

However, I believe Amazon remains largely a misunderstood investment story. Most investors still under-appreciate the magnitude of the AWS opportunity as growth and margin forecasts appear far too low by most sell-side analysts. Bezos’ investment time horizon is longer than most investors, who typically under-price the long-term growth prospects of high-quality compounders. The market also typically does a bad job of valuing divergent cash flow streams such as, in this case, the Retail segment vs. the Public Cloud Infrastructure segment; Most analysts still have not woken up to the fact that AWS is a material value driver and consequently do not value Amazon as a sum-of-the-parts but instead assign a consolidated multiple as their main valuation framework. I believe this has led to grossly conservative implied valuations of AWS, which I believe will become a much more valuable franchise than the Retail business over time. As an industry, public cloud infrastructure services also has a limited reporting history, and investors have assumed that it is a very low-return, unprofitable business. Financial disclosure of hyper-scale cloud infrastructure providers such as AWS, Azure and Google Cloud remains quite limited as Azure and Google currently do not break out their cloud division financials. What’s more, publicly-traded companies with comparable economic characteristics to AWS are not obvious to the casual market observer, making it harder to value. Finally, there is a misunderstanding of Retail’s long-term earnings power due to the different growth initiatives within this segment such as Prime, FBA, and 3P which all have different growth and margin structures – and all at different points of their respective investment cycles – which mean lazy analysis will likely lead to a faulty investment conclusion.


AWS – The Fastest Growing Enterprise Technology Company in History

Brief Business Overview

AWS was formed in 2006 to sell excess cloud computing capacity unused mainly by the retail website. Providing cloud infrastructure services is largely a recurring, subscription-based business which can be further broken out into three main service lines: Infrastructure-as-a-Service (IaaS), Platform-as-a-Service (PaaS), and Software-as-a-Service (SaaS). IaaS is the provision of storage, computing power, virtualization and networking services over the cloud. PaaS is the provision of an operating system platform and related services over the cloud, and SaaS is the provision of application software such as Salesforce CRM, for example, over the cloud.

Source: Gartner: Magic Quadrant for Cloud Infrastructure as a Service, Worldwide report

AWS is the clear market leader and should be posting revenues of nearly $8bn this year and well above $12bn next year, making it the fastest growing enterprise technology company in history. For reference, Google is the only other technology company to achieve $10bn in revenues in less than 10 years!


Value Proposition

Similar to how households or enterprises can pay for electricity service from a local utility provider, customers can rent computing and storage units over the cloud from an infrastructure cloud service provider on a pay-as-you-go basis. Since companies already outsource their electricity requirements, there is little reason why IT infrastructure shouldn’t be commoditized over the cloud as well. The current shift to public cloud services is reminiscent of a time during the industrial revolution when companies started shifting their power consumption to electric utilities instead of generating their own power source in-house. WRT to alternative IT solutions, traditional IT outsourcing solutions provided by firms such as IBM or HP are typically more expensive, and on-premise solutions require large, upfront investments into in-house IT resources such as software, hardware and consulting services.


“No company that we [Andreessen Horowitz] invest in anymore actually ever

buys any hardware” – Marc Andreessen, TechCrunch, January 2013


The head of AWS, Andy Jassy, discussed several key reasons why companies are flocking to the cloud.[2]

  • Cloud enables a service consumption model that transforms a customer’s fixed capex to variable cost.
  • Due to superior capital efficiency, hyper-scalers such as AWS realize far more economies of scale than many enterprises could on their own. Hyper-scalers achieve superior asset utilization vs. customers that may have sub-20% data centre utilization rates in some cases.
  • Cloud enables on-demand models to prevent over or under provisioning of storage and computing during peak or low demand periods.
  • Companies can outsource IT infrastructure requirements and focus their resources on their core business.
  • Pricing is very attractive in comparison to legacy on-premise solutions. As shown below AWS has a huge pricing umbrella over traditional on-premise solutions with pricing for basic computing and storage services ranging from 68%-80% cheaper than comparable on-premise solutions.

Source: Gartner, Deutsche Bank

Because of these reasons and the increasing comfort around the security and reliability of hosting data over the public cloud, adoption is hitting a major inflection point according to CIO surveys. General Electric, for example, is a major customer of AWS and is planning to shut down 90% of their 32 data centers over the next five years.


The Moat – it’s very wide, and growing

Economies of scale act as a large entry-barrier as significant capex is required to break-even in this business. AWS truly is the 800-pound gorilla in this space with greater than 10x the computing capacity of the next 14 largest competitors combined. As a result, they are the only current existing player operating at scale. In addition, switching costs are also increasing over time as customers that migrate large data workloads over to a single cloud vender can easily get locked-in. Switching costs also increase as customers purchase incremental value-added services on top of AWS’ basic infrastructure services. One notable example of customer lock-in is Netflix, which relies on AWS for its entire IT infrastructure; Netflix has said that it would be a “significant multi-year effort to switch infrastructure cloud providers.” For AWS this is all great news as they have already reached a critical mass of 1 million plus sticky customers and operate a largely subscription-based business model that benefits from massive scale economies and high barriers to entry. Finally and most importantly, the business will also benefit from a massive network effect of 3rd party developers/software application vendors as customers will likely stick with only 1-2 cloud provider platforms with the largest breadth of IT services.


With respect to pricing, unlike what many investors believe, the business of providing public cloud infrastructure services is not a pure commodity-like business. Yes, at the basic core the business is about renting out uniform storage capacity and computing power units. But other competitive factors such as security, reliability, speed and a broad set of features are critical for large, sophisticated, enterprise-grade customers who are beginning to shift an increasing amount of mission-critical data to the public cloud. Some of AWS’ competitors with businesses tied to traditional on-premise solutions have argued that AWS is only suitable for start-ups and is not an “enterprise-grade” service. This is clearly not the case if we take a quick look at AWS’ customer base, which includes large enterprises such as General Electric, Comcast, Vodafone, Unilever and the CIA. The lucrative CIA contract was won by AWS over IBM Softlayer, despite Softlayer’s lower quote, because according to the CIA, AWS had a “superior technical solution”. If this is not the smoking gun that attests to AWS’ “enterprise-grade” quality, which helped the company win over a contract from an organization with one of the strictest security standards in the world, then I don’t know what is.


Attractive Industry Structure and Economics Developing

Gartner projects the IaaS market will be worth $17bn in 2015 and will double over the next 3 years. I believe Gartner’s CAGR’s estimates are too low and I have modelled an industry CAGR closer to 50% over the next five years. Why? Well, AWS’ compute and storage services’ usage rates are growing at 90%+ YoY, (Revenue is growing nearly 80% YoY) Microsoft recently disclosed that its Azure business is growing revenues 135% YoY, and Google Cloud is likely growing at triple-digits as well. So with the market leaders currently growing at 3x-4x the rate that Gartner projects, and with the industry conservatively at less than 5% of the TAM and rapidly growing due to a major multi-decade shift in IT spending, do we really think that industry growth will be just 30% per annum over the next few years? Even assuming 50% per annum growth over the next 5 years, the size of the cloud infrastructure market will still be ~13%-26% of the TAM, implying plenty of growth well beyond 2020.


In terms of competition, simply due to the massive economies of scale required, I see the majority of share in the IaaS market split between AWS, Microsoft Azure, and Google Cloud over the next several years. The current market setup is a 2-horse race between AWS and Azure, with Google at a distant third and not in the minds of most large enterprises. AWS has been steadily gaining market share and is now nearly 5x larger than Azure with a ~47% share; Azure will likely generate run-rate revenues of ~$1.6bn this year and according to my industry due diligence Google Cloud is likely a sub-$1bn business. The rest of the industry is mostly comprised of the traditional enterprise IT incumbents such as HP[3], IBM, and Oracle who have an incentive to protect their legacy businesses which will likely be cannibalized.[4] As a result, they emphasize more of a hybrid-cloud approach, and unlike Microsoft’s Nadella, were very late in the game in pursuing a “cloud-first” strategy. Due to the high entry barriers, these sub-scale players will likely operate a niche cloud business without any significant market presence. For reference, the Goldman Sachs analyst thinks that even Azure is likely operating on negative gross margins and is not expected to break even until the second half of 2016 or early 2017 despite being the clear #2 player with a $1.6bn business!


“While many companies are developing commercial cloud offerings, there are only two driving enterprise cloud platform innovation at massive scale: Amazon and Microsoft.” – Microsoft CEO Satya Nadella, Microsoft Q1 2016 Conference Call


There appears to be some sort of consensus that, longer-term, the market will eventually develop into a duopoly between AWS and Azure. Although a possibility, I have to disagree. I think Google is currently being underestimated and could potentially be a very large player in this space. I believe Google’s limited traction thus far in the cloud infrastructure market has largely been 1) a lack of focus, especially in developing a rich feature set such as the one available on AWS, 2) very limited marketing to enterprises, and 3) limited time in market, as their cloud business only launched 2 years ago. The first issue shouldn’t be a problem for Google longer-term given their technical prowess. The recently announced hiring of VMware cofounder Diane Green to head Google’s Cloud business, to me, signals that Google is willing to tackle the enterprise market more aggressively.


Google’s 8th employee and SVP of technical infrastructure, Urs Holzle, recently stated that he thinks in 5 years Google’s Cloud business could be larger than its entire Search Advertising business! I think Google’s advertising business will likely top $100bn in revenue by 2020. So what he is basically saying is that Google Cloud will grow by over 100x in 5 years! For reference, I am only projecting AWS to grow to ~$54bn in revenues by 2020. At first I thought Mr. Holzle was being delusional. However, the more I thought about it the more I see a bit of truth in his statement. Although Google Cloud is subscale now, I believe the conditions are present for them to compete very effectively. Firstly, they likely have one of the largest existing datacentre footprints available that power their heavy-traffic, security-sensitive, consumer-oriented cloud apps such as YouTube, Google Maps, Drive, and Gmail; with that also comes the expertise required to host extremely large data sets. As such, because of their existing scale I believe they are likely already operating at gross margins higher than Azure, or at the very least have the infrastructure in place to scale up very quickly. Secondly, unlike the traditional IT incumbents, Google doesn’t have a highly profitable legacy business to protect, and they are willing to tolerate large losses for a long time in order to scale up. Obviously having a war chest of nearly $80bn also helps. Thirdly, unlike Azure but like AWS, Google intends to build its cloud OS platform with open source technologies. Similar to their rather successful strategy in mobile by using Android to develop an open ecosystem of 3rd party developers and customers, I believe this strategy will play out well in the cloud infrastructure world as well. The fact of the matter is that despite being able to work with other technologies, Azure’s cloud platform is built with very Microsoft-centric technologies, which is not friendly to the modern day developer who doesn’t code in the .NET Framework. Instead, Azure appears built for Microsoft’s existing enterprise customer base, which they hope to protect from AWS and Google. Finally, Mr. Holzle has said that only ~1% of total storage capacity in the world is on the public cloud (implying a more aggressive TAM estimate than my own), meaning that we are still on the 1st pitch of the first inning in this game. In my view, Google has plenty of time to catch up.


With that said, it’s difficult to imagine AWS not maintaining its current share or even increasing it over time as they far along in the learning curve, are considered the clear industry leader by enterprises with the most robust and sophisticated features, and already have the largest 3rd party marketplace of applications on their platform. To be conservative and due to potential volatile changes in market share within a hyper-growth market, I model for AWS a 5-year top-line CAGR in-line with the cloud IaaS industry.


With respect to industry pricing, prices for basic IT infrastructure services are largely driven by Moore’s Law.[5] AWS has cut its prices nearly 50 times for basic IaaS storage and compute offerings over the course of the past 6 years, and Azure and Google have cut prices in-line to keep up. Google announced deep pricing cuts in April 2014, thereby effectively resetting IaaS prices for the industry, stating that AWS was over-earning by not passing on the full Moore’s Law cost savings to customers. Google cited that public cloud infrastructure providers such as AWS and Azure were cutting IaaS prices closer to 6%-8% per annum, which is a sign that industry pricing was already starting to firm up in true duopoly fashion. Due to the risk of more competitive pricing – mainly from Google – I am modelling a conservative base case scenario of IaaS pricing falling by 10%-20% per annum, which should be roughly in line with hardware cost savings from Moore’s Law and scale efficiencies from increased bargaining power. I believe the risk of a pricing war will decrease over time since share will mainly be allocated to a small handful of rational players. Azure has historically not been aggressive on pricing, and has a large installed base of customers to harvest cash flows from and to transition into the cloud. For Google, I believe their priority now is to dramatically improve their platform, such as launching additional features and services for their PaaS offering. I believe my industry pricing assumptions could potentially be a very conservative, especially if Google figures out that destroying the industry value pool alone will not win them share. The dream bull case would be if Google fails to gain any real traction, and the market evolves into a duopoly/quasi-monopoly between Azure and AWS with AWS having a dominating 60%-70% market share; pricing power of course would be much stronger.


Expansion into Adjacent Markets and the OS Ecosystem/Network Effect

Although an important component of the AWS investment story, I believe that the market has largely overlooked AWS’ expansion into the adjacent PaaS market, which should lead to a stickier, higher-margin business profile for AWS and a wider moat over time. PaaS offerings are higher value-added than basic IT infrastructure services with better pricing power and terrific incremental margins. These services encompass areas such as the Internet of Things, Mobile, Big Data Analytics, Email, and Desktop Virtualization that make up the foundation of a modern operating system (OS) platform over the public cloud. I think everyone in the industry has now woken up to the fact that the PaaS layer will be the most important public cloud battleground of the future; however, few have a leading, profitable IaaS business such as AWS’ with the customer base to cross-sell into.


One notable example of AWS’ success in growing their PaaS platform is their recently launched Amazon Aurora service. Aurora is a MySQL-compatible database engine with 5x better performance than the typical MySQL database and at one-tenth the cost of high-end commercial database offerings. Barely 2 years old, Aurora is already a $1bn+ business growing 127% YoY and is actually the fastest growing service line in Amazon company history. The database market is one of the largest sub-segments of platform software at around $40bn and Gartner thinks that cloud database services can grow at 45% CAGRs over the next several years. Clearly, Aurora is stealing massive market share away from database incumbents Microsoft and Oracle who have the leading on-premise solutions in this space; my due diligence suggests that Oracle’s database cloud product is growing closer to under 40% per annum. Aurora’s success gives me great confidence that AWS has the capability to build a leading PaaS offering amongst incumbents who have been in this space for decades.


Due to the favourable mix-shift of a faster growing PaaS business with better pricing power than IaaS, I believe AWS’ operating profit margins have more upside risk than what the Street anticipates. However, there are no good comparable publicly-traded businesses that can give us a clue on how AWS’ long-term margins can potentially look like. For this issue, I have to give credit a brilliant friend of mine who pointed out to Intel’s PC division as perhaps a relevant comparable.[6] How are these two businesses similar? Well, Intel’s PC business is another Moore’s Law type of business with high fixed costs, it benefits from tremendous R&D scale efficiencies, and is a dominant market share leader in PC processors with an 80%+ share. For reference, Intel’s PC segment reported ~$35bn in revenues and generated 42% operating margins in 2014. With the exception of perhaps a larger enterprise sales force, I believe AWS’ IaaS business shares quite a similar financial profile to Intel’s now mature PC business. However, as I already noted, AWS’ expansion into PaaS offerings with higher contribution margins vs. its more commoditized IaaS offering should lead to even greater margin expansion over time. This leads me to believe that eventually AWS could become an even more profitable business than Intel’s PC division ever was.


Growing on the back of a vast installed base of customers, AWS’ cloud computing platform Elastic Beanstalk will likely have a massive ecosystem of 3rd party developers/software vendors; Intel never had this type of network effect advantage. But what other technology company had a similar advantage? Off the top of my head, one business I can think of that benefitted from a similar type of ecosystem and thus had an overwhelming market share lead was Microsoft’s Windows OS for PCs. This was a phenomenal business that sold pre-packaged software at 100% incremental margins into an enormous open-ended growth market which propelled Microsoft stock to be one of the most valuable companies in the world at the turn of the 21st century. Just like how Windows was the dominant OS of the PC era, and iOS and Android are the dominant OS of the Mobile era, my belief is that AWS will likely be among one of the very few dominant OS platforms of the public cloud era. Already having achieved a critical mass of having the largest marketplace of 3rd party application software for 1 million+ sticky customers, and the most robust set of features (over 1,000 features have been introduced since inception), and with a business multiple times the size of the rest of the industry, I do not think this prediction is unrealistic. Also worth noting is that AWS should be able to easily leverage its R&D scale efficiencies to expand even further up the cloud stack into higher-margin application software such as SaaS over time, which will further expand its TAM. This is additional free upside not baked into Street estimates in my view. Now I can clearly see why Bezos wrote that AWS is market-size unconstrained.


In summary, I think AWS’ long-term economics will look like something in between Intel’s PC division and Microsoft’s Windows OS for PCs when they were nearing a mature growth phase, but with the added benefit of having a much larger TAM, and possessing the best combination of competitive advantages a business can have in my view – the network effect and massive economies of scale. By 2020, I believe AWS can grow revenues closer to $54bn (much larger than Intel’s PC segment), and generate operating profit margins somewhere between 40%-50% and EBITDA margins north of 60%-65%.[7]


Retail Segment – The Bezos Flywheel

As mentioned in my thesis the growth of FBA, Amazon Prime and 3P marketplace sales should drive general margin expansion for the retail segment over time, and further propel Bezos’ flywheel. Some analysts have pointed to Amazon’s slowing reported retail sales growth, but fail to appreciate the fact that faster growing 3rd party sales understates total retail sales to an extent, due to the fact that this is a commission-based business that earns a take-rate off of 3P GMV. The more important driver here is the growth in 3P GMV, which should remain very strong; this is due to the Amazon customer wallet being relatively under-penetrated in certain areas such as apparel, along with a massive remaining growth runway in retail sales. For reference, total US retail sales was ~$4.53 trillion in 2013, and is likely growing at a nominal GDP-like rate. I estimate that Amazon’s total global GMV (including 1P and 3P) will still be less than $1 trillion by 2020.


3P Marketplace, Amazon Prime and FBA – Trying to Decipher the Genius of Bezos 

Amazon Prime is a very high-quality, fast growing business that generates annuity-like, subscription-based revenue streams. Prime membership numbers aren’t disclosed, but estimates based on surveys suggest that there may be up to 60-80 million members worldwide. Prime members tend to make more frequent purchases on Amazon (up to 2x-3x more in value than non-members).


Initially I was quite skeptical of the launch of a SVOD service for Prime members due to the multi-billion dollar content investments necessary to build a compelling offering, but over time I have come to see the attractiveness of such a business. One strategy a Pay-TV distributor can use to differentiate itself from the competition is to have differentiated content. Traditional Pay-TV distributors have licensed rights to exclusive sports content in order to protect the Pay-TV bundle. Another type of content strategy that appears to provide differentiation for a cable network or SVOD is to invest in exclusive original content. Over the past several years, we have seen distributors such as AMC networks, Starz, and Netflix pursue a strategy of investing in exclusive original content to some success. Amazon is now pursuing a similar strategy by producing, for example, three new seasons of Top Gear that will be exclusive on Amazon Prime. I believe Amazon is probably spending a couple of billion dollars on content streaming rights and production presently, and this expense pool will likely peak at around $3-$5bn over the next few years. For reference, Amazon’s largest OTT competitor, Netflix, spent ~$3bn+ on content in 2014, and is expected to spend between $4bn – $5bn this year.[8]


I think the economics of producing content appear much more attractive when it is paired with a global SVOD distributor which has access to a global pool of potential subscribers. Perhaps this is the main reason why John Malone recently built an equity stake in Lions Gate: I could be wrong, but the end game thesis could be to unleash some synergies by leveraging Discovery and Starz’ brand equity and global base of customer relationships to eventually build a high-quality, global subscription-based streaming service. With Lions Gate’s existing content streaming library and scale in content production, this business is currently experiencing a positive tailwind of high-quality content being re-priced higher due to steadily growing incremental demand from OTT players who are experiencing rapid growth in global markets. Maybe the legend John Malone sees this same inflection point in the economics of content production assets. With that said, I see the economics for Amazon’s streaming service particularly attractive over time since Amazon already has a global customer base that they can leverage for Prime subscription growth. Some analysts forecast that Netflix can eventually reach 200 million subscribers globally. Given Amazon’s global presence, I don’t see why they can’t get there eventually. This business will eventually throw off great incremental margins once it reaches a critical mass, as largely fixed content expenses will be amortized over a growing base of Prime subscribers. Based on Netflix’s per-subscriber valuations, I am extremely bullish on this business.


The genius of FBA is that it completes the virtuous cycle of more Prime eligible SKUs, better control of the customer experience, leveraging incremental fulfillment scale efficiencies, lower prices, and more Prime members. Long-term, this is superior model to e-commerce competitors who lack the breadth of SKUs and a high-quality, uniform customer experience. Credit to Andreessen Horowitz’ blog for this great image below which illustrates the Amazon Flywheel.

Source: A16Z Blog

Amazon reminds me of the successful Costco model of sharing scale efficiencies with customers, and maintaining a low mark-up pricing policy. The market consensus on Costco 10-20 years ago was that it was a low-margin retailer and expensive stock. Now the business is better understood as one of the most successful retailers in history.


Retail Segment Long-Term Economics

Quite detailed analysis is required in order to come up with an informed view of how consolidated margins may look like for the retail segment long-term. After discovering all these moving parts in the retail business which greatly complicates the story, it is no wonder that the sell-side has consistently for a long period of time under-estimated Amazon Retail’s margin upside.


Amazon’s Retail business can be separated into 1P and 3P sales. Because 3P sales (which are 100% gross margin) are based off a commission of 3P merchandise sold, I think the best way to think about how the retail segment’s long-term operating margins might evolve into is to start with Amazon’s GMV. GMV is an important metric for analyzing e-commerce models such as Amazon’s since the business derives total revenue from a mix of 1st party (1P) and 3P (marketplace) sales. Currently Amazon doesn’t disclose their GMV (what a surprise), but some analysts estimate that it might have been ~$180bn in 2014 or slightly 2x Amazon’s total retail sales. I believe this estimate is quite reasonable. If we assume that 60% of Retail’s GMV was 3P, and given Amazon’s take-rate of ~12% (this figure is based off of merchandise category), 2014 3P sales should be ~$13bn. Add $72bn for 1P sales and we arrive at around $85bn in total retail sales, which is around what reported Retail sales were for Amazon in 2014. There should also be a few billion of revenues in the mix from Prime subscription fees and FBA but for the sake of simplicity I will ignore these businesses for this analysis.


Now, let’s further split our analysis between North America (NA) and International. First off let me say that I am working on the general premise that Amazon has a much more efficient retail model compared to B&M, and current investments are obscuring the true profitability of this business. To summarize, items that are obscuring the “core” profitability of the retail business include R&D spending on the Drone program, investments in Kiva Robotics, the Fire Phone, TV and Tablet, Amazon Prime Now, Amazon Fresh, content streaming licenses and production, incrementally moving delivery services in-house and general growth investments into building additional fulfillment infrastructure closer to end markets. A few of these investments such as the Fire Phone may have a questionable return on investment profile, but I believe that most of these initiatives will turn out to be quite accretive to shareholder value. Ultimately, if you believe that Amazon doesn’t have a more efficient model than B&M, then I can’t help you here. For reference, the Bernstein internet analyst “gets it”, and has published an excellent note covering this topic.


North America 1P & 3P Operating Margins

For the more mature NA segment, if Amazon has a more efficient retail model, its 1P business should be able to earn operating profit margins higher than the most efficient B&M retailers at comparable sizes. I think Costco and Walmart are pretty good benchmarks. Costco is a $117bn business and generates ~3% operating margins; Walmart is a 5% operating margin business. From a product mix perspective, Amazon’s 1P gross margins are likely in the mid-teens, compared to Costco’s at around 10%-11%. Given what we know here, I’m confident that over time Amazon’s NA 1P business should be able to earn at least mid-single digit operating margins and potentially much higher. Note also that higher-margin categories such as CPG are still relatively under-penetrated by Amazon, and there should be a 1P sales mix-shift towards these categories.


In terms of GMV, the 3P business is likely growing much faster than 1P sales due to the growth of 3rd party merchants, FBA sellers and Prime users. By 2020, I estimate that 3P GMV could closer to 75% of total Retail GMV of ~$955bn or above $700bn. WRT the long-term 3P operating margin forecast, eBay’s marketplace segment is probably the best reference here. Despite eBay losing massive e-commerce share and underinvesting on its marketplace platform, it sports 30%+ EBIT margins with a GMV of $83bn in 2014. After taking into account payment processing expense differences from the PayPal segment, and differences between take rates (12-13% for Amazon vs. 8.5% for eBay), Amazon’s 3P operating margins should be conservatively at least ~30%-35% by 2020. I think this could potentially be a very conservative guess because I think eBay in general is not the most well-run business, and by 2020, Amazon’s NA 3P GMV should be at least multiple times larger than eBay’s GMV, providing much more scale efficiencies. Note that I am not adjusting for Amazon’s fulfillment expenses for 3rd party merchants here given that I am not sure what FBA’s contribution margins are. I would say that FBA strengthens the Bezos flywheel further and this business leverages scale efficiencies by utilizing fulfillment infrastructure that supports the 1P business. In addition, when the Kiva Robotics program is fully implemented, this initiative could easily lead to upside of a few hundred basis points of margin expansion which I am not capturing in my model.[9]


By 2020 I am modelling a 3P sales mix of 28% out of total retail sales. On that retail mix of 72%/28% of 1P/3P sales at 5%/30% operating margins, respectively, consolidated GAAP NA margins should be around low double-digits.



The largest criticism I have about this business is the company’s massive loses in China and the lack of any real traction in that market. Amazon entered China in 2004 and at one point not too long ago had the same amount of fulfillment space as (which I think is a pretty cheap stock btw). This is despite the fact that they currently have a 1% market share in direct-selling B2C marketplace sales compared to JD’s ~47% share. I think it’s time for an exit, and a sale of this business for an equity stake in could be the most attractive option at this point.


Within International Amazon has more mature businesses in markets such as the UK, France, Germany and Japan, and ones that are still subscale in China, India, Mexico, Spain and Italy. The growth opportunity in International remains enormous, but it will likely take a very long time before any large profits are realized. Thankfully, the International segment will likely remain a less valuable piece than NA for a very long time, and as such, is less of a key driver.


I am modelling 0%-5% GAAP EBIT margins for International by 2020, which I think prices in the risk of capitalizing losses permanently in failed markets such as China. When combined with low double-digit NA EBIT margins, Amazon Retail’s consolidated “core” operating profit margins should be within the HSD to LDD range by 2020. Note that this is still quite a rough guess and I have tried to be very conservative with my assumptions here, and have allowed some space in my analysis for potential low-return investments.[10] Due to the huge operating leverage in fulfillment, I see potential upside risk to this estimate.


Concerns – It’s all about the “Long-Term”

The most common argument I hear from the bears is something along the lines that Jeff Bezos is an empire builder who doesn’t care about profits or shareholder value.[11] Some also believe that Amazon is a de facto charity disguised as a for-profit company, run purely for the benefit of consumers at the expense of shareholders; I think this is almost akin to calling Amazon stock a Ponzi scheme. These are pretty ridiculous assertions in my view.


Is Jeff Bezos an empire builder? Probably. Does that make Amazon a bad investment? I don’t think so. When you are growing so quickly and reinvesting most of your profits in two of the largest markets in the world there is risk that you look like an empire builder and want to grow at any price. Bezos is obsessed about creative destruction and his investment time horizon of 5-10 years is longer than most CEOs and public market investors. In general his investment philosophy appears very flexible where he is willing to invest in lots of different projects where the risk/reward profiles range from substantial downside, but also a lot of upside optionality. When the inevitable failed project becomes apparent, the investment community are quick to scrutinize these low-returns.


In the grander scheme of things, I don’t believe a genius capital allocator has to head Amazon in order to make a lot of money here. Let’s take Amazon Prime for a quick example. If Amazon Prime raises its annual subscription price by 20% tomorrow, membership growth would likely remain very strong, implying that this would be a very wise decision in light of the goal to maximize shareholder value. Bezos won’t do this often, which might suggest that he is not a rational actor or shareholder friendly CEO. Perhaps this is the truth, yet I honestly think that this will eventually look like a rounding error in a DCF model. In my view, this is one case where the business is so wonderful it overrides the management factor in the investment thesis. I also think that critiques haven’t given Bezos enough credit for his successful investments and start-ups such as AWS.


For the record let’s take a brief look at some of Jeff Bezos’ capital allocation decisions:

-Acquired Twitch for around $1bn in 2014. Twitch is a hyper-growth, online live video streaming service with a niche audience. I think this media property has a very attractive platform for pursuing either an advertising heavy or subscription-based revenue model. In general I am quite bullish on the future of e-sports gaming and think this purchase could potentially be a home-run.

-Acquired Kiva Systems for $775 million in 2012. I think this was a pretty good investment as the Kiva robots can take out a lot of labour costs in Amazon’s fulfillment centers.

-Acquired Zappos for $1.2bn in 2009. All I know about this purchase is that Zappos was a very customer-centric shoe retailer that seemed pretty well-run and by 2008 was doing more than $1bn in GMV.

-Started AWS in 2006. I think this business alone makes up for all the losses and failed investments that Amazon will ever incur. If you own an asset that can be worth over $1 trillion within the next 10 years, I highly doubt you’re a value destroyer. The logic that Bezos doesn’t care about profits simply falls apart here when this business is at the cusp of one of the greatest technology growth cycles of our generation and is already reporting run-rate 19% GAAP operating profit margins. If Bezos is an irrational empire builder then why would he not operate AWS at 0% margins? Instead, industry prices for cloud infrastructure services are already firming up. So unless you think there are some serious sketchy accounting games going on here with the segment reporting, the “profitless forever” argument simply does not hold for AWS.

-The Fire phone has been an absolute disaster. In general it seems like Bezos’ strategy in consumer hardware is to sell products at a loss in order to drive incremental sales on the core retail platform.

-China has obviously been a disaster; nothing much needed to be said here. India, on the other hand, is a huge potential market and looks very promising.

-Amazon Now, AmazonFresh, Amazon Prime, and the Drone program. With the exception of Prime, these are all pretty large investment programs where the long-term pay-off may be questionable. Need a bit more time to judge these fairly.


Overall, I think his batting average is not perfect, but pretty damn good when you actually look at the record, and certainly better than most CEOs. Share dilution has also been quite limited over time. He writes that his job is to maximize long-term FCF per share in his shareholder letters. I just find it hard to believe that he is bullshitting in every letter just to trick shareholders into believing the Amazon story. It’s clear that Bezos thinks reinvesting all of Amazon’s profits into long-term projects is a more attractive use of capital then returning it to shareholders or reporting a healthy GAAP profit for Wall Street. What’s most important here is that Amazon’s earnings power has consistently increased over time, not what the company is reporting in GAAP profits.


Valuation – The Most Valuable Company in the World

On near-term valuation multiples, Amazon looks very expensive. It trades at ~42x 2016e EBIT[12] by my numbers, but this multiple will rapidly shrink in my outer projections years as AWS grows its profits significantly. By 2019 and 2020, backing out the Retail segment’s value, I believe we are getting the AWS business for 1x and -5x EBIT! On a fully consolidated basis, Amazon trades at just under 7x my 2020e EBIT projection. Even if we assign 0 value to the Retail business, we are paying 13.5x 2020e EBIT for AWS, which is still way too cheap in my view.


Base case, I am valuing the Retail segment on 20x 2020e EBIT, or ~$470bn ($961 per share), which translates into a GMV multiple of 0.5x. This is a large discount compared to Amazon’s historical GMV trading multiples of between 0.8x-1.0x, but reasonable I think, given the more mature future growth profile. For reference, large-scale US-based retailers with slower growth and without a high-margin marketplace business have typically traded between 0.6x-1.0x GMV. Worst case scenario, in 5 years this segment should be worth at least the current market-cap today.


I feel AWS deserves a higher multiple than Retail, and I am valuing this business at 25x 2020e EBIT or ~$600bn ($1,240 per share or nearly 2x Amazon’s entire current market-cap). This translates into ~11x 2020e sales and ~19x 2020e EBITDA. These multiples may look aggressive but I believe are well justified. Post-2020, AWS will still likely grow operating profits at 20%-30% per annum or higher on the back of massive ongoing cloud services growth. The business will also throw off increasingly predictable cash flow streams as enterprises are locked-in to a single cloud platform provider with most of their mission-critical IT workloads. Benefitting from a long-term secular industry tailwind, the business is also relatively non-cyclical; in fact I think it will be quite recession resilient and perhaps even counter-cyclical as enterprises have a greater incentive to cut costs by moving workloads over to the public cloud during a recession. If we take publicly-traded enterprise horizontal SaaS venders with near-infinite growth horizons as a set of comparables, I think AWS is a much better business than most of these names that trade at 8x-11x forward revenues with non-existent earnings, greater competition, lower switching costs, and smaller TAMs.


With the addition of the total incremental FCF and working capital that will be generated over the next 4 years, I think Amazon shares are worth between $2,000 – $2,350 by 2020 which should provide a 4-year annually compounded internal rate of return of 31%-37%. Worst case scenario, I think the stock trades at 19x my consolidated 2020e bear case operating profit numbers, which means shares are still worth $1,300 or 94% higher than where it trades today. This gives us about a mid-teens IRR. The stock would have to trade at a sub-10x 2020e EBIT multiple in order to be worth less than where it is today. This seems like a pretty good risk/reward.


The Bigger Picture: My Margin of Safety in Quality & Growth

Stepping back a bit, my former blog mate predicted here that Alibaba will become the most valuable company in the world in 10 years. I’d have to respectfully disagree with him. 7 to 10 years from now AWS alone could be worth well over a trillion dollars[13] and I’d bet that Amazon will be the first company with a trillion dollar market-cap. I love high-quality compounders with near-infinite/open ended growth horizons that are evolving into monopoly-like businesses, and I think the chances of me being wrong on both the prospects of AWS and Retail is much smaller than me being independently wrong on either one of them.[14] As such, I feel comfortable with the probability that either one of these businesses can more than justify the entire Amazon market-cap today, giving me my desired margin of safety.


Catalysts – Warning: Long-Term Time Horizon Required[iii]

I do not think this is a great holding for traditional hedge fund-like strategies that focus on shorter-term, event-driven trading opportunities. But make no mistake, I believe the timing for this investment is generally good and my suspicion is that AWS will continue to blow away Street consensus over the next several quarters. Therefore, I think the stock will continue to re-rate as growth-oriented investors pile in.

Catalysts may include:

  • Additional AWS financial disclosure such as volume, pricing, cost structure and PaaS and SaaS business lines; A spin-off of AWS since there are virtually no synergies with the Retail segment (this move would be very unlikely, since Bezos would likely lose control); I believe if this segment were to be spun out today, shares could trade 50%+ higher. I would be very impressed with Bezos if he did this.
  • Retail consolidated operating margin expansion from mix-shift to faster growing 3P operating profits, Prime subscription fees, current heavy investment phase rolling-off and greater operating leverage from fulfillment.
  • Time: “The indefinite continued progress of existence and events in the past, present, and future regarded as a whole”.



In general studying Amazon was a very challenging and intellectually stimulating exercise. What I love about this idea is that it isn’t a hedge fund hotel or a consensus trade. I still think there are a lot of skeptics out there that love to hate the stock and criticize the lack of reported profits. I would not be surprised to receive a lot of push back from my readership base this time, even from the well-informed, very smart crowd.


Other potential ways to play the public cloud computing megatrend:

  • Alphabet/Google: Could be an interesting backdoor play on the public cloud if their business begins to take off. Not a guarantee but I don’t think this is priced in at all.
  • Microsoft: Thinking about this company makes me bored. But in all seriousness I think they will do OK.
  • Chinese Internet Companies: According to some sources Alibaba’s IaaS has 1.4 million customers. Other major Chinese internet firms such as Baidu, JD, or Tencent may eventually get into this space.
  • Short IBM/Oracle:

IBM is again on its death bed, and has to reinvent itself in order to remain relevant. Honestly I think their business is going to shrink a lot, and I don’t think there’s room for another major IaaS/PaaS player in the market. Commoditization of IT services is going to absolutely kill them. No one’s going to use their consultants or outsource their IT infrastructure to these guys if they can do it on the public cloud for much cheaper with a superior technical service. Even industries with tons of customer and regulatory sensitive data such as the Public sector, Financials, Insurance and Healthcare will all eventually move the vast majority of their IT workloads to the Public Cloud.


Oracle is another potentially interesting short. The issue for these guys isn’t that they won’t successfully transition into a cloud vender, but that it’s a much less profitable business than on-premise. When you earn 95% gross margins on your application maintenance fee streams and have to replace those with SaaS subscription fees at closer to 60%-70% gross margins, your business is going to get hurt. Also it appears that Amazon Aurora is gaining much more traction in the market compared to Oracle’s existing cloud database service.


[1] I think people under-estimate how price-sensitive consumers are to purchasing commoditized products

[2] Personally, after developing a web application myself, I know it would have been extremely inconvenient, very slow and more costly to purchase the servers to host my app over the internet instead of using a public cloud provider such as AWS.

[3] In fact, HP has already given up its Cloud Helion business and has recently announced a new partnership with Microsoft

[4] Just like how the Salesforces and Workdays of the world continue to disrupt the application software market, I see the same phenomenon playing out in the infrastructure services world

[5] Between October 2013 and December 2014, Amazon’s average monthly cost per GB RAM fell from $42 to $25, while Google’s dropped from $52 to $32. Increased bargaining power with hardware suppliers could also mean lower capex per unit going forward.

[6] Sometimes we have to use our imaginations to produce great analysis

[7] Assuming maintenance capex in the mid-teens

[8] I am a large bull on Netflix’ prospects as well but have not been able to find an attractive entry-point.

[9] Kiva Robots are estimated to replace 1.5 human workers in fulfillment centers and cost $25k a piece with an economic life of roughly 5 years

[10] My thesis is also not based on a bet that current large investments will roll-off by 2020, and thus margins will lift-off and shares will see a re-rating. I am just trying to come up with an educated guess about how margins may look like if we back out these investments by 2020.  I am all for value accretive investments if they present themselves and if they are the best use of capital. So reported GAAP EBIT margins may never reach this EBIT margin range this decade, which is OK with me as long as I’m confident that capital is being allocated wisely. Honestly Amazon’s Retail business was one of the most difficult businesses I’ve ever analyzed, and I’ve never been a proponent of using precise calculations to drive an investment thesis/valuation.

[11] Amazon in fact recorded GAAP operating margins in the MSD during the mid-2,000’s

[12] I believe operating income will be the key driver of shares going forward. Street tends to focus on CSOI. I focus on GAAP EBIT because I think stock-based comp should be capitalized going forward

[13] Just assume 50% share in a TAM of $500bn and 40% operating margins = annual operating profits of $100bn; A modest 10x multiple would mean a $1 trillion dollar valuation!

[14] Risk is increased if you don’t know what you are doing.

[i] As a side note, part of the reason why I believe excessive diversification is overrated is because the intrinsic value of certain stocks held in a concentrated portfolio are the summation of multiple businesses that are potentially diverse across customer base, geography and product lines etc. Of course, certain single-stock/idiosyncratic risks still apply, such as value destructive capital allocation.

[ii] which comprises of spending on hardware, software, and services across the entire software stack

[iii] And when I mean “long-term” I mean 5-10 years!

Charter Communications / Time Warner Cable – Betting Big on the US Cable Industry


“I have said in an inflationary world that a toll bridge would be a great thing to own if it was unregulated … you have laid out the capital costs. You build the bridge in old dollars and you don’t have to keep replacing it.” – Buffett


Overview – Merger Arbitrage is Very Profitable Again:

I like Charter here @ $170 per share. I believe heavy selling pressure from arbitrageurs and the complexity of the proposed merger with TWC and Bright House Networks has created a very attractive entry-point. A long-term investment in Charter shares today could potentially generate a very attractive 31% – 39% multi-year annually compounded internal rate of return.

As some of you that regularly read this blog might know by now, I have been a cable bull for quite some time and I still think the industry’s long-term prospects are very attractive both in the US and in most of Europe. I love analyzing and investing in cable equities in general and I love rapidly growing levered equities.

I also like investment theses where the underlying target company is a very good one but is operating within an industry clouded by uncertainty. Despite all the naysayers and the extreme negativity in the mainstream media towards US cable operators – from my perspective it seems like the major papers absolutely love to hate the cable industry – cable is a very attractive business. To gain a better perspective on the negativity, simply take a look at the cover or business section of the Wall Street Journal every other week or so, and you will likely find some article focussed on cord-cutting or cord-shaving (subscribers migrating to less expensive programming packages), the demise of the Pay-TV bundle, some type of major programming dispute a MVPD has with a cable network, or profiles of newly emerging streaming services that will change the face of content consumption. I believe major news reporters have a misinformed view of the economic implications of cord-cutting for cable operators, and that fears are overblown. I think most of the market and the Street still under-appreciate the likely future improving economics of the cable business and are instead overly focussed on the sustainability of their Pay-TV profits streams, programming cost pressures, and regulatory uncertainty. Over the next 7 – 10 years, I expect cable operators in mature markets will continue to transition into very high-margin, less capital-intensive cash cows with a de facto monopoly or duopoly on the high-speed broadband market; moreover, there is ample opportunity to continue to expand into adjacent growing markets such as enterprise/SMB, out-of-home WiFi, and advanced home security/automation services. The industry is also in a rapid final wave of consolidation which should greatly improve economies of scale for aggressive acquirers such as Charter Communications.

The thesis is very simple: Bet on Malone and his legendary capital allocation, bet on Rutledge and his operational prowess, and bet on a growing broadband business.


The Deal:

Charter is acquiring TWC for $195.70 per share in cash and stock and TWC’s shareholders can elect to either receive $100 or $115 per share in cash for the consideration. Based on my numbers, “New Charter” should be able to compound FCF per share at a higher rate if more TWC shareholders elect to receive less cash and more Charter stock – assuming Charter stock stays above current trading levels at the deal closing date.


Nearly every analyst on the Street came up with different purchase multiples based on various adjustments to TWC’s yearend expected balance sheet and free cash flow generation. On my numbers, Charter is paying around 9.3x 2015 EBITDA for TWC. The headline purchase multiple appears optically high relative to prior cable industry deals; however, due to M&A speculation a large chunk of the consideration is comprised of relatively inflated Charter stock, and also with the benefits of massive easily realizable tax, operating cost, capex and financing synergies, I believe the deal is likely free cash flow per share accretive to Charter on a near-term and longer-term basis.

Time Warner Cable: The Sleeping Giant

The deal expands upon the Charter roll-up thesis; TWC’s management will be able to cash out in a huge golden parachute and Rutledge and his highly capable team will better manage TWC’s systems and improve per-subscriber unit economics by investing in long overdue high IRR projects across the entire HFC network. Adhering to the same operating model that has accelerated Charter’s own free cash flow growth, they will: 1) convert legacy analog systems to digital across TWC’s entire footprint (like they have for Charter’s footprint already), which should reduce churn, accelerate ARPU growth, and extend average subscriber lives by offering a higher quality service, 2) greatly improve customer service, 3) up-sell advanced/incremental video services, 4) free up spectrum capacity in the pipe to offer much faster minimum data speeds than most competing broadband services which should allow them to continue growing their broadband share and 5) offer attractive triple-play (and future quad-play) bundles with superior value propositions to existing Telco fiber/copper and direct-to-home Satellite offerings. These initiatives should, along with a management team and board laser focussed on shareholder returns, greatly improve TWC’s fixed asset utilization across their network and accelerate growth in the key EBITDA per homes passed metric.

The bottom line is that Time Warner Cable is a very attractive cable asset with a highly clustered set of systems across America and has reasonable Telco fiber competitive overlap within its existing footprint. The company is managed by a mediocre executive team and had a passive shareholder base focused on near-term shareholder returns over aggressively growing long-term equity value. I believe the market has yet to price in the upside of a growing TWC business.

Altice’s surprise entry into the US cable industry provided TWC with an extra bargaining chip and likely forced Charter to pay ~$15 per share more with less advantageous terms than otherwise. Originally I was expecting a purchase price per share closer to $175 – $185. I feel like the Charter idea was almost a no-brainer prior to Altice’s entry. Mr. Drahi likely ruined the dream bull case scenario for Charter longs now that he will be fiercely competing to buy US cable assets, and consequently inflate industry trading multiples. Aside from the potential minor anti-trust concerns, my previous long-term outlook on Charter was that it would have likely rolled-up the balance of the US cable industry accretively and eventually match or even exceed Comcast’s size. Despite this, I believe Charter remains a very attractive idea and I don’t believe Dr. Malone and Mr. Rutledge would have pursued this deal if they didn’t think it was accretive to Charter. This is also likely Dr. Malone’s final opportunity to come full circle in his career to build a powerhouse cable company in the US where he was a pioneer.

Acquisition Multiples

Interestingly enough, the Bright House portion of the deal is the exact same one that that was agreed upon contingent on the consummation of the failed TWC/Comcast/Charter transactions. In my view, the Brighthouse portion of the deal is another example of brilliant financial engineering by Dr. Malone in order to shore up Charter’s balance sheet to make a large cash consideration for TWC. The total consideration is $10.4B comprised of $2B in cash, $5.9B in common stock and $2.5B in preferred stock units that will have a 40% conversion premium to New Charter’s stock price. I think it goes without saying that by preferring to receive such a large portion of the consideration in New Charter equity, the Newhouse family are quite bullish on Charter’s future prospects. And I think they should be. The Newhouse family are long-time successful US cable entrepreneurs and industry veterans and have invested alongside Dr. Malone in the past, partnering in deals such as investing in Discovery Communications when it was nearly bankrupt. I find it interesting that the “smartest money” in the business are all betting big on the US cable industry; three very successful cable entrepreneurs and investors (Malone, Drahi, the Newhouse family) with some of the best value creation track records in the industry are bullish and directly putting their money where their mouth is. Great investors typically see what the market is largely missing several years down the road and bet big when the odds are heavily stacked in their favour.

great investors

From Charter’s most recent 14A, Charter’s largest shareholders are some of the greatest value investors and capital allocators of the 20th century.



On the leverage front Charter management stated in the merger deck that they plan to deleverage to the “lower end of their target leverage range” of between 4.0x – 4.5x post transaction. Given that Dr. Malone is the de facto strategic capital allocator/investor behind Charter, I highly doubt that they’re going to deleverage anywhere close to 4.0x, especially if rates stay this low. My bet and part of my thesis is that they’re going to maintain a continuously levered capital structure around 4.5x over my projection period and aggressively shrink the equity. And I don’t see why this leverage ratio is not unreasonable for New Charter. Liberty Global and Altice are similar cable roll-up growth equities with similar risk profiles and are typically levered closer to 5.0 and frequently go above this level. I target a comfortable EBITDA/Interest coverage ratio above 3.5x for New Charter which should provide ample EBITDA cushion.


I think when we have a great proven operator in place that is disciplined in allocating capital and a business which is essentially a non-cyclical, lightly regulated monopoly/duopoly that sells an essential service and generates very predictable utility-like cash flows, a high leverage ratio is appropriate. This is compounded by my view that New Charter’s EBITDA will likely grow in the high single-digit range, supporting an aggressive but appropriately leveraged equity shrink playbook.

Management also confirmed that Charter and TWC should be able to retain their separate lending silos and TWC will likely retain their investment grade rating post-deal closure. I conservatively assume that total transaction debt will be issued at a blended 5.85% rate, and will of course be mostly long-dated, fixed with a staggered maturity profile in separate non-recourse holdcos. Based on precedent high-yield bond and cable debt offerings with similar equity growth profiles (Altice, DirecTV, Charter, Liberty Global etc) along with the current attractive credit market environment, I think the inability to secure adequate financing will be quite low. On future rates, my assumption is that they will likely increase slowly over time and I model the cost of debt creeping up 50 bps higher per annum. If the yield curve flattens on the back of a rising Feds funds rate the long end of the curve should remain attractive for burrowers such as Charter. I also think that there’s a possibility that we may be living in a zero interest rate environment for the next 5-10 years or potentially even longer. There is very little visibility in this future probability distribution curve and the range of possible future outcomes can potentially be very wide.


New Charter Pro-Forma Model:


The numbers above are for my base case and assumes the deal is accretive on a FCF per share basis by nearly 20% in year 1. How I prefer to model is to reverse engineer the projections necessary to arrive at my target return profile, and then assess if these projections are reasonable. Originally I was projecting around $30 per share in fully-taxed free cash flow for Charter by 2019/2020 under the failed Comcast/TWC/Charter proposed transactions. I think that under my base case New Charter should be able to comfortably achieve this same number by 2019 under the new transaction.


Key Drivers:

Aside from the operating cost synergy upside and aggressive deployment of capital into further M&A and share buybacks, I think a key driver of New Charter’s stock will be whether Rutledge and his team can accelerate TWC’s revenue growth. Most of the Street appears to modelling quite steep video sub declines for both Charter and TWC past 2015. I think continued video sub declines are likely but my decline rates are much softer than most analysts. Given the inherent sizable operating leverage in this business, I believe a return to video revenue growth or at the very least measured, small declines in net video subscribers is likely required for this thesis to play out. The good news is that I believe future cord-cutting is a measurable risk, and in the severe downside scenario of accelerated cord-cutting and shaving, I believe there are 3 major mitigants:

  • For consumers that choose to consume their content purely over-the-top instead of part of a traditional cable TV bundle, high-speed broadband has become a ubiquitous service. To the extent that additional OTT competition continues to enter the video streaming market and disrupts the traditional bundle, cable has the ultimate hedge by owning the critical last-mile infrastructure or pipe that efficiently transports high-speed data (HSD) and video services to the customer; cable operators can easily price discriminate with a tiered pricing strategy as higher-speeds and capacity are demanded to stream content online. Cable’s dominant HSD service will only become more valuable over time as data speeds and bandwidth capacity demands continue to grow exponentially. In essence, I view the cable business as a collection of lightly regulated local toll-booths on inevitable, growing data consumption.
  • Due to high programming cost pressures over the past decade and promotional pricing strategies in an increasingly competitive video marketplace, Charter’s video business gross margins have been squeezed to around 35% today, and is quickly becoming a loss leader within the cable triple-play bundle. So the net effect of any further declines in video subscriber losses will increasingly become negligible over the next several years. Charter’s Spectrum package currently offers an attractive triple-play bundle at an entry-level promotional price-point of ~$90 that ramps up over 1-2 years. Since pro-forma programming costs per sub per month are projected to be in the mid-$40’s range in 2016 for New Charter, Charter is already selling the video service at near break-even levels. At this point in the video business’ product life cycle, I believe it is more of an “add-on” service for potential cord-cutters, and is used by cable operators to help preserve the customer relationship by enticing consumers to pay around $10-$20 more per month for a competitive triple-play bundle. As long as the entire customer relationship (selling either a data, video, or telephony service) is not lost the hit to an operator’s gross profits and cash flows will not be as severe as standalone broadband services can be priced higher as opposed to within a bundle. For subscribers that purchase pricier pay-TV packages which include more premium content, I believe these customers are typically an older demographic, wealthier, and consequently less likely to “cut the cord”.
  • For the growing 12 million or so US homes that will never subscribe to a traditional cable bundle, I see no reason why cable operators or any MVPD for that matter can’t offer their own competitive over-the-top skinny TV bundle to chase this market to help offset the shrinking video business. Despite having roughly 14 million Pay-TV subscribers, DISH has already launched a direct-to-customer online streaming product called Sling which is likely a 10% net margin business at a $20 per month price-point. There is certainly risk of increased cannibalization of their traditional TV revenue streams but I believe these packages are designed, priced and marketed squarely to broadband-only homes. Given the shifting economics of content distribution from the distributor to the cable networks and producers within the traditional Pay-TV ecosystem, I believe ultimately the cable networks that monetize their content through wholesale channels have more to lose than the distributors if more customers elect to replace traditional bundles with skinny ones.

Stepping back from these strong mitigants in a crash case scenario, my view on cord-cutting hasn’t really changed over the years. I think 1) A basic Pay-TV package still provides a great and unparalleled value proposition for consumers looking for basic entertainment, especially considering the fact that Americans on average watch 4-5 hours of television per day 2) US cable networks remain unwilling to aggressively license their “must have” and most valuable content outside the lucrative Pay-TV bundle as they are not willing to cannibalize their existing revenue streams over the short-term, 3) Due to inertia cord-cutting is likely to be a slow, and measured decline as it has been, 4) Operators are now more focussed on improving customer service, 5) Operators are stepping it up on the technology front by offering sleek next generation cloud-based user interfaces[1] that they previously never did, 6) Growth in OTT services such as Netflix have far exceeded the growth in broadband-only homes; Netflix has around 40 million US subscribers which is around 3.5x as many broadband-only homes, indicating that an OTT streaming service is still a complementary service, not a complete substitute, for many consumers. 6) US household formation is ticking up and could potentially provide an additional tailwind for Pay-TV subscription growth, blah, blah, blah… The cord-cutting trend is real but is blown out of proportion by the media.

So the video business is likely a melting ice cube in secular decline, but an upside driver to this thesis is for New Charter to regain lost market share, mainly from the direct-to-home satellite distributors that were able to undercut cable operators in video pricing and were competing against a largely inferior analog cable product throughout the past 2 decades.[2] With the video product becoming increasingly commoditized across all MVPDs with little differentiation now that cable operators are upgrading to an all-digital network, with the right execution, I am confident that cable can regain lost video share. I am particularly confident in Rutledge and his team’s ability to up-sell and cross-sell incremental and advanced video and broadband services at high incremental margins to TWC’s subscriber base, drive up TWC’s existing low ~33% triple-play penetration and ARPU and add more value and better customer service to the customer relationship which should ultimately reduce churn. And Rutledge’s team already have a proven track record of doing just that.

Rutledge left New York-based Cablevision which currently leads the cable industry in EBITDA per homes passing at ~$450 and penetration rates and took the helm at Charter in late 2011. Since then 1) Charter’s video sub base has stabilized as they have nearly stopped bleeding video subs and can potentially start growing positive net subs again over the next several years, 2) Charter’s EBITDA per homes passing has started growing steadily again since the turnaround that began in 2012; it has grown by ~15% since then. Further industry-wide evidence that support the view of an improving cable video business include TWC’s recently reported quarterly numbers showing ~3% yoy net video sub losses; a decent improvement over heavy losses in 2013. Unfortunately, the cable and telco operators don’t disclose their churn and subscriber acquisition costs (SAC) metrics like the DBS operators do – which is really a shame for the purposes of our analysis of a subscription-based revenue model. However, my bet is that New Charter’s greater scale should drive lower churn and SAC as CPE and network-related hardware costs decline over time. Most importantly, Mr. Rutledge has nearly 35 years of industry experience, with a proven track record as COO of Cablevision from 2004 – 2011, and a strong familiarity with TWC’s systems as former president of TWC. So I think if there’s anyone that’s best suited for this job, it’s undoubtedly him.

“During his tenure at Cablevision, Mr. Rutledge met Mr. Malone, a larger-than-life figure who was one of the industry’s pioneers. Mr. Malone tried to recruit Mr. Rutledge to run DirecTV, the satellite operator he controlled at the time.

Mr. Rutledge was not interested, but agreed to meet Mr. Malone for a dinner at the University Club in New York.

“I thought the idea of sitting in a room and telling him why I didn’t want to go to DirecTV would be fascinating,” Mr. Rutledge said. “He is a frictionless thinker. By the end of the conversation, we were talking about how great cable is.”

–The New York Times

At the time, DirecTV was Dr. Malone’s largest personal holding, and he was likely looking for a great operator to replace Chase Carey. One final comment on Rutledge is that I like the fact he’s a very long-term oriented operator who sees the need for cable operators to sacrifice near-term profitability in order to maximize shareholder value longer-term. He has done this by adhering to a proven operating model by investing heavily in the fixed network infrastructure and customer service capabilities necessary to better compete long-term.


The Future: High Speed Data

I am modelling high-single digit residential broadband revenue growth on the back of 1) Increasing broadband penetration from a 40% pro-forma footprint penetration today, to closer to 50%-60% 5 – 7 years from now, and 2) Mid-single digit growth in data ARPU, driven by a mix-shift towards higher speed tiers and modest inflationary pricing increases. Broadband sells for near 100% incremental EBITDA margins excluding subscriber acquisition costs and is a much more attractive business than video as there are no programming expenses. The commercial business also continues to take market share from ILECs and this business is growing top-line at a mid-to-high teens rates, driven by all 3 service lines.

In terms of the outlook for future broadband internet penetration rates, there are a few references. Cablevision is already at an industry-leading 55% penetration in its New York-centred footprint despite competing against Verizon’s superior fiber-to-the-home (FTTH) FioS product which overlaps nearly 70% of its footprint. Yes, New York is a wealthier demographic, but the competition is also fierce. Comcast is currently at around 40% penetration despite having around 55% – 60% telco-based fiber overlap. Another comparable is Telenet which is a Belgium-based cable operator that currently has broadband penetration rates above 55% and has fiber overlap from Belgacom across the majority of its footprint. Other European peers operating in developed countries such as Virgin Media, Ziggo, Numericable Group, Kabel Deutschland and the Scandinavian cable-based operators are still steadily increasing their broadband penetration. Right now I estimate that New Charter has around 38% – 40% fiber-based overlap with U-verse and to a smaller extent FioS which is relatively low compared to its other large, US-based peers.

fiber overlap

So I see no reason why over that over the long-term penetration levels will not reach my target.

On pricing, the Federal Communications Commission (FCC) actively monitors broadband and video pricing and it would probably not be wise for cable operators to abuse their market power in “uncompetitive markets”. The big bet here is on data demand growth. Some of us may have read the Cisco reports that forecast rapidly growing data-usage demand (~30%-40% compounded annually) over the next 5 years or so. Personally growing up being enamoured as part the “digital age”, this is one of those few secular trends where I have a very high conviction. It’s not like data services are new – we all remember the crappy dial-up services in the “old days” – the application of the technology just hasn’t accelerated until the recent explosion of bandwidth-intensive applications. With the proliferation of multiple devices outside and within the home, and the increasing amount of time spent on applications on these devices, (an increasing number of two-way interactive, customer-facing applications such as Facebook/Instagram/Snapchat/Tinder/WhatsApp, and streaming HD quality shows/movies) demand for these services will likely grow exponentially from here.

In terms of broadband competition, in a scale business the key question is really who can meet the growing demand for data the most cost effectively. The simple answer is that only cable with its fiber-to-the-node HFC[3] network can. Cable’s current DOCSIS 3.0 technology is capable of providing downstream speeds of up to 1 gbps. The technology roadmap to higher speeds is also clear. DOCSIS 3.1 is already being field tested by Cox Communications and Comcast in select markets and this technology will be able to offer downstream speeds of up to 10 gbps. Most importantly, the incremental cost of capital per home for upgrading to DOCSIS 3.1 is attractive at only $70-$75 or less. Right now only about a third of Comcast’s current HSD customers purchase a broadband service above 25 Mbps – the threshold that was arbitrary defined by the FCC as “high-speed broadband”. But as speed demands increase it will be clearer that cable has a natural monopoly on speeds above this level across parts of their footprint.

The main reason why cable has such a huge competitive advantage today is that operators have already invested the tens of billions of dollars in building out their massive fixed network infrastructure[4] in the 90’s and early 2000’s; these major infrastructure costs have been laid out in old dollars and never have to get replaced. I estimate that both Charter and TWC currently earn a mid-20’s pre-tax return on net tangible capital, and future incremental returns on capital should continue to improve as HSD profits increasingly become a larger piece of company-wide profits. It will likely be another 15 – 20 years before cable operators have to even consider overbuilding a FTTH product to maintain their competitive advantage. Until then cable should continue to take the large majority of incremental new broadband subs – especially from regional incumbent local exchange carriers (ILEC) that offer an inferior DSL service.

Partly due to regulatory uncertainty, the major telcos have basically stopped their fiber roll-outs. AT&T has upgraded parts of its legacy DSL-based twisted pair copper wire network to offer a VDSL product by overbuilding fiber optic cable to the node. Through vectoring and bonding the last-mile copper-to-the-home they can only boost max headline download speeds of up to 100 – 250 mbps depending on the length of the local loop. Verizon’s FTTH FioS service and Google Fiber are the only available products right now that can match and exceed cable’s downstream speeds, but building a FTTH network is extremely capital-intensive[5] and for now the economics only make sense for the highest-density population cities.

Due to the laws of physics, data over wireless spectrum can’t be transported as efficiently over the air than within a pipe, and the price of licensed spectrum is soaring due to shortages across major wireless operators. Right now wireless data demand is far outstripping available spectrum capacity and there is an increasing need to use WiFi offload as a solution. In order to provide seamless mobile-fixed connectivity to customers, convergence has been a hot topic lately in the cable world. The cable WiFi consortium in the US already has over 300K WiFi hotspots deployed across the country using unlicensed spectrum. There is an additional growth avenue by leasing additional wireless network capacity from AT&T and/or Verizon and as a mobile virtual network operator (MVNO) bundle an out-of-home WiFi service. Quad-play bundles typically further reduce churn and improve subscriber economics.


Synergy Upside:             

Management have provided a very conservative guidance of $800 million in run-rate cost synergies. I think precedent cable M&A deals where scale efficiencies were sizable and obvious such as Liberty Global/Virgin Media and Liberty Global/Ziggo have demonstrated the massive potential upside in conservative synergy estimates. In both these cases, the actual synergies actually doubled the initial estimates.

New Charter Synergy Assumptions:

  • Assuming no revenue synergies.
  • Programming synergies
    • I estimate ~$775 million in total run-rate programming cost synergies based on a pro-forma affiliate rate card slightly lower than TWC’s 2016 projected monthly rate of $46.60; I conservatively project that these run-rate synergies will be gradually layered into years 1 to 3 by 25%, 50%, and 75%, respectively, as expired affiliate fee agreements are renegotiated over the next several years. It won’t be until 2019 that New Charter will capture the full run-rate programming cost synergies.

programming synergies

Programming cost synergy estimate

  • OpEx synergies (excl. programming costs)
    • I assume 3.5% of the pro-forma cost base or ~$636 million in full run-rate operating cost synergies by 2018, again gradually layering this into years 1- 3. Most of these cost savings should come from higher efficiencies in local economies of scale in marketing, advertising, and customer service, etc. As you can see on this map below there will definitely be incremental benefits of servicing subscribers in a continuous footprint for New Charter where the 3 companies merging currently overlap (in markets such as Texas, California, etc). The clustering effect of systems will help the new company easily achieve greater economies of scale in local markets.

New Charter’s footprint

map footprint

  • CapEx Synergies and Projected Capital Spending:
    • The low hanging fruit here is definitely the increased bargaining power in the procurement of customer premise equipment and other network-related hardware with a larger subscriber base. In Europe, Altice and Liberty Global’s capital spending plans for upgrading their network to DOCSIS 3.1 have cost them ~50-60 Euros per subscriber relationship. If we conservatively assume New Charter spends $75 per sub upgrading the balance of TWC and Bright House’s network to digital[6] (~8-10 million subs I estimate), they will likely spend around $600 – $750 million over 2-3 years for this capex cycle. Remember, this is mostly success-based capex spending where incremental revenues per sub are received for every upgraded home/business, and churn will likely be reduced as well. Upgraded subs are more likely to purchase bundled and advanced/premium services; even if we assume a $5 per month per sub revenue uplift, the payback period for this capex project is less than 1.5 years
    • TWC has already begun a 3-year investment cycle upgrading its systems that was initiated in 2014 (the following year after the company suffered a disastrous year with nearly 7% net video subscriber losses), rolling out its Maxx service to select high population density markets. Charter will accelerate this roll-out, along with digitalizing Bright House’s systems and brand the combined company’s service under Charter Spectrum, offering minimum data speeds of 60 mbps, hundreds of HD channels and advanced video services, at-home WiFi, an improved cloud-based user interface, digital DOCSIS 3.0 enabled modems and improved customer service. By year 3 I expect the majority of the network upgrades to be completed, and capital intensity will decline rapidly from there. Charter has already completed upgrading its network to all-digital and on a standalone basis their capital intensity is set to decline. There should also be some capex savings from the increased clustering of systems and less truck rolls from an improved TWC customer service.
  • Tax synergies: Very easily realizable. There will be a higher intangible asset base that can be amortized from purchase accounting. On the higher tax basis, I project the company will start paying full cash taxes in 2018 as Charter’s NOL runs out and assume no further M&A.

Integration and execution risk are likely not considerable here due to nature of the assets and the business (human capital is not the most critical resource and company cultural factors are not as important), and given Rutledge’s past track record in integrating cable systems successfully. Overall, I project New Charter can potentially achieve ~$1.4B in full run-rate synergies out of the pro-forma operating cost base by 2019, or 75% higher than management’s initial estimates. TWC should be run much more efficiently under Rutledge and his team.


EBITDA or “Operating Cash Flow” margins and growth, leveraged share buybacks and accelerating free cash flow per share growth

ebitda per passing

Core Charter is already growing revenue and EBITDA at high-single to low-double digits driven by its operational turnaround. New Charter’s EBITDA and EBITDA per passing should be growing at similar high-single digits. I’m targeting nearly $19B of EBITDA at a 38.5% margin and roughly $375 of EBITDA per passing by 2019. Pro-forma EBITDA per passing is around $270 for 2015, which is still considerably below the industry average. My operating model implies that Charter should be able to partially close the gap with its peers; EBITDA per passing should grow to around $370 by 2019, which would still be a nearly 20% discount to Cablevison today.  For reference, Comcast’s cable division generated ~$330 of EBITDA per home passed and ~41% EBITDA margins in FY2014. Despite being larger, Comcast has a much more balkanized footprint largely due to past inorganic growth and a higher % fiber overlap across its footprint than New Charter.

I differ from the Street on the key operating model projections on a longer-term basis (I believe operational gearing, EBITDA and FCF margins will kick in on the backend of my projection period and by 2019/2020 should converge closer to Comcast’s current levels).


Levered Equity Shrink:

I also differ from the Street on New Charter’s capital allocation policy. After reading over at least a dozen of the analyst reports that were released related to the merger, almost none of them (except for one who I won’t mention) modelled future share repurchases. Some of the bulge-bracket investment bank research analysts such as Citi, Goldman and Morgan Stanley have ceased their coverage of Charter and TWC since they are advising on the merger. Still, I find it very typical that after studying the Street’s under-appreciation of potential future buybacks in previous similar situations, most analysts are just assuming that New Charter will use the bulk of its FCF to de-lever the balance sheet. Do we really think that management will just de-lever substantially if tax-sheltered FCFs are growing at mid-20’s percent?

“I used to say in the cable industry that if your interest rate was lower than your growth rate, your present value is infinite. That’s why the cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money. If you do any arithmetic at all, the present value calculation tends toward infinity under that thesis.” – Dr. Malone

It is always difficult trying to predict Malone’s end game strategy, and it’s near impossible trying to stay one step ahead. But one thing I’ve learned from closely studying his opportunistic investment style and past major holdings is that he really likes obscurity and complexity in his deals and investments. This typically leads to mis-pricing, but savvy management eventually unlocks substantial value with hidden catalysts that the market doesn’t anticipate. So my bet is that as long as Charter’s free cash flows are steadily growing, management will aggressively buy back the stock at a 4.5x leverage ratio. Also, if more of TWC’s shareholders decide to receive more Charter stock and less cash, then New Charter should be able to start buying back stock within the first year; I assume that half of them do under my base case and Charter will de-lever by 0.2x in year 1. By 2019 New Charter can potentially retire around 35% of its pro-forma float if management maintains a continuously levered capital structure and uses all available FCF to buy back shares.


Additional M&A Optionality:

Like what Altice’s CEO Dexter Goei has said, everything below Comcast is effectively in consolidation mode right now. I think if the current Charter/TWC/BH deal is approved by regulators as contemplated it will already be a great result for all shareholders, but any additional acquisitions of smaller cable systems is free upside to my thesis. Despite Altice’s intention to grow their US-based revenues, I think it is very likely that New Charter will aggressively compete for smaller cable systems post-merger. In judging the attractiveness of a potential M&A target, I believe the two most important factors to take into account are the competitive fiber overlap and high-speed data penetration. Obviously the smaller both of these are the better. Other considerations include any continuous system overlap in a hypothetical pro-forma company, potential triple-play penetration upside and the percentage of systems that have been upgraded to digital. Suddenlink is an example of a very attractive rural-based operator with a ~12% fiber overlap and a 37% HSD penetration that Altice recently acquired a 70% stake of.

m&a targets

There are a couple of future potential attractive M&A targets:

Mediacom is an incumbent rural cable operator with ~900K basic video subs, an estimated 38% HSD penetration and an attractive ~12% Fiber-to-the-node (FTTN) overbuild within its footprint. Mediacom was taken private by its founder Rocco Commisso a few years ago but he is now 65 and may be looking to cash out soon in the current wave of cable consolidation.

Cable One is an incumbent rural cable system with about 680K total customer relationships and 500K data subs with a total 25% VDSL overlap and 1% FioS overlap in its footprint. This stub will likely get spun out of Graham Holdings Corp. (formerly the Washington Post) over the next 45 – 60 days. On my numbers, I think Cable One is likely worth around $2.8 – $3.0 billion or 9x – 10x 2015 EBITDA / ~$4,000 per customer relationship to a strategic acquirer. Given their lack of scale, Cable One has been shedding basic video subs at 15% – 20% run-rates due to management’s decision to delay upgrading their analog systems. Out of all potential cable M&A targets, I think this asset likely has the highest probability of being rolled-up into a larger player. I place a 95%+ probability that Cable One will get bought out by either Altice or New Charter. Since Charter/TWC will be waiting for the current proposed deal to be approved by regulators, I think it is more likely that Altice will make a bid for Cable One when it gets spun out in the next little while. Altice is basically a well-run, publicly-traded portfolio of globally diversified cable assets run by a management team with private equity-like targeted returns.

Two family controlled and larger operators that are more of a wild card are Cox Communications and Cablevision. Cox is a privately-held operator with a little over 4.1 million basic video subs and a very attractive rural-based footprint. Cox was taken private several years ago and I believe the company is very well run, but it doesn’t appear like the Cox family are in a hurry to cash out. Cablevision is controlled by the Dolan family and its footprint is mainly in the highly competitive New York area market. CEO James Dolan basically put up the company for sale at the Television and Internet Expo 2015. Despite the Dolan’s openness to a sale, I believe they will not be the first in line to get acquired given that the more attractive assets mentioned above will likely get rolled-up first.

Other potential smaller targets include WideOpenWest (WOW) holdings which has ~900K customer relationships and RCN. The common theme among these smaller systems is that they’ve all likely been bleeding basic video subs, typically in the 10%-15% range yoy. As programming costs continue to escalate and these smaller operators delay upgrading their systems, becoming part of a larger company with additional scale benefits remains the end game.


Valuation Summary:

New Charter Base Case: Assuming a $210 YE Charter share price

pro forma multiples

Malone recently said at the Liberty annual meeting that he is targeting high-teens to low-20’s annually compounded equity returns for Charter. I believe this is a very conservative projection but it is my downside case nonetheless assuming the deal closes.

Unlike the majority of media investors, I do not value cable firms on an EV / EBITDA multiple. I think this metric is relevant for evaluating potential M&A targets but aside from that this metric is misleading because 1) Not all debt is created equal, 2) Future capital intensity should be taken into account, and 3) Cash taxes have to be taken into account to adjust for potential large tax assets such as NOLs.

“It’s not about earnings, it’s about wealth creation and levered cash-flow growth. Tell them you don’t care about earnings.” – Dr. Malone

I think a levered FCF per share multiple is the most relevant metric, and this is another differentiated view I have from the Street that likes to value cable operators on an EV / EBITDA basis. Assuming we back out the present value of Charter’s NOL at $24 per share, currently standalone Charter trades for around 15x 2016 fully-taxed FCF per share. Assuming no further M&A, and all incremental FCF generated will be used to repurchase shares at reasonable multiples, New Charter can potentially earn above $30 per share in fully-taxed FCF ex-growth capex by 2019. I am conservatively assuming a post-merger, pro-forma multiple re-rating to 18x FCF per share or 3 turns higher over a 4-year period, potentially providing compounded annual returns of 35%. On these numbers, Charter shares can potentially be worth $507 – $634 by 2019, providing a huge margin of safety today. I think this is a very reasonable exit multiple given the predictability and non-cyclicality of Charter’s cash flows, future returns on capital, and its growth profile.

Pro-Forma Charter Communications 4-year Target Return Profile:

target returns

Unlevered FCF Valuation:  


Target multiples on an unlevered basis:

target multiples unelvered

On an unlevered basis we are within the same valuation ballpark assuming we apply similar multiple valuation ranges.

On a side note, I know there are some who consider themselves value investors who would typically avoid investing in any company with a lot of debt. Well, to them I say this: To a man with a hammer, everything looks like a nail, 2) There’s something very powerful called the levered cash-on-cash return on equity model.

In my view, it is quite dangerous to always act within a confined set of hard rules or to be forever chained towards one type of thinking. The best way to negate this inherent bias is to relentlessly seek the truth. Elon Musk who I highly admire often talks about this principal. I think the truth behind appropriately levered equities is that they can potentially yield higher risk-adjusted rates of return than otherwise. Any leveraged equity will always face the probability of an impairment of capital for the equity holders. For a largely subscription-based, recurring revenue business model that sells a basic essential service to an extremely diversified customer base I just think the probability here is very, very low.


Nightmare Case: The Deal Breaks and Charter Standalone Valuation

I place a 10% probability that the deal will get blocked by regulators and no additional M&A event materializes.

chtr standalone valuation

Standalone Charter should be earning around $10 of FCF per share by 2016. Assigning a 16x – 20x FCF per share valuation range and adding the present value of its NOL should yield a 1-year target intrinsic value range of $181 – $220 per share. However, there is also the $2 billion break-up fee to consider should the deal break. This would subtract about $20 per share to our valuation so our max downside could be anywhere from $160-$200 per share.

chtr standalone target



The Setup:

At the core, this is an event-driven / merger-arbitrage type idea, so I think there are a few ways to play the thesis.

  • Long TWC @ $176. Capture full deal spread assuming deal closes and roll TWC stock into New Charter to play long-term growth equity thesis. If deal breaks TWC stock will likely fall over the short-term, however, Altice will be waiting just around the corner. I think the probability that TWC remains an independent company regardless of whether the deal breaks or not is very slim. In the absolute worst-case scenario that no other bid materializes, TWC’s core business has shown early signs of improvement and my bet is that this operating momentum will continue.
  • Long Charter @ $170. Charter’s FCF growth is already at an inflection point so if the deal gets blocked the max downside should be minimal as I highlighted above.
  • Long both TWC and Charter. Both shares will collapse into New Charter at deal close and subsequently long-term growth equity thesis will take hold. I liked TWC @ around the mid $150’s as I placed a very high probability of a Charter bid materializing at around $175 – $185. Like most situations I like, having a longer-term time horizon is a huge edge here.
  • Merger Arbitrage Trade: Long TWC @ $176, Short 0.475 Charter shares @ $170 to lock in deal spread, receive $115 of cash per TWC share at deal closing. Trade duration: 6 – 9 months.


Catalysts / Event-Path: Next 12 – 36 months

  • Deal expected to close by year end or Q1 of 2016.
  • Post-merger re-rating with Street and investors focussed on pro-forma growth numbers and stabilizing TWC video business.
  • Post-deal closure synergy estimate revision upside by management and adjusted EBITDA margins and FCF ramp-up; Charter’s standalone free cash flow growth is already at an inflection point.
  • De-leveraging post deal close to target leverage ratio and announcement of massive share buybacks by year 2.
  • Additional accretive M&A of smaller systems (Cable One, Mediacom, WOW, RCN, etc) and/or system swaps with Comcast, Cox, or Cablevision to drive greater system clustering efficiencies.
  • TWC’s video business begins to stabilize and standalone revenue accelerates throughout the rest of 2015 driven by the roll-out of its Maxx service.
  • Easing of market concerns over potential increased broadband pricing regulation post-deal.


Risks to Thesis:

Key man risk – Dr. Malone. There is always key man risk when investing behind one of Malone’s holdings, and this is just the reality of betting behind any superstar capital allocator. Based on reading his biography Cable Cowboy, Malone ate “a lot” of steak and drank a lot of whisky with Bob Magness and the TCI team when he was president of TCI. I don’t know what his health habits are now but he looks pretty healthy to me. And for some reason, I have a sense that media moguls live pretty long lives. The legendary cable cowboy is now 74, and certainly appears at the top of his game being actively involved in many large, ongoing complex deals. If he is near the end of his career he will likely be going out in a “bang”, and I don’t mind going along for the ride.


Regulatory risk – As part of their net neutrality/open internet goals, the FCC has recently reclassified broadband from an “Information Service” to a “Telecommunications Service” under Title II regulation of the Telecommunications Act. Title II has raised investors’ concerns about potential increased future regulations on ISPs such as cable/broadband operators like Charter/TWC. If you want more background on the net neutrality debate, I highly recommend the Master Switch by Timothy Wu.

If the FCC just wanted to prevent ISPs from blocking, throttling or allowing paid prioritization of internet traffic, reclassifying broadband to Title II seems quite overkill in my view. Due to forbearance on pricing and forced last-mile unbundling, the medium-term implications on the economics of the cable business are negligible (maybe there will be some increased legal fees), but the real concern is that longer-term, as cable’s market dominance at higher broadband speeds in uncompetitive markets becomes more evident, regulators may impose pricing controls on broadband. I do think that this is the single biggest risk to the thesis. Given the unpredictable actions of regulators at times, it is more difficult to come up with a range of likely possible future outcomes within a defined timeline.

I believe in what appears to be a move framed to protect internet users from the potential abuses of ISPs will ironically cost internet users more over the long-run. Think of an ISP’s broadband pipe as a highway with data from various internet companies such as Netflix, Google and Amazon being transported along the highway to the end user. The open internet/net neutrality principles were designed so that ISPs can’t further monetize parts of their pipe, or sell a “fast lane” to an interested party like Netflix, for example, that wants priority traffic, or alternatively block or throttle a lane when traffic becomes congested during peak hours/usage. What this means is that the FCC has basically decided that internet consumers will basically foot the bill for their higher broadband usage instead of the content/internet companies.

Another irony of Title II is that is has created a more uncertain regulatory environment for ISPs looking to potentially invest in or expand their networks, which is the exact opposite of what the FCC would like to see in the broadband market – increased competition. Title II is most akin to utility-style regulation that has been used for services such as fixed voice networks, electricity and water providers. Due to pricing regulations, companies operating within these industries have barely invested the capital necessary to maintain or upgrade their infrastructure given the regulated returns on capital. That’s why we see deteriorating landlines and poor service quality across these services in America today. But broadband services are much more dynamic. As speed and capacity demands continue to increase, ISPs have to continue upgrading their networks to service the market.

Regarding competition and market power, like most local newspapers in many rural towns and lower tier cities in America today, the business of providing broadband service remains a natural monopoly. The scale requirements to connect every home in a local market provides the incumbent with a substantial entry barrier, and being first to market is a major advantage. It is difficult for any private operator to justify overbuilding a fully upgraded fiber-optic cable network in a poorer, low population density area with an incumbent operator already present. I think as long as incumbent ISPs such as cable operators continue to upgrade their networks to provide faster speeds and more capacity for consumers at “reasonable” prices, they will less likely draw future additional regulatory scrutiny. In addition, as high-speed broadband becomes more ubiquitous over time, and as the economics of providing the service continue to improve, continued overbuilding by the telco competitors can potentially stem regulator’s concerns about competition. Obviously this is a very sensitive topic right now given what appears to be a more hostile regulatory environment. Thinking about this issue reminds me of a great quote from Peter Thiel: “Monopolies like to downplay their dominance to avoid getting regulated, and companies operating in perfect competition pretend to be doing something unique to stand out or raise capital.”

On pricing, the main issue with imposing any future pricing caps on high-speed brand services is that less active users would basically be subsidizing the service for heavy users. Nonetheless, the severity and form of any potential future pricing caps is very uncertain. It could range anywhere from pricing caps for providing speed tiers up to a certain level such 25 mbps in markets that are deemed uncompetitive (which is a type of regulation similar to how prices for basic video services are capped today in “uncompetitive markets”) to regulated returns on capital across the entire industry for all ISPs. I must admit that the probability distribution here is very wide.

One final thought on this is that regulations can change over time, and a new pro-business FCC can easily reverse bad regulation. After reading parts of the ~400 page FCC document / ruling on Title II, I must say that it reads like a crock of shit. A lot of the motivation behind Title II and the blocking of the TWC/Comcast merger seems very politically-driven given the President’s stance on this issue. I can’t help but think that the FCC arbitrary defined high-speed broadband as 25 mbps or above intentionally just to fuck over Comcast. As a reference, I think there are market models in other parts of the world such as the Netherlands that make a lot of sense where there is a single lightly regulated cable company (Ziggo / UPC Netherlands) providing very high-quality, high-speed broadband service across virtually all homes in the country at very reasonable prices.


Increasing broadband competition – Google Fiber expansion, subsidized local municipalities building fiber, and increased Telco fiber overbuilds. Google fiber is only available in a few US cities with plans to expand to a few additional tier 2 cities. This service is currently priced at only ~$70 per month for up to 1 Gigabytes per second. At this price-point it doesn’t appear like the project is earning its cost of capital given the huge initial capital outlay, the existing incumbent competition, and the markets targeted are not particularly attractive. Given that we have a controlled company with a management team that doesn’t prioritize return on capital and has interests not fully aligned with shareholders, it appears that Google Fiber remains just one of many of Google’s pet science projects.

AT&T may look to further expand their U-verse project to more cities after the merger with DirecTV closes. I believe any additional competition from future U-verse expansion plans would emerge slowly. Ironically, Title II and net neutrality goals have created a more uncertain business environment for both AT&T and Verizon in terms of investing in fixed infrastructure, and is one of the reasons why they’ve largely stopped expanding their fiber overbuilds. Aren’t regulators/anti-trust authorities suppose to help maintain/encourage a more competitive market environment instead of hindering one?


Deal risk – I place a 10% probability that the deal will get blocked by regulators. Another potential regulatory concern are concessions that will require asset divestitures. I think this deal has a higher likelihood of passing regulatory approval than the proposed Comcast/TWC merger mainly given that 1) New Charter will have a 30% market share of the FCC defined high-speed broadband market at 25 mbps or higher vs a pro-forma ~57% share for Comcast/TWC and 2) A combined TWC/Charter/Bright House will be a much smaller entity than a combined Comcast/TWC. I also think Charter’s capital plans to upgrade the balance of TWC and BH’s systems to provide higher capacity and 60 mbps minimum downstream speeds to customers and to insource call centre jobs from overseas will be looked upon favourably by regulators. Management and Malone said that they are very confident that the deal will withstand regulatory scrutiny and were willing to provide a $2 billion break-up fee. Most importantly, even in the unlikely event that the deal gets blocked by regulators, the max downside risk I’ve quantified in my standalone Charter valuation is very limited.


Blog Update:

There is a cheaper derivative play on Charter, and I think it is quite obvious what it is. Due to an emerging pattern of unusual and/or above average trading volumes on smaller ideas shortly after they have been posted on this blog, I am no longer posting ideas of smaller-cap or illiquid ideas. I’m certainly flattered by Mr. Market now that I’m starting to influence stock prices with an obscure value investing blog but I don’t think it’s worth it to risk looking like a stock pumper or promoter and potentially encourage a portion of my readers to engage in short-term speculation without doing their own proper due diligence. I know that there are many hedge funds and fund managers subscribed to this blog, and I think that it is quite obvious that some of these guys are very short-term oriented traders. As a long-term, concentrated value investor that likes to accumulate shares on weakness, I think it is wise to keep my best ideas a secret from now on, or post them somewhere else anonymously. Given that there are likely close to zero attractive US large caps right now that match my hurdle rate, it may be a very long time before I post anything attractive again.


Cable All over the World:

In general I’m bullish on the entire industry. Other cable names I like include Liberty Global, Altice, Televisa and Comcast.

I like event-driven ideas and I think a potential Global and Vodafone deal looks very interesting. The best outcome for Global shareholders would likely be that Global acquires Vodafone while Vodafone’s non-European/emerging markets segment are spun-out in a separate entity. This way Malone’s team would maintain control over the newly merged entity, maintain an aggressive leverage ratio of 5x and use the bulk of FCF and cheap debt to repurchase shares. Due to the considerable overlap of operations between Vodafone’s European segment and Global’s cable assets, especially in the UK, Holland and Germany, the synergies would be massive. From a high level, I think the FCF per share accretion from such a deal would be very impressive.

Comcast to me just looks undervalued right now and is a more conservative way to bet on the US cable industry.

Of course, I don’t think any of these names are likely cheaper than a potential Charter/TWC. Charter is not one of my top ideas anymore but if I had to compare and reverse engineer a past media investment, I would have to say that I like this idea more than DirecTV when it was @ $50 per share on a 10 p/e.

Does anyone else use Tinder by the way?




Some house cleaning:

Sold out of QVCA, AutoCanada, and AIG warrants. I think these are all still attractive ideas but on a longer-term time horizon not as good as my current holdings. I think Fiat-Chrysler Automotive looks attractive here, and an aggressive actavist investor might be able to force GM to seriously consider a merger with FCA. Idea tracker is now also updated.

“The great personal fortunes in the country weren’t built on a portfolio of fifty companies. They were built by someone who identified one wonderful business. With each investment you make, you should have the courage and conviction to place at least 10 per cent of your net worth in that stock” – Buffett


customer servcie


Media and Telecommunications Information Sources:


Industry Sources:

[1] Comcast’s X1 platform appears pretty impressive

[2] Eg. In 2007, DBS video offerings of up to 100 channels were priced at $35 compared to Charter’s most comparable offering priced at $50, or a 30% discount

[3] Hybrid fiber-coaxial

[4] Building fiber optic cable to the node

[5] A FTTH build-out can cost several thousand dollars per home

[6] This capital spending will mostly consist of replacing some electronic equipment in the cable plants/headends, purchasing DOCSIS 3.0 enabled modems for digital services, and the labor installation/maintenance cost

The Security I Like Best: Interactive Brokers

“I always have been attracted to the low cost operator in any business and, when you can find a combination of (i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation.” – Warren Buffett


Interactive Brokers (IBKR) currently offers a rare opportunity to invest in an extremely high-quality, fast-growing compounder operating within the large, secular growing electronic online brokerage industry. IBKR is a fully-automated electronic online discount broker and market-maker that was founded by billionaire Thomas Peterffy in 1977. The thesis is pretty simple: 1) The e-broker business is massively under-earning WRT its true earnings power and 2) due to IBKR’s extremely deep and durable moat which allows the e-broker to operate with the lowest-cost structure in a largely commoditized industry, the business (with considerable operating leverage) should be able to grow after-tax earnings at 30%-35% per annum over the next 3-5 years or more.

If that isn’t enough for you, then we also have several free “call options” that I have not fully priced into my base case valuation.

1) Tremendous earnings accretion from having a steadily growing margin lending business being leveraged to rising interest rates,

2) Under-appreciated enormous untapped pricing power in the brokerage business, and

3) At this stage of the cycle, the business is a great hedge against rising market volatility based on the rather subdued daily average revenue trades (DARTs) per average account metric


Pricing is by far the most important driver within the global electronic brokerage industry, and IBKR is by far the price leader in margin lending and commission rates since the business operates at an enviable position at the low-end of the industry cost-curve.

Figure 1: Comparing IB’s margin and commission rates with its largest US competitors

Figure 1: Comparing IB’s margin and commission rates with its largest US competitors

IBKR’s deep moat is sustainable not because its intellectual property can’t be replicated[1], (although it will be an extremely difficult and time-consuming process) but because its main competitors largely operate with a different ethos. In the US market, Schwab, TD Ameritrade and E-Trade primarily target the mass online retail market and employ a more asset-intensive distribution and sales model by deploying physical branches and large sales forces; their services are tailored to less financially sophisticated, lower-value accounts. In order for IBKR’s competitors to profitably price their services even remotely close to IBKR’s levels, they would have to cut an enormous amount of fat in their cost structure. Think about all the branches[2] that will need to be closed down, the firing of thousands of employees, the difficulties in hiring a ton of smart developers and technical staff (that are currently in short supply) in order to automate a large portion of their operations that will take a very long time, and the courage needed from senior management to drastically change a long traditional corporate culture that is focussed on sales, marketing and distribution to a technologically-driven culture. Let’s just say the execution risk and opportunity cost will be enormous. It has literally taken IBKR decades to develop their full suite of technologies[3] that continue to improve year after year, similar to how Google has consistently perfected their search engine algorithm. In fact, I believe even Google would have a better chance of replicating IBKR’s technology than IBKR’s main competitors.


In terms of prime brokerage competitors such as Morgan Stanley and Goldman Sachs that focus on the institutional market, they offer inferior trading execution and uncompetitive commission rates relative to IB, and also operate at a large cost disadvantage by employing expensive labour all the way from the front-to-back office. So it’s no surprise that IBKR’s operating and pre-tax margins are roughly double the US industry average, and with reasonable top-line growth should approach or exceed 70% over the next 2-3 years.


“I think in 10 years we could be the biggest broker in the world, and I am not kidding, because our technology is way ahead.” Thomas Peterffy, Chairman and CEO – from IB’s Q3 2014 earnings conference call.


IBKR has an extremely long runway of secular growth in end markets powered by an increasing geographic mix-shift to the under-penetrated, higher-growth Asian market and a rapidly growing attractive core customer profile that consists of emerging hedge funds, independent financial advisors, proprietary trading groups, and introducing brokers among other institutional clients. Just in the US alone, IBKR’s market share is a miniscule 1% in terms of customer accounts and total online brokerage assets. WRT customer economics, IBKR has the lowest customer acquisition costs in the industry; for perspective, Schwab and TD Ameritrade each spend ~$250MM on marketing and advertising annually (~5% and ~8% of their total revenues, respectively), and E-trade financial spends ~$120MM (~6%-7% of revenues). IBKR has a near fully-automated customer registration process and spends almost nothing on marketing and sales yet the business is growing high-value customer accounts and customer equity 3x-4x faster than its closest competitors. Why? Because the most efficient operator – not the most well-known franchise or sales organization – will be the long-term winner in this industry. A referred customer incurs no marketing spend and is typically a stickier and more valuable customer over the long-term, and roughly 1 in 4 of IBKR’s new accounts are generated through customer referrals.


To size up IBKR’s growth prospects in greater detail, we have to account for the discount brokerage industry growing faster than traditional higher-cost brokerage, the trend of emerging small institutional investors such as financial advisors and hedge funds migrating to higher-value proposition brokerage services, and in general above-average growth in global wealth creation in excess of long-term global GDP rates (especially in Asia where 60% of IBKR’s business is now coming from at current run-rates). Finally IBKR’s wide moat will allow them to continue to take market share for a very long time. All-in-all it is no surprise that IBKR is growing customer accounts and equity at near 20% with little marketing spend, compared to mid-single digits growth for the rest of the industry. Due to these industry dynamics and IBKR’s sustainable moat, above-average earnings growth should easily be sustainable in the double-digits or more and be measured in decades – not years – out.


IBKR has an extremely scalable business model due to the breadth and depth of its automation of many functions all the way to customer acquisition to client risk controls which should lead to improving returns on equity for the brokerage business as it continues to grow at a rapid clip over time. IBKR’s growth in DARTs, margin lending, customer accounts and equity comes with very low marginal costs because of the business’ automated trading infrastructure.

ibkr roe

I believe backing out 75% of excess capital in my ROE estimate for the brokerage business is reasonable.  Remember, this is basically idle capital that is in excess of regulatory requirements, and based on the size of rather large client account blow-ups over the past few years, I believe this is a conservative assumption in light of IBKR’s superior risk management controls. I’m not saying that larger client account losses are not possible, but the $2.5 billion in excess capital set aside creates a fortress balance sheet which has no debt.  Furthermore, all margin loans within IBKR’s margin lending business are basically recourse debt, so IBKR can go after customer assets[4] if they’ve suffered large losses on margin.


Unlike other large online retail-focussed brokerages that sacrifice client order execution for better brokerage economics, IBKR does not sell its customer order flow to the highest bidder, which has spurred considerable controversy in the industry. The founder, Mr. Peterffy, has been an outspoken proponent against high frequency trading (HFT) and its negative implications for the industry. I’m also comforted by the fact that Mr. Peterffy was an industry pioneer in electronic trading, and has structured IB in a way that puts its customers’ interests first. He’s also quite shareholder friendly, with a record of returning excess capital from the market-making segment in the form of special dividends. Although I typically almost always prefer share buybacks over dividends as a superior tax-efficient method of shareholder return, I understand Mr. Peterffy’s interest of increasing the public float over time. With an ~75% stake in the total capitalization of IB and founding the business itself, Mr. Peterffy is an archetypical “owner-operator” – a special class of management that I typically favour partnering with given their propensity to act in the long-term interests of all shareholders. The only concern I have is the current pricing of commission and margin rates. I actually believe IBKR’s rates are priced excessively low, well below rates that they can charge where the incremental value created will vastly outweigh any marginal decline on total DARTs, margin lending, or customer equity growth. With such a large gap between the operating costs of IBKR’s model vs. competitors (with pricing ranging from 10%-20% the industry average levels), and vastly superior pricing execution[5], the vast majority of clients would not even consider switching brokers and trading volumes and total margin loans should be marginally affected due to the vastly uncompetitive alternatives. Even a reasonable 50%-100% increase in average commissions and margin lending rates will flow straight to the bottom line, which should create nearly the same amount of incremental shareholder value. That’s why I believe IBKR has tremendous untapped pricing power. Although I assume it’s not in the cards for Mr. Peterffy to raise prices since he is overly focussed, in my view, on volume growth, (a negative given that he could literally raise prices tomorrow to maximize the value of the business), a sale of the entire business to a strategic buyer should reflect this untapped pricing power. Due to easily realizable synergies and a takeover valuation reflecting higher rational economic pricing, we could easily arrive at a present value of $75-$100 per share on the back of IBKR’s unique franchise under this upside case. And I assume Mr. Peterffy is not stupid enough to not recognize the enormous untapped pricing power in his business. In fact I believe this scenario will increasingly become more probable over time as he ages and looks for an exit.


What is Mr. Market Missing?

Complex accounting and holding structure, obscuring the true profitability of the e-broker business and making the headline earnings multiple misleading. The business is also very under the radar, and almost never gets mentioned in industry reports. Due to the stock’s small public float (~14.5% of all shares outstanding worth ~$1.9 billion) and IBKR’s lack of business with the Street, sell-side research coverage is extremely limited with around 2 boutique broker-dealers actively covering the name (I don’t think they’re doing a good job, by the way). The market also typically doesn’t do a good job valuing 2 divergent cash flow streams (the market-maker vs. the e-broker).


So why now? Aside from the huge margin of safety at today’s stock price, I believe we are at or near an inflection point where outsized share appreciation will be driven by 1) increasing investor awareness of IBKR’s electronic brokerage growth story along with the market-maker business becoming irrelevant and/or 2) We should be near or at the sweet spot of the interest-rate cycle where the market will begin to appropriately price in earnings accretion from higher rates. The market is certainly already partially pricing in higher rates for Schwab, TD Ameritrade, and E-Trade Financial.


On the cost front, despite the sizable volume growth in brokerage cleared trades, the exchanges have been pressured on transaction fees due to heavy pricing competition from dark pools, leading to a large decline in IBKR’s variable execution and clearing fees.[6] Long-term fixed costs should be roughly 50% of total non-interest expenses, providing plenty of operating leverage. After netting out the market-making business’ ~$1 billion in equity conservatively at 1x tangible book value, we are effectively paying slightly less than 18x my estimate of 2015E after-tax earnings for the phenomenal, high-growth brokerage business. My conservative implied valuation of this business is 30x my estimate of 2015 earnings. Because of the business’ largely untapped pricing power and the depressed current interest-rate environment, even if growth rates temporarily slow down, the smoking gun is that the brokerage business is massively under-earning which de-risks my thesis to a large extent. In fact, aside from spiralling deflation, I can’t think of anything else that can tank my thesis.


The stock is conservatively worth $45 today, and $50 per share by 2015YE on the back of a multiple re-rating, providing more than 50% upside 1-year from now: Although this is my short-term forecast, I’m much more excited about the high likelihood that the growth in intrinsic value per share will exceed the share price growth for many years to come, implying a potentially very long-term holding period. Another way to think of valuation is that if we assume a 30%-35% annually compounded growth in the brokerage business’ intrinsic value over the next 3-5 years, an 18x multiple throughout the holding period is very reasonable for a business with such an attractive long-term, predictable earnings growth profile and very high returns on equity.


Interactive Brokers is the Security I Like Best: It is what Buffett would call an “inevitable[7]”, a high-quality, long-term compounder where I can reasonably predict its earnings power 10-20 years from now.




Disclaimer: I hold shares of IBKR and may buy or sell shares at any time without notice.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer’s securities.

1) All content of this blog, including correspondence between the author and readers, represents only the authors’ personal opinions and is neither investment advice nor a recommendation to buy or sell a security. No information presented on this blog is designed to be timely and accurate and should be used only for informational purposes.

2) The authors are likely to transact on securities mentioned on this blog without notice to the reader. Disclosure of the authors’ holdings of any securities mentioned will be done on a best effort basis.

3) The reader agrees not to invest based on information presented on this blog and should conduct his or her own due diligence with respect to the securities mentioned before initiating a position.


Here’s my shameless promotion: I’ve used IBKR’s trading platforms for the past 4 years now and absolutely love it, and so does everyone else I know that uses it. I highly recommend it to anyone.




[1] Feel free to ask any competent computer engineer how difficult and time-consuming it would be to develop all the algorithms and test and fix all the bugs that will be required to scale and automate all the processes involved in providing customers with the best execution across all significant worldwide exchanges and products

[2] Schwab, TD Ameritrade, and E-Trade have over 300, 100, and 30 branches, respectively

[3] I believe the most important pieces are their fully-automated IB smart routing and risk management algorithms

[4] Based on the size of future potential losses, I believe most would come from institutional customers, which are more likely to have valuable assets that IBKR can go after vs. retail investors

[5] Largely due to IB’s SmartRouting technology

[6] My research suggests that pricing may be starting to firm up again from the exchanges, especially in their cash equities business. I’ve conservatively assumed growth largely in-line with volumes.

[7] A business which will be much more valuable 10-20 years from now


Share Price: $39.22 CAD | Market Capitalization: $961,269 CAD | Adjusted Enterprise Value: $1,072,499 CAD | Idea Type: Growth at a VERY reasonable price

Note: As I was writing this up the stock has gone up nearly 30% since the panic low last Friday. I believe the shares still remain very undervalued and provide a highly asymmetric risk/reward scenario. All calculations are based on a $39.20 share price.

”Be fearful when others are greedy and greedy when others are fearful” – Warren Buffett

Synopsis and Elevator Pitch:
AutoCanada is what Peter Lynch would call a “fallen angel” and one of the fattest pitches I see today in my small-cap Canadian stock universe. I had bids set last Friday as the shares plunged to around $32 that unfortunately were not filled; that was a very costly mistake, as the shares have surged up nearly 30% since then! AutoCanada was a high-flying Canadian stock market darling that experienced an atmospheric rise last summer on the back of a string of accretive acquisitions and strong growth in Canadian retail vehicle sales. The main headline risk now is that the precipitous fall of oil prices will have a negative effect on the Alberta economy and consequently falling employment in that region. In fact if we compare AutoCanada’s share price history over the past several months you’ll notice that it’s largely been trading in sync with WTI. Although I believe a slowdown in the Alberta economy is very likely, I believe investor fears over AutoCanada’s exposure are way overblown. Mr. Market’s overreaction and manic depressive behaviour has rewarded us with a current share price which provides a tremendous opportunity for investors to buy shares in an extremely well-run auto retail growth business at a large discount to intrinsic value. Even in the unlikely event that nationwide new vehicle sales decline double-digits and AutoCanada closes no further accretive deals in 2015 (very unrealistic, nearly impossible based on a confluence of factors that I will explain) – shares are still worth between $47 to $51, providing 19% to 30% upside one year from today. In my more realistic but still rather conservative base case scenario, the shares are worth $61 to $65, providing 1-year upside of 56% to 65% upside.


Quick Company Summary:
AutoCanada is a high-growth story and the only publicly-traded Canadian franchised auto dealership group. The business was taken public in 2006 with the thesis of tapping into the public markets to consolidate the fragmented Canadian automotive retail industry. Since the company’s IPO, AutoCanada has acquired or opened 34 additional dealerships and expanded its lineup of partner OEM brands to 19. Last year alone the company acquired/opened 16 dealerships as growth accelerated. The founder and new chairman, Patrick Priestner, was a university dropout who started his career in the industry as top salesman selling Chrysler branded cars at the age of 17 in Alberta.

Thesis – The Devil is in the Details:
1) Despite AutoCanada’s relatively large dealership exposure to the vulnerable Alberta economy, I estimate that only 33% of AutoCanada’s current 48 dealerships are truly “at-risk” to Alberta’s slowing oil sands’ economy and consequently weaker employment. Furthermore, if we further digest the news of large CapEx budget cuts announced by the E&P companies in Alberta’s high cost oil sands, then we can reasonably assume that fleet sales (corporate sales) should be disproportionately negatively affected in a business slowdown relative to retail sales. Fleet sales are very low margin (typically less than 1% gross margins) and thus should have a miniscule effect on consolidated gross profits even if we assume large volume decreases in this category. Due to this favourable business mix-shift in the event of rapidly falling new corporate vehicle demand, I argue that the situation is less dire than what is perceived by the market.

2) I believe the bears (or panic sellers?) in general under-appreciate the resiliency of the franchised multi-dealership business model and especially AutoCanada’s track record of achieving best-in-class operational efficiency in their parts & services (P&S) segment. This segment is basically the bread-and-butter of every franchised car dealership should perform strongly even in an economic downturn.

3) Despite AutoCanada’s heavy Western Canadian exposure, the business is quickly diversifying in terms of acquiring new OEM partner brand dealerships outside of Alberta. The size of these acquisitions have been growing larger as the business scales its dealership base which should help mitigate the risk of declining profits in the event of any serious downturn in the Alberta economy.

4) I believe the market is pricing in the absolute worst case scenario where AutoCanada will do no more acquisitions or open up anymore dealerships (highly unrealistic) over the next several years. With a highly fragmented Canadian auto industry (~3,500 dealerships nationwide), acquisition targets remain plentiful and this predictable growth cannot be ignored. In short, management’s proven strategy of high-quality growth by acquisition remains intact, and should provide a long runway of multi-year growth compounding at high rates of return well into the end of this decade.

Debunking the Bear Case:
1) What’s really at risk?

Alberta, like many Canadian provinces, is quite big, and although is very reliant on the oil industry, there are more moving parts to consider. In fact, slightly more than a quarter of AutoCanada’s Alberta-based dealerships are located in Grand Prairie, which is an area that is more exposed to natural gas, forestry and the US housing industry than to oil. The rest of the company’s 22 Alberta dealerships are located in Calgary, Edmonton, Sherwood Park and Ponoka. Due to their employment demographics, these dealerships should be considered more exposed to a slowing local oil sands economy.

at risk dealerships

It’s all about the gross profit, not the sales.

I believe the slowdown in total new vehicle sales should disproportionately affect fleet sales (corporate sales) more than retail sales. As mentioned, fleet sales gross margins are very low and are typically less than one tenth of new retail vehicle gross margins. We can assume that the E&P companies will be cutting back on purchasing light pick-up trucks on the back of falling oil prices and budget cuts. In fact, if we look at the most recently reported quarterly results (see below), we’re already seeing same-store fleet sales volume decline considerably YoY on a 3 month and 9 month basis. I believe AutoCanada’s new fleet sales are more cyclical relative to new retail sales, especially given the company’s exposure to the Alberta’s oil-centric economy.

“Management cannot confirm, but believes that much of the increase in the overall Canadian new vehicle market can be attributed to increases in fleet sales from 2009.” – AutoCanada’s 2010 Annual Report

Looking at same-store-sales (SSS) in the latest reported quarter can give us a bit of a clue in what to expect in 2015 if we assume the cycle turns in Alberta.


sss 2

As we can see, even with the sizable drop in new fleet volume and fleet SSS, same-store new vehicle gross profits still managed to grow 20.5% and 7.8% on a three and nine month’s basis, respectively; as long as we assume new retail vehicle ASPs remain stable or increase slightly (like they have been), small increases in new retail sales can offset larger fleet sales declines. In the event that even new retail sales volumes decline, I believe it’s reasonable to assume that AutoCanada’s used vehicle gross margins and gross profits will hold up strongly even in a severe downturn, supported by the fact that consumers and enterprises typically trade down to used vehicles to save costs during tougher economic times.

What’s interesting is that even if we look at the latest auto sales data that was released in January 15’, Dec 14’, Nov 14’, etc. there hasn’t been any real indication that there’s been any significant weakness in Alberta vehicle sales. Even if we assume there should be a slight lag in the industry data following oil price movements (oil starting crashing last July), November and December industry sales were both up 4.8 and 4.4 percent YoY, respectively, and nationwide industry sales have also been strong. The provincial data hasn’t been released in January 15’ yet, but overall industry sales are up and light truck sales have been outperforming. Given the recent data, it’s rather perplexing as to why retail sales haven’t been strongly affected in Alberta yet, and there’s even reason to believe that the lower oil prices have been incentivizing consumers to buy larger vehicles. My conversations with some of AutoCanada’s dealers largely confirm this thesis that new retail sales remain strong.

autocanada graph

Finally, the auto dealership model in general has quite a variable cost structure, helping reduce costs in a downturn. The vehicle sales and F&I segments that are most vulnerable to the cycle have the least operating leverage due to the highly variable nature of a car salesmen’s compensation structure.

2) The focus over the next several years should be on P&S, not new vehicle sales

I) I believe the franchise dealership business model is much more recession resilient than what the market gives it credit for. Despite the company’s cyclical exposure to new vehicle sales, parts & servicing (P&S) is where the real money is made, where gross margins are typically 50%+, are much more recession resilient, and recurring in nature. P&S is the most important segment for any auto retailer, and based on my research AutoCanada’s operating metrics are among the highest in the industry. If we look at AutoCanada’s operating history, the business has consistently achieved high “absorption rates” at near 90%, a metric which measures operational efficiency in the P&S segment. P&S is also a relatively counter-cyclical segment as consumers tend to keep their cars longer in downturns, and thus require ongoing vehicle maintenance and replacement parts.

II) As shown below in the excel sheet AutoCanada’s P&S segment is typically between 30-35% of their total gross profit in a mid-cycle year, and this percentage should experience outsized grow relative to vehicle sales when the cycle turns. Furthermore, there is a larger secular growth tailwind at play here as outsized growth in the stock of new vehicles aged between 1-5 years on the road today should boost same-store P&S gross profit growth at high-single to low-double digits (even higher EBIT growth due to operating leverage) well into the end of this decade; many consumers delayed purchasing new vehicles during the last downturn and there are now over 8 million cars over 10 years old on the road today. I believe this is one of the most overlooked key drivers by the market and the Street. AutoCanada’s P&S SSS has consistently grown at around high-single digits for the past couple of years, supporting this thesis. Many industry experts have always assumed this segment can only grew at mid-single digits longer-term; I believe this will prove to be a very conservative forecast, especially given recent strong growth in retail sales in Alberta

III) The P&S segment has the most operating leverage and highest incremental margins, and this is exactly the segment you want the most leverage as it is more predictable and recurring relative to new vehicle sales. I conservatively estimate that around 50% of P&S gross profits flows through SG&A. This segment also has good pricing power as vehicles repair and maintenance work becomes increasingly complex on newer vehicles and warranty contracts continue to lengthen. Light trucks which AutoCanada’s Alberta-based dealerships sell a lot of typically require more maintenance work on a more regular basis due to heavy usage compared to passenger cars.

IV) OEM franchised dealerships should continue to take servicing and repair market share from mom-and-pop repair shops that do not invest in the sophisticated equipment and software required to perform repairs and warranties on today’s increasingly complex vehicles. Each OEM requires specialized equipment for their own vehicle models which should freeze out mom-and-pops that under-invest in these areas.

AutoCanada’s Historical Segment and Margin Analysis:

autocanada margin

3) This time is really different, if there is a “this time”; 2009 is a poor precedent.

-Finance & Insurance (F&I) is a sizable portion in consolidated gross profits (90%+ gross margins). Decreased in FY2009 because of tight lending conditions – the company’s largest 3rd party financing partner, Chrysler Financial Canada, declared bankruptcy so they had to switch to GM Acceptance Corporation, which today is the newly re-organized, well-capitalized Ally Financial.
-Despite going through an extremely severe recession, having their largest OEM partner (Chrysler) go through a bankruptcy restructuring which affected the company’s access to floorplan financing to fund inventory purchases (I will touch upon floorplan financing later), AutoCanada’s same-store gross profits fell only 2.6% and 7.8% in 2008 and 2009, respectively; quite impressive for a cyclically exposed retailer
-Despite falling auto demand during the past recession, access to credit was a major issue. Around 85 and 60 percent of new auto and used auto sales today are financed with credit, respectively. Due to the continual low interest rate environment and a healthy credit market, credit should not be a problem this time around
-Not core to the thesis but industry analysts are still forecasting strong light vehicle growth in Canada (~1.8 million vehicles for 2015). The US numbers look strong as well. I believe despite the bear’s concerns about falling employment in Alberta, lower oil prices and the plunging Canadian dollar should help the company’s dealerships outside the province. Also keep in mind that this time the reason why oil took a hit was largely supply-driven. In 2008/2009, it was largely a demand-related shock. I think the recently reported industry data is already confirming that the sky is not falling and light vehicle sales across the country will remain strong.

4) Diversifying away from Western Canada
Despite having 22 out of its 48 dealerships in Alberta, we should really be focussed on new retail sales volume per dealership. Last year AutoCanada acquired a set of 2 powerhouse BMW/Mini dealerships in Quebec, which marks the first time they’ve expanded into the BMW/Mini OEM brand and into the French Canadian province. These dealerships are around 2.5x the size of an average AutoCanada Calgary-based dealership and combined they sold 3,860 and 1393 new vehicles and used vehicles, respectively, in 2013. These figures alone represent ~65% of all the vehicle sales volume of AutoCanada’s Calgary-based dealerships. AutoCanada’s new Montreal BMW/mini dealership alone volumes ~60-65% of all the BMW/mini cars sold in the city. What’s more important I think is BMW/Mini’s acceptance of AutoCanada’s public dealership model, which provides further diversification away from AutoCanada’s heavy D3 exposure. I believe the warranty and maintenance work for higher-end German vehicles is very attractive.
Finally, if we look at AutoCanada’s OEM brand mix, it’s heavily weighted towards the Detroit 3 and Japanese brands. I believe the luxury brands will be more at risk compared to these midline brands if we head into a slowdown. The company only has 1 Volkswagen dealership in Calgary purchased in 2014.

autocanada brand

dealership locations

Quick Industry Overview:
I believe the market currently under-appreciates AutoCanada’s long runway for growth driven by consolidating the fragmented Canadian auto franchise dealership industry. Based on my research, there are ~3,500 Canadian dealerships and more than 2,000 single owners. According to PwC, around 70% of auto dealership owners in Canada are either looking to retire or semi-retire, and selling their dealership is an attractive option. However, there are OEMs that restrict public ownership in Canada; Ford, Toyota and Honda are such brands and currently represent about 28% of all dealerships in the country. Even if we factor in these restricted brands, AutoCanada’s market share (by dealership number) is still less than 3% of all publicly-allowed dealerships in Canada. Due to the sheer number of acquisition targets for AutoCanada, these restrictions still do not derail the growth by acquisition thesis that should last well into the end of this decade and beyond. Also, it’s very possible that these restricted brands may eventually allow public ownership Canada, where it has already happened in the US. I this scenario as an additional free option to the growth thesis.
-Only a few privately-held dealerships of comparable size are competing for deals (Dilawri Group is the largest in Canada), and since they are private, they’ll most likely focus on acquiring non-restricted brands, so I believe given the sheer number of targets and the overall succession issue, average purchase multiples should remain reasonable (within 4x-6x EBITDA depending on the location and OEM brand).

Briefly looking upstream:
-Fiat-Chrysler has emerged post-bankruptcy as a strong, re-organized company with a good balance sheet that continues to take overall market share in Canada (only second to Ford). If we look at just light vehicle sales, Fiat-Chrysler actually has top market share at ~18%.
-OEMs were concerned about dealership group concentration in the past when the industry was much more competitive (some D3 franchised dealerships were closed down during the last recession and have emerged as independent used car dealerships), but now they are more focused on dealership profitability and supporting their P&S departments by including longer warranties and service plans on vehicle purchases.

Business Model:

This is a rather good retail business. They have good dealerships in good locations and generate a lot of free cash flow. Inventory risk is extremely low. The overall cost structure is quite variable for a cyclically exposed business. Where there is operating leverage it is where you want it to be (in P&S). This segment continues to take market share from independent garages and has good pricing power. There is virtually no internet disintermediation risk. The business generates high returns on invested and tangible capital; I estimate that AutoCanada generates around mid-20s on pre-tax returns on capital employed. I expect the return on invested capital to continue to improve as they ramp-up newly acquired dealerships and continue to leverage their fixed costs as they scale.
-The business is not capital-intensive (leases are quite low and are not inflationary) and capital intensity is shrinking as they have bought back some real estate; maintenance CapEx runs at ~1.5% of gross profits
-Barriers to entry for franchising an auto dealership are quite high; OEMs rarely allow new dealership openings, especially in areas where there are already enough distribution points, protecting the incumbent distributors. The total number of franchised OEM dealerships in Canada has roughly remained the same over the past decade, and may have even decreased slightly since the last recession due to D3 restructurings
-Competition on the new vehicle side is quite limited; franchised dealerships operate in de facto local monopolies or within a highly oligopolistic industry structure; eg. Only a few dealerships in any densely populated areas are granted franchises by OEMs

Management and Capital Allocation:
Anytime we have an extremely acquisitive company we need to make sure that management have considerable skin in the game, a strong track record of value creation, and incentives properly aligned with shareholders.

1) Ownership Structure:
Canada One Automotive Group (CAG) is a privately-held dealership group controlled by AutoCanada’s chairman and founder Mr. Priestner who has a ~87% equity stake in CAG. CAG owns one Ford, one Lexus, and one Toyota dealership (currently OEM brands that do not allow public ownership in Canada but will most likely be acquired by AutoCanada if this restriction is lifted) and has a nearly 10% stake in AutoCanada shares. If we do the math, the value of Mr. Priestner’s current equity stake in AutoCanada via CAG comes out to roughly $87 million.
-CAG recently sold several GM dealerships to AutoCanada with Mr. Priestner retaining a 15% ownership stake with voting control as owner-operator (a requirement by GM Canada). I believe having the seller retain partial ownership post-sale better aligns the economic incentives between the seller and acquirer when it comes to improving operations post-acquisition.
-The current President Tom Orysiuk was formerly AutoCanada’s CFO when he joined as the CFO of Liquor Stores Income Fund and based on his track record he understands good capital allocation.

2) Management’s Capital Allocation Track Record:
-Raised ~$200 million in equity financing when shares were near $78 last summer; this represents more than 20% of the entire market capitalization today! At $78 per share, essentially they were diluting the equity at ~32x 2014E earnings, ~26x 2015E earnings, and using the capital to purchase dealerships at 4-6x EBITDA. So issuing equity at a little over a 3% earnings yield to purchase assets at a more than 10% earnings yield. You can call this a “roll-up” if you want but I think it’s a pretty value accretive roll-up.
Furthermore, the company is buying real estate at attractive cap rates at 10% or greater; in fact I believe the 11 real estate related-party transactions that the company bought from CAG late in 2013 were purchased at close to a 10% cap rate. I would have much rather preferred it if management funded these purchases primarily with non-recourse debt. They could have funded these purchases primarily low cost mortgages at 4-5%, so essentially getting a high ROE with very low cost financing.
Some observers have pointed to CAG’s stake being continually diluted down over time via secondary offerings as a concern. For example, at the time of the large $200 million equity issuance last summer CAG exercised its over-allotment option and diluted its stake down to ~9.5% in AutoCanada today. I think we have to put the dilution and over-allotment in context. The stock price was basically trading at 32x earnings, not exactly a low multiple even for a high-growth company such as this one. If I were the largest shareholders I probably wouldn’t mind taking a bit of money off the table given the atmospheric rise of the stock price since the 2009 lows and especially given that the shares were likely overvalued. In retrospect, most of the cash raised at that high share price has been used to acquire additional dealerships at low multiples, so I believe it was a deal in the best interest for all shareholders. I think about it this way in terms of value creation: we’re basically getting a smaller piece of a much larger pie. One thing I should point out is that the over-allotment generated around $203 million in additional gross proceeds for the CAG shareholders. So the only thing that gives me pause or slightly concerns me is that I didn’t see any insider buying by Mr. Priestner when the stock tanked to the low 30’s. I don’t think this is a deal breaker to my thesis, but certainly a bit of a question mark.
-based on their past history, I haven’t seen them dilute the equity at a forward P/E multiple of less than 15x; remember, Mr. Priestner still has a large personal economic stake in the company
– They have a good, stable independent board with decent share ownership that has to approve related-party transactions
-I believe acquisitions remain the highest return on capital option and the best use of free cash flow

3) Alignment of Incentives:
AutoCanada’s management team have a terrific track record in acquiring well-run dealerships (at attractive 4-6x EBITDA multiples and no turnaround plays) at good locations and ramping up newly acquired mom-and-pop dealerships to their full potential after 2 years. 70% of AutoCanada’s “at-risk” dealerships were acquired in 2014, leaving lots of room for improving scale and operational efficiency. As mentioned they are starting to diversify their OEM brand mix and are definitely aware of the concentration of dealerships in Alberta
-President says they are buying dealerships at 5-6x pre-tax income; if they purchased the 2 BMW/Mini dealerships in Quebec within this valuation range it would be well below the range luxury brand dealerships typically sell for (closer to 6-7x EBITDA). They have a track record of improving operations from acquired mom and pop dealerships, leveraging best-in-class IT practices such as CRM, sharing inventory within a close proximity network etc.
-Based on the chairman’s industry contacts developed over 30 years in the business he has somehow managed to convince Chrysler to lift dealership number restriction rules and GM Canada to lift its public restriction
For 2014 the annual incentive plan was 40% weighted to adjusted free cash flow per share, 30% weighted to adjusted gross profit, and 30% was discretionary. In the prior year instead of adjusted gross profit the performance metric was adjusted return on capital. It’s not a deal breaker to me that they changed this metric but I will be seeing if they eventually put ROC back into their annual incentive package which properly measures an acquisitive company’s performance. They typically track this metric in their filings. Executive annual compensation remain a small % of the value of their holdings in the company.
In summary, I believe the AutoCanada’s management team are among the best auto retail operators in Canada. They have a long successful operating track record, and are allocating capital well. My only remaining concern is the absence of large insider share purchases at these current trading levels.

This is a retailer and it’s all about the same store metrics…
Since this is such an acquisitive company that closes deals almost every quarter it’s very difficult to project growth even on a run-rate basis, but I have basically modelled same-store metrics and applied them to the total number of company-owned dealerships on a forward basis. It’s a bit complicated but I believe it is a good, conservative rough estimation of intrinsic value.

Quick summary of Key Business Drivers:
Bear Case Scenario: I have modelled the key drivers for an overly pessimistic, unrealistic “bear case” scenario. I also sensitize the bear case intrinsic value with a “no acquisition” scenario that assigns 0 value to the incremental FCF that will be generated (basically assuming the cash just accumulates on the balance sheet) and an acquisition scenario with 6-8 deals (still below management’s annual guidance of 8-10 deals per year) closed in 2015. For all my key driver assumptions please see the appendix.

P&S Segment:
Based on my conversations with some of AutoCanada’s dealers, I believe ~50% of gross profits from P&S should flow through SG&A; (eg. if P&S gross profits grow by 5%, EBIT should grow by ~7.5%). I assume same-store P&S gross profits grows at low-to-mid single digits which I believe will prove very conservative.

New Vehicles Segment:
Fleet vs Retail Sales:
-Fleet is more cyclical, due to activities of major companies and being concentrated in Alberta which is a more cyclically exposed province due to oil industry exposure -> lower gross margins due to bulk wholesale pricing
-Fleet should decline more than retail sales; I assume company-wide new vehicle gross profits decline by high-single digits, driven largely by new fleet (largest decline) and retail sales (more muted) in Alberta, and even a single-digit decline in rest the rest of the country
Retail sales – on average, light trucks have higher ASPs (higher gross margins) vs passengers which are lower ASPs (lower gross margins); I assume a slight decline in average selling prices (ASPs) as consumers trade down to lower-priced cars even though the most recent data is showing that light trucks sales are growing faster than passenger vehicles

Used Vehicles Segment:
Management expects used vehicle ASPs and gross margins to continue to be pressured in the future. I assume a decline in same-store used vehicle sales, but more muted than new vehicle sales since consumers typically trade-down to used vehicles in downturns

Finance & Insurance Segment:
-Tied to new and used vehicle sales and their ASPs and to health of the credit markets
-I model a SSS decline in-line with same-store new vehicle sales; again this should prove very conservative since vehicle leasing and financing has been growing steadily due to the growing availability of credit

SG&A: I model this at 79.5% of gross profits, a nearly 200 bps increase from 2014E levels. I believe this is an extremely conservative assumption especially after the fact that the company purchased the real estate of 11 of its dealerships that it used to lease in late 2013; this should decrease their lease expense ~$10 million on an annual run-rate basis. Also they now have 48 dealerships which is ~50% more than in 2013 year end. Some cost savings and synergies on these additional dealerships acquired should be easily realized.

Capital Allocation and use of FCF:
I’ve layered in 6-8 acquisitions to my valuation with the deal assumptions shown below which conservatively leads to a few dollars of incremental value per share. I also have a scenario where the company closes no deals which is essentially assuming that the ~$65 million in incremental FCF that will be generated in 15’ piles on the balance sheet (highly unlikely for a management team that have consistently allocated capital at a high rate of return).


Bear Case Summary and why this scenario is overly pessimistic:
Aside from the points I’ve already made in my thesis:

-We still have to take into account the typical 2-year ramp-up period and larger size of the most recent acquisitions outside of Alberta over the past year. Last year alone the company acquired/opened 16-17 dealerships which should boost FCF dramatically
-I arrive at a consolidated negative gross profit growth of 8.7%; just to put this figure in perspective it is a greater decline than in 2009 where same-store gross profits fell by less than 8%
-Most of the publicly-traded US auto dealer groups have been recently reporting high to single-low digit SSS growth in their P&S segments, which is supporting the young vehicle age growth thesis in North America
-Only a few good acquisitions are needed to fully offset any temporary weakness in organic growth, and the company certainly has the balance sheet to execute. Based on management’s track record this is almost a near certainty. I view further acquisitions as rather low risk since they are small in size, will have low valuations, and are not dependent on synergies for accretion

Unrealistic Worst Case Summary: Still upside in an Armageddon-like scenario

bear case

A Quick and Dirty way to sanity check my bear case valuation:
I took my bear case projected adjusted EBITDA figure and divided it the number of dealerships to get the average EBITDA per dealership. By this measure, the implied average EBITDA per dealership is ~$2 million. I simply believe this figure is far too low. If we look at the average deal size over the past 25 or so acquisitions that company has completed, and assume a 5x-6x purchase multiple range (mid-to-upper point range of management’s guidance) for these acquisitions, it implies that the most recently acquired dealerships should be generating on average at least $2.5 – $3 million in EBITDA. Also, remember that these dealerships haven’t fully gone through the 2-year ramp-up period, where better operational efficiency, and cost and revenue synergies can be easily realized. Therefore, I believe my bear case sanity check supports the case that this scenario is overly conservative.

bear case sanity

Base Case Valuation Summary:
$61-$65 target price by 2015 year end

base case

I believe AutoCanada should trade at a slight premium (1 – 2 turns) to Asbury Automotive Group, AutoNation and the other US publicly-traded auto dealership groups (which are arguably undervalued as a whole sector). These comparable companies are trading at around 15x-16x forward P/E multiples, and 10x-11x forward EBITDA multiples and should have lower growth prospects. On an absolute basis an 8% FCF yield is quite attractive for this business. Another way to look at the current valuation is that we’re essentially getting a lot of future growth for free.


The Bull Case is straight forward: I think this business could potentially be worth $100+ per share 3 years from now. This implies a valuation of 29x – 30x 2015 free cash flow per share of $3.30 – $3.45. The key drivers here are an acceleration in accretive deals as the business scales and P&S gross profits continue to grow at high single-digit rates. I don’t believe this scenario is too far out of reach.

Valuation and Target Return Profile:


Why does this opportunity exist and what’s my edge?

1) The stock doesn’t screen well on an EV/EBITDA metric and appears over-leveraged given the large floorplan financing. EV/EBITDA should be adjusted for floorplan financing, which I treat not as debt but a use of working capital. AutoCanada’s floorplan financing has consistently been below inventory levels, indicating that the dealerships are turning over inventory efficiently within the 45-60 day interest-free period and that there is actually excess cash hidden in the floorplan.

2) This is very acquisitive company so the GAAP accounting is very messy. Obviously, the company has been making a lot of acquisitions, which obscure the true profitability of the business. Projecting forward earnings has to take into account both organic and inorganic growth which isn’t a simple task. The company also doesn’t break out the same-store figures from the growth from acquisitions.

3) Panic selling caused by retail investors and a short-term market overreaction to oil’s crash and its implications to AutoCanada’s intrinsic value

4) Small-capitalization company so more under the radar

What can go wrong?

-Similar to my DirecTV idea, I really don’t see anything that can “torpedo” my thesis. Even if we were to assume that Canada enters into a very deep recession, acquisition targets should remain plentiful and could likely increase due to owners worried about the cycle turning, and as mentioned AutoCanada’s cost structure is very variable. The only scenario I see that can cause permanent impairment of value at this price is management destroying shareholder value. Given the arguments I made above, I believe this is an unrealistic scenario.

-Oil continues to crash, causing further employment losses in Alberta; although I have argued that this is already largely priced in

-Interest rates spike up substantially. This is very unlikely. In fact the Bank of Canada just recently cut interest rates

-Auto credit bubble, Canadian housing bubble, record Canadian household debt-to-income levels all happening simultaneously stymieing demand for vehicles

Event Path and Catalysts:
These things are not important to my thesis since I believe that the shares are trading at such a discount to intrinsic value that 1 year from now I expect the stock to be trading much higher. I would also like to hold this business for the longer-term as long as it remains reasonably valued and provides a high IRR given the long runway for high-quality growth. Also as highlighted above, I think it’s a pretty good retail business that I would be happy to own longer-term.
1) WTI begins to sharply recover, and ACQ follows suit.

2) Announcement of large accretive deals; the company definitely has the balance sheet to execute.

3) This is a great example of how prices are much more volatile than underlying business values; prices can overshoot to the upside and to the downside; the core growth thesis remains intact and once the markets starts shaking off the oil plunge fears this stock can take off very quickly again and re-rate to a 20x multiple to properly reflect the growth prospects. This is a very likely scenario since this is a high-growth dividend-paying stock that should attract a lot of interest again especially as Bay Street will continue promote the stock. 

4) Monthly industry data continue to point to strong performance and less muted effect of lower oil on vehicle sales in Alberta.

5) Fiscal year 2014 year end results will be reported in March which will show strong inorganic and acquisitive-driven growth.

1) This is a high-quality compounder with plenty of growth that has temporarily fallen out of favour – a classic “value investment”.

2) We have a fantastic management team focussed on driving shareholder value, are well aligned with shareholders, and are experienced in the industry with a suburb operational and capital allocation track record.

3) The bear case has no legs, and even if it does, there is virtually little to no downside at current trading levels. In fact there is plenty of upside since we are getting such a bargain price as until the market comes to its senses. I believe this situation exemplifies Monish Pabrai’s famous quote: Heads I win; tails I don’t lose much.


“In the short term the market is a voting machine, in the long-run it is a weighing machine” – Benjamin Graham
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” – Warren Buffett



1) Modelling Assumptions: Bear case and Base Case


Base Case: Average Dealership Financial Estimates:


Base Case same-store estimates (assuming no acquisitions):


Base Case Unlevered FCF reconciliation:


Adjusting TEV by hidden excess cash in floorplan

Adjusting TEV by hidden excess cash in floorplan

Liberty Global – TCI 2.0 – Deep Dive into Media Companies Series, Part 1

“I used to say in the cable industry that if your interest rate was lower than your growth rate, your present value is infinite. That’s why the cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money. If you do any arithmetic at all, the present value calculation tends toward infinity under that thesis.” – John Malone

Part I of a Series of Deep Dives into Media Companies

Liberty Global – TCI 2.0

Date: 03/08/2013 | Ticker: LBTYA/K | Price: $43.55/$42.19 | Market Cap: $33.75 billion/ Idea Type: Great Capital Allocator/Sum-of-the-Parts

I’ve been reading a lot of business biographies lately, especially ones covering media moguls such as Ted Turner, Robert Murdoch, the Roberts and even Richard Branson[1]. One commonality I discovered through reading these bios was how focused these entrepreneurs were on building their empires at almost any price, without taking into any serious consideration the potential downside. Bad deals were the norm. For most of these men net worth was a relatively low priority. Instead their obsession was on building the largest media empire possible. Overpaying for licenses to coveted orbital satellite slots, or holding on to cash sucking newspaper businesses were just a couple of examples of a disregard for value mentality. I fear this same mentality remains largely prevalent today in the “new generation” of internet/media entrepreneurs in Silicon Valley.

Bad deals such as Facebook’s recent acquisition of WhatsApp is a prime example. Unless you think Facebook’s shares are worth closer to 10-25% to where they are trading today (I believe the consideration included $12B in stock and $3B in RSUs), there is no way in hell that WhatsApp is worth anywhere near $19 billion to any rational buyer.

If there is any media mogul that is disciplined about capital allocation and return on invested capital, that would have to be John Malone. As a shareholder to a company I am basically entrusting the management to rationally deploy the company’s capital to maximize returns. As a long-term investor, I would want to partner with the right people who are good stewards of my hard-earned capital or why the F#&$ should I entrust them with my money? Great capital allocators are rare to find in any industry, and the difference it makes to a company’s long-term value that is run by a great capital allocator and a horrible one can be enormous.

By the way, if you are looking for an actionable idea this post is probably not for you, but if you like reading about the cable and media industry then read on!


At the latest Liberty Media Capital annual meeting John Malone hinted that future growth opportunities in the cable industry would most likely be greater outside the United States. Although this should have been obvious to me already given my observation of the slowly shrinking U.S. Pay-TV industry, I decided to take a closer look at Liberty Global (LGI).

LGI is basically a large collection of cable operations across Europe, the UK, Puerto Rico and Chile. It is actually the largest cable operator, globally.

In my view, LGI’s strategy of rolling up the fragmented cable industry in Europe is very similar to the Tele-Communications Inc. (TCI) playbook back in the 1980’s. For reference, TCI was started by a cattle rancher, Bob Magness in 1968. When Malone took over as President and CEO he built up TCI from a bankrupt company to the largest cable company in the United States, generating 30%+ returns for shareholders. The end game was an overvalued sale to AT&T in 1999. I don’t recall what the transaction multiple was, but I think AT&T paid something ridiculous, maybe something in the mid-teens EBITDA range for a cable business on the verge of facing serious satellite competition.

For LGI, we have seen this leveraged equity shrink story play out before, although in a more favourable competitive environment. During the old TCI days, Malone had a virtual monopoly on the distribution side, and large controlling stakes in major cable TV networks such as Turner Broadcasting that supplied the high-quality programming. Telcos were also not a threat back then; direct-to-home Satellite was just an emerging delivery system, and there was no over-the-top internet-TV threat.

The Thesis

The holding co. is quite complex, but my thesis is quite simple; I believe LGI is poised to continue to gain broadband share and build scale across growing European markets mainly via inorganically through acquiring smaller cable assets and organically through up-selling video and broadband services to an underpenetrated market. I see 30% upside under my base case scenario which is nothing amazing.

1)     Europe remains fertile ground for accretive M&A activity across Cable and Telco industries. On top, you get the best capital allocator in the cable and media industry, John Malone and Michael Fries steering the ship, and I expect continued accretive leveraged buybacks going forward. I believe the industry’s next phase will continue with lots of M&A activity and rationalization of markets. Complementing this consolidation outlook is an overlooked theme in that LGI’s core markets consist of either a duopolistic or oligopolistic structure, with operators mainly competing on broadband speeds.

2)     I believe the market has under-appreciated the LGI’s superior market position and fixed network relative to their main competitors (the incumbent Telcos) as consumers continue to display an insatiable demand for data consumption and faster speeds. LGI should benefit greatly from its competitive advantage in broadband by offering superior speeds and should be well-positioned to monetize higher speeds over the long-term. European Telcos are currently in the middle innings of a large CapEx cycle of upgrading their copper wire infrastructure to support faster speeds, but I believe the market has overly discounted this competitive threat.

Why does this opportunity exist?

1)     Liberty Global is an extremely complex holding company, with cable operations across most of western and central Europe along with minority and controlling equity stakes. As you can imagine, there are many moving parts to this story. Sometimes complexity may turn off investors that want to invest in simple and clear ideas. However, I think complexity can sometimes be an advantage to the enterprising investor who’s willing to invest the time to uncover key value drivers and hidden value behind an investment.

2)     LGI is a horizontal acquisition machine which makes at least 1 sizable acquisition a year, which adds to the difficulty in reaching the “right” pro-forma valuation. In addition, LGI won’t typically show up on any “value screens” since its unprofitable on a GAAP income basis.

3)     LGI pays no dividend, so it doesn’t attract yield hungry investors and thus trades at a lower multiple of EBITDA relative to European and Telco peers.

What I think the Market Sees:

1)     A complex holding company/structure with sizable operations in 14 different countries

2)     A capital-intensive business with CapEx consistently above 20% of total revenues and a business that generates sub-10% returns on invested capital

3)     Overall declining net video subscribers as fierce competition such as Telcos takes market share away with new network investments into VDSL coupled with vectoring and the threat of Fiber overbuilds

4)     A highly indebted company with a gross debt to EBITDA ratio of more than 5x

5)     A company that has historically  reported negative net earnings on a GAAP basis

6)     A company with its top-line being pressured by a weak consumer environment and a struggling Euro zone economy plagued by weak southern economies


What I See:

1)     A highly predictable, non-cyclical and growing leveraged free cash flow machine with unmatched scale operating in healthy, affluent, western European markets

2)     An opportunistic consolidator in a large, fragmented European cable industry

3)     A company with an optimized capital structure given the stability of the business model, and headed by one of the best capital allocators in the industry

4)     A company with unmatched product superiority in broadband internet, which should become a long-term secular growth driver supported by a structural change in viewer habits

5)     GAAP income is a meaningless metric here; moreover, negative pre-tax earnings are a positive, since LGI can save on cash taxes; I believe the right metric for LGI is free cash flow per share

6)     All this and a rather reasonable valuation; LGI is currently trading at slightly more than 13-14x free cash flow per share in 2014 by my estimates, which I think is unwarranted

Company Overview

Liberty Global (LGI) is the largest cable company globally, offering video, telephony and broadband internet services to over ~48 million RGU[2]s in 14 countries including 12 in continental Europe. Over the past several years, LGI has strategically re-positioned itself into growing markets in Western Europe, and divested cable assets in Japan and Australia. In terms of cable market share LGI is the largest in 9 of 12 European countries. They are the largest cable provider in every country they operate except Germany, The Netherlands, and Romania.


LGI typically makes at least one major acquisition a year, and this year I believe they made a great one in buying Virgin Media (VMED) for ~9x EBITDA post-synergies. The initial $180 million in cost synergy estimate turned out to be very conservative and estimates have been doubled, but I will circle back to VMED later on. LGI also holds a 28.5% equity stake in Ziggo (the largest cable operator in the Netherlands), most of which was acquired throughout 2013 for an average price of around 25-26 Euros a share I believe.  They also hold a 58.4% stake in Telenet (the largest cable operator in Belgium), an 80% stake in VTR (a cable operator based in Chile) and a 60% stake in Liberty Puerto Rico. The latter two assets are considered non-core by management, and I believe there is a good chance that they will eventually be sold at a later date, at a good price, of course.

Most of my analysis will be focused on LGI’s 5 core markets of Germany, UK, The Netherlands, Switzerland and Belgium that make up ~86% of LGI’s 2014e operating cash flow (OCF). OCF is a key driver and management considers OCF the same as adjusted EBITDA, so for the purpose of this write-up they will be used interchangeably.

Pro-Forma Consolidated Financials

Pro-Forma Consolidated Financials

I: Geographic Mix by Revenues                                              II: Bundling Mix:

bundling mix geo mix

Source: LGI Corporate Website


Brief Industry Overview

At first glance Europe’s telecommunications industry is much more fragmented compared to the US. While I believe there are less than 15 cable operators in the US today, and literally 2 major Telcos, there are ~120 mobile operators, ~1,000 Telcos, and ~7000 cable operators in Europe. While the Cable industry appears balkanized, cable coverage is quite ubiquitous across LGI’s core markets, with cable coverage well north of 90% of households in Switzerland, The Netherlands and Belgium but slightly lower in the UK and Germany.


Industry Growth:

Looking at the top-line, there are two key growth drivers here: 1) up-selling to the existing subscriber base with digital, High-definition (HD) and increased bandwidth (speeds) services which will drive ARPU growth and 2) volume growth through increased broadband and mobile growth, especially in Germany which will drive RGUs, and growth in B2B and mobile.

1)     There remains a large opportunity to up-sell additional video services to the subscriber base which will grow ARPU. The largest trend here is the steady migration of subscribers going from analog to digital TV services. Europe remains well behind the US in terms of digitalizing their subscriber base, and I believe digitalization levels will eventually approach near 100% in Europe, following the footsteps of US cable operators as a necessity to remain competitive against Satellite competitors. Currently ~50% of LGI’s TV subscriber base is still on analog TV and advanced TV platforms such as DVRs, HDTV and Video on Demand (VOD) will help with this transition. ARPU typically doubles when a subscriber converts from analog to digital which is accretive to long-term cash flow as incremental costs and CapEx lag behind. Finally, an underappreciated growth driver will be higher ARPU from broadband as LGI slowly monetizes higher speeds down the road, which I believe the market has not priced in.

2)     LGI benefits largely from operating in affluent, relatively underpenetrated Western European countries where dense cable builds are yielding attractive economics. Within these markets, Germany remains the fastest growing broadband market in Europe as penetration remains relatively low (please see table above). The average broadband penetration rate in LGI’s footprint is 28%. Broadband penetration rates are relatively low across Germany and the UK, as shown in the chart above. Moreover, deployment of Horizon TV to core markets such as Germany, Switzerland, The Netherlands and growth in the B2B business, which is in a similar fast growth stage similar to the US should help drive top-line. Europe also offers lower churn given that content costs remain subdued and cable-TV bills remain very affordable, along with aggressive triple-play bundling. Most Pay-TV operators are reporting yearly churn of less than 15%, which compares favourably vs. US operators which usually report above 20%. I believe increased bundling remains a large opportunity as LGI has a large % of its subscriber base on single play. Comcast has only 23% of their base on single play operating in the more mature US market.

product penetration

Note: For my modeling assumptions on video and broadband ARPU, RGUs and other key drivers for LGI’s most important markets, please see in Appendix in part II.

Competitive Landscape

1)     Broadband speeds and capacity will be the key competitive differentiator over the longer-term as users continue to transition from linear TV to internet TV on multiple devices such as mobile.

2)     Unlike in the US where premium content is in the hands of several large cable networks, in Europe most content is available free-over-air supplied by broadcasters with the exception of the UK. In Europe, content players are relatively fragmented and programming costs are not out of control like in the US. On a monthly per sub basis, LGI pays on average 15-20 Euros for programming costs vs. US cable operators that typically pay $35-40.

3)     It’s reasonable to expect LGI to experience video subscriber share losses over the foreseeable future and higher churn rates as Telcos slowly upgrade their networks and as analog subscribers churn. However, cable is still capturing at least 60-70% of the incremental broadband growth across its markets. Cable seems to offer higher speeds are very competitive prices, similar to Telcos. I think going forward; the two key competing variables will be speed and price.

4)     All the major incumbent Telcos in every LGI core market should have VDSL rolled out over 2014-2016. Major trends are quite similar to the US where LGI is losing Pay-TV market share to incumbent Telco’s IPTV product but is still gaining share on broadband.

5)     Based on my research, I believe the industry will remain rational in all of LGI’s core markets as the incumbent Telcos and main cable rivals have shown a consistent history of co-operation, limiting discount promotion periods, and eventually monetizing their heavy CapEx cycles by raising prices.

I may be stating the obvious here but in the Cable business scale is everything, in fact, I would say scale is lifeblood of a cable company. In simple terms, scale allows a cable operator to secure high-quality content from programming networks and other content vendors; scale allows a cable operator to secure this content at attractive prices given the increased bargaining power; scale allows a cable operator to purchase hardware such as set-top boxes at attractive terms and rationalize other operating and IT networks such as call centers and trucks; scale allows a cable operator to provide a leading technology roadmap including high-quality user interfaces and innovative new products; scale allows a cable operator better access to capital markets and attractive financing terms.

Aside from scale, cable as a business offers a great value proposition to the customer, is recession resilient, and operates within an oligopolistic industry structure consisting mainly of incumbent Telcos and Direct-to-Home satellite competitors. Given these business characteristics, I can see why Malone loves employing his leveraged equity shrink playbook.

LGI Core Markets: Germany and UK: ~50% of LGI’s OCF

1)     Germany:

UnityMedia KabelBW (subsidiary of LGI) is the second largest cable TV provider in Germany with ~6.7 million video subscribers; 4.5 million are on analog and 2.2 million are on digital. Kabel Deutschland is the larger cable company in the country. Deutsch Telekom (DT) would be the incumbent Telco in Germany. DT is targeting two thirds Fiber-to-the-Curve (FttC) coverage by 2016.

UnityMedia KabelBW’s footprint passes through ~31% of German homes. An interesting fact about the Germany market is that ~60% of UnityMedia’s subscribers are part of large housing associations which provides a captured customer base. Housing association tenants must pay their basic cable bills as part of their rental contracts with the housing association. Housing associations usually have very long-term contracts with Cable operators in the range of 10+ years, and as such, provide a stable, predictable recurring stream of cash flows and are a perfect customer base to cross-sell high speed broadband.

The other interesting fact about the German cable market that shocked me is that carriage fees are paid by the public broadcasters to distributors. As a result, carriage fee revenue streams are not only at risk of disappearing, but could be moving towards a model similar to the US where the cable operators are paying a retransmission fee back to broadcasters. I believe it is the only market in Europe that still has this practice. In the US, the high growth in retransmission fees has been a central topic in network/distributor negotiations. Regarding the current dispute over carriage fees in Germany (public broadcasters have stopped paying them and German cable operators have threatened to cut their broadcasts), I believe it is unlikely that the German cable operators will begin paying a fee to the public broadcasters and I have already conservatively assumed 0 carriage fee revenues in my model going forward.

In terms of growth, Germany looks like Holland 10 years ago. I believe there is considerably upside from broadband penetration; currently, penetration levels are at ~70% and I think will approach closer to 90% to match penetration levels in Holland. Growth will come from volume primarily, but I also believe pricing will increase. I think German cable TV service is currently underpriced for several reasons: 1) due to a lack of real pricing increases when the industry was more fragmented, 2) the Pay-TV segment remains underdeveloped, and 3) a ceding of distribution and control to housing associations to set cable prices. Now that Malone and LGI have consolidated the second and third largest cable operators in the nation, I believe that cable TV pricing will increase at a faster rate than the historical ~2%, supported by a rational Telco incumbent and increased Pay-TV and digital penetration.

2)     The Netherlands, Belgium and Switzerland

These are the three countries in Europe that pretty much have ubiquitous cable coverage across homes. Across the rest of Europe, cable coverage is closer to 75%. Another commonality among these countries is that population and network density is amongst the highest of all of Europe, leading to more attractive economics. All three countries have very attractive market structures in fixed-line.

UPC Netherlands is the second largest cable TV provider in the Netherlands with ~1.7 million video subscribers; ~650,000 on analog and 1.1 million on digital. UPC Netherlands passes through ~37% of Dutch homes. LGI also has a 28.5% minority stake in Ziggo which is the largest cable operator in the Netherlands. Together, Ziggo and UPC Netherlands passes through roughly 90% of all Dutch homes. KPN, the incumbent Telco, has a JV that passes through 20% of all Dutch homes with Fiber-to-the-Home (FttH). KPN has been steadily losing share in broadband and has seen its operating results struggle lately, so the market has been concerned that they would begin entering a price war with Ziggo and UPC Netherlands. I believe this will not likely be the case as KPN is only one of two Telcos in Europe that is heavily investing in FttH, and I think they will most likely want to see that investment generate good returns via higher pricing. Also, there is evidence that the competitive environment remains rational as KPN raised prices by ~3% on July 1st just last year. Recent history also supports that they are a rational market player as they raised prices on their IP TV service from 11/month EUR in 2011 to 15/month in 2012.

Ziggo is a great asset that LGI currently holds a 28.5% stake in and I believe LGI will acquire the rest of this company in the near future. Ziggo passes through ~56% of homes in The Netherlands. Ziggo’s EBITDA figure is depressed relative to the typical industry metric since Ziggo doesn’t capitalize their  set-top boxes and instead fully expenses this line-item as they acquire new subscribers. This is extremely conservative accounting as I’m not aware of too many cable companies that fully expense this line-item; some partially expense it as part of their subscriber acquisition cost like DirecTV, but the rest is usually capitalized.

With respect to the recent deal to acquire the rest of Ziggo, I think they actually paid a good to fair price given the strategic value of this asset. Considering that Ziggo’s EBITDA is understated, the large cost synergies available from streamlining major costs with UPC Netherlands, and the growth from bundling mobile services, 11x 2014 EBITDA (pre-synergies) is quite a reasonable price to pay to consolidate cable in the Netherlands. Population density is very high in the Netherlands; in fact, the country has the highest density in Western Europe with 487 people per square km. This leads to very attractive cable economics in large urban clusters as scale effects really kick in.

ziggo stake analysis

netherlands marketshare

LGI has a 58.4% stake in Telenet which is the largest cable TV provider in Belgium with ~2.1 million video subscribers; 550,000 on analog and ~1.5 million on digital. Telenet currently serves ~46% of the total television market and passes through 62% of all Belgian homes. The Belgian market is one of the most saturated in the world in terms of broadband penetration with close to 80% of all homes having broadband service. Higher broadband speed adoption rates have definitely picked up as average speed of entire broadband customer base is around 61 Mbps with over half of base surfing on speeds above 50 Mbps. The market is pretty much a duopoly as the combined market share of Telco incumbent Belgacom and Telenet is ~90% resulting in limited price competition.

LGI is the largest cable TV provider in Switzerland with ~1.5 million video subscribers; ~850,000 on analog and ~600,000 on digital. UPC Switzerland passes ~57% of Swiss homes. This market is probably the most rational out of LGI’s core markets, since its national regulator has been extremely passive with dealing with any anti-competitive behavior. Switzerland is another duopoly between Swisscom and UPC Switzerland. 

switzerland market share

I will have to update the rest of this write-up for recent major news affecting Liberty Global… stay tuned!

Appendix I: Financial Model of Liberty Global’s largest markets – Germany and the UK, base case scenario

Germany Model

UK model


[1] Branson might have been an exception as he typically weighed the downside of his business decisions

[2] Revenue Generating Unit (includes video, internet, and voice subscribers)


Date: 09/12/2013 / Ticker: LINTA / Price: $23.70 / Market Cap: $12.3 billion / Idea Type: GARP, Recap

Would you invest in a company that 1) is among the highest quality business franchises in the world, 2) is run by a world-class management with a Buffett-beating long-term track record in value creation, 3) is buying back its own undervalued shares hand over fist, at a growing 10% free cash flow yield, in a world of 3% long-term interest rates and 17 multiple S&P?

Liberty Interactive (NASDAQ: LINTA) presents a unique opportunity to participate in the said proposition. I believe LINTA at $23.70 is trading at less than two thirds of its current conservatively estimated NAV, which coupled with medium term business growth and highly accretive, debt/FCF financed share repurchases, should grow to $45 – $60 a share by the end of 2015.

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Liberty Interactive (NASDAQ: LINTA) is a tracking stock that represents interests in three high-quality retail properties. Among the smallest of John Malone’s media mini-empires, LINTA does not attract nearly the same level of public interest as the big boys (Liberty Media/Global, Sirius XM, Discovery, etc.) and is largely misunderstood due to its complex capital structure.

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Why This Opportunity Exists:

1. LINTA operates under a highly obscure and complex tracking stock structure. My research indicates that it is one of the very few (if not the only) public tracking stocks out there. John Malone invented this complicated arrangement in 1994 when he split out Liberty Media from TCI. The structure is poorly understood among investors and in the case of LINTA, often inappropriately assigned a NAV discount.

2. QVC’s detailed stand-alone financials are not publicly disclosed within LINTA’s filings. Despite being a wholly-owned subsidiary of LINTA, QVC actually reports separately with the SEC to fulfill disclosure requirements for issuing its own bonds. Not many people are aware of this and simply write off the idea due to inadequate information.

3. QVC reports a large $400 mil per year amortization expense, most of which is related to purchase accounting. I estimate that this understates the company’s earnings power by at least $250 mil a year.

4. LINTA has a valuable collection of e-commerce assets and a Chinese TV shopping JV that have generally been ignored by the investment community due to their relatively small size compared to QVC, but are worth billions even valued at historical cost.

5. LINTA does not pay a dividend like HSN/retail peers and uses all of its free cash flow generation for repurchases, making it unattractive to income-seeking investors.

QVC – “It Grows and Throws”[1]

QVC is in my opinion the best retail model in existence due to its unique business model and resultant structural competitive advantages.

QVC is the largest home shopping TV network in the world, and is a market leader in the U.S., Japan, Germany and the U.K. The company recently expanded into Italy and China (through a joint venture with China National Radio) and is planning to enter into other new markets in the next few years. QVC’s live televised shopping programs are distributed to over 215 million homes globally, between 17 – 24 hours a day, and 364 days a year.

In effect, QVC is a 24/7 giant infomercial, except it does not get paid for advertising. Instead, QVC is a retailer; it uses its own vendor channels, holds its own inventory and realizes the full economic value in the retail model. The U.S. is currently QVC’s largest market, constituting two thirds of consolidated sales and over 70% of adjusted OIBDA (EBITDA + stock-based compensation).

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QVC’s typical customer is a wealthy 45 year old female early adopter. Most of QVC’s products are highly-differentiated department store level goods, and many are new product concepts exclusively distributed on QVC. In a way, QVC’s enormous marketing clout allows it to become a venture capitalist, by endorsing new products on its channel. This way, QVC can enjoy the upside of selling innovative concepts without the downside of having to put up capital. Many of QVC’s products are endorsed by celebrities and designers who are invited to QVC to promote such products, making the promotional programs a very sticky service for viewers.

Customers order products while watching QVC’s promotional programs. Historically most orders have been made on the phone, though an increasing portion of the core QVC customer base is now ordering products through QVC’s e-commerce website. E-commerce accounted for 42% of QVC’s US sales as of Q2 2013, and a large % of online sales is now from mobile devices.

Business Quality:

QVC’s business quality is one of the highest among large international enterprises. Assuming 1% sales for working capital cash, QVC has achieved an average return on tangible capital of 87% in the last three years, a figure unheard of anywhere else in the retail industry.

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QVC is also a very stable and resilient business. Sales went down by only 1.3% in 2008, making it one of the best performing retailers during the financial crisis. OIBDA margin has stayed at 21% – 22% for ten years, which is extremely high by retailer standards.

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QVC operates in an extremely entrenched competitive position, as it benefits from a very strong form of the network effect, from multiple perspectives:

1. Since QVC generates the highest sales among home shopping networks, it can negotiate lower carriage fee ratios with programming distributors than its smaller competitors (home shopping networks all must pay cable/satellite TV companies a commission for carriage), allowing QVC to price its products at a discount, attracting more customers/sales in the process.

2. QVC’s superior sales exposure makes it a more attractive sales medium for vendors, who are often obligated to sign exclusive distribution agreements. A better selection of merchandise draws even more sales, in turn making QVC more attractive for vendors.

3. Being the most “productive” source of carriage fees for pay TV operators, QVC can negotiate privileged channel placement. This typically means a low channel number and adjacency to popular entertainment channels that smaller competitors cannot access.

This lethal combination of competitive forces makes the home shopping market largely a national “winner-take-all” situation. Profitable entry into this business is close to impossible, because only the top retailers can generate enough gross profits to cover fixed overhead. In other words, you must be very big to reach critical mass, but if you are small, you can never become big in the first place. The best example of this is the U.S. market, where QVC has controlled over 65% of the market for well over a decade. HSN (NASDAQ: HSNI, 38% owned by LINTA), the no.2 player, has a market share of only 27%. The remaining 7% belongs to ShopNBC (NASDAQ: VVTV), which is in decline and has never made a profit since its founding in 1990.

QVC vs. Department Stores & Amazon:

QVC primarily competes with retailers selling department store grade merchandise. To understand why QVC is fundamentally a far superior retail model, consider the following statistics:

1. QVC charges 20% below most department stores and 5% below Amazon for identical products, which is already pricing merchandise far below profit-maximizing levels.[2] QVC’s exclusive products, whose vendors are more reliant on QVC sales, are likely sold at an even larger discount relative to similar products elsewhere. Unlike its brick and mortar competitors, QVC’s margin is not Jeff Bezos’s opportunity.

2. Over 75% of QVC’s products are exclusive. Wells Fargo found that there is a product overlap of only 7.2% with Amazon, 1.1% at Macy’s and 6.0% with other retailers.

3. Over 86% of sales are repeat purchases, a ratio that QVC has maintained for many years, so revenue is largely recurring due to the loyal customer base. Studies show that almost all customers with more than five purchases become customers for life.

4. QVC pays out 5% of its net sales in “rent” to pay TV companies vs. over 10% for most brick-and-mortar retail tenants.

5. QVC spends 3% of its net sales on maintenance Capex vs. 4% – 10% for most retailers and 6% for Amazon.

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6. QVC generates an OIBDA margin in excess of 21% vs. mid 10%s for quality department stores, 6% for Amazon and 10% for HSN.

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The point I am trying to demonstrate is that QVC has structural advantages over its competitors at almost every layer of the cost structure. This, combined with low capital intensity (assets employed = program production studio, a few call centers and warehouses vs. thousands of store fronts, logistical & distribution assets for brick & mortar competitors), produces a phenomenal ROIC that very few businesses can hope to match.

Furthermore, QVC enjoys significant advantages on the sales side. QVC’s televised programs are a far more controlled medium for marketing than other retail channels and exploit various psychological influences in its selling techniques to great effect. For example:

1. Program hosts at QVC usually thoroughly demonstrate the functionality of the items being promoted. This reduces the “search cost” associated with buying unfamiliar products and makes viewers feel more engaged with the products on display.

2. QVC often airs phone conversations between viewers and hosts, where a viewer is chosen to provide favorable reviews of the products on display. This triggers effects of social proof, since people are more motivated to purchase items viewed favorably by those similar to them.

3. QVC’s programs often display the limited quantity/time window of the items being promoted. Since most of QVC’s products are exclusive, the limited and diminishing availability of the items makes viewers perceive them to be scarce and therefore more desirable than items that are more widely available, even though the quality difference may be insignificant.

4. Celebrities and popular designers are frequently invited to QVC’s shows to promote certain products, making it more likely for their fans to make a purchase. Program hosts also tend to be quite attractive to their core audience and build their own fan base/popularity over time.

5. QVC programs are designed to be very entertaining, and provide a unique social experience to those who enjoy shopping. Core customers spend many hours every day watching QVC programs for the content value.

These selling schemes make QVC programs a very effective marketing platform, and QVC monetizes this platform by demanding higher discounts/exclusivity from its vendors, making its product line more affordable and differentiated. Brick and mortar competitors as well as e-commerce sites are simply not capable of offering nearly the same level of interaction and marketing value.

The demonstrative aspect of the programs is also particularly useful for introducing new product concepts by un-established innovators, many of whom become instant millionaires after their products receive a QVC national endorsement. QVC realizes a higher margin on new products sold to early adopters due to their initial scarcity.

Growth Opportunities:

1. E-commerce (mobile): An increasing portion of QVC’s sales is now done on the company’s e-commerce site. The company’s U.S. business now gets 42% of its orders from its website, and management believes e-commerce orders will be over half of all revenue in a few years. While this does not fully constitute revenue growth (many online orders are simply conversions from phone orders), it does produce the effects of 1) lowering expenses by reducing reliance on call centers, 2) making purchases more interactive, and 3) lowering the overall age group of customers.

QVC’s website, as of last year, was the 9th largest e-commerce site in the United States ranked by sales. QVC’s mobile site is the second largest mobile e-commerce site after Amazon, and now accounts for 28% of online orders, or 12% of total orders. The company’s aggressive move into e-commerce/mobile distribution is now attracting younger customers. QVC’s 2012 Investor Presentation showed that new customers in 2011 were on average 5 – 10 years younger than the company’s existing customer base.

I think continued online/mobile adoption in the foreseeable future should address the major concern of an aging customer base at QVC.

2. International Growth: According to management, QVC is aiming to expand into a new market every two years, by leveraging the company’s strong international brand awareness and differentiated supplier base. Compared to the U.S., most international markets are characterized by weaker competition and pay TV under-penetration. Management is currently looking at France and Brazil for near-term expansion, Canada, Indian and Spain for medium term expansion. These markets, combined with recent expansions (China, Italy), have a total projected GDP of over $26 trillion by 2016, which will exceed the combined GDP of QVC’s maturing markets (U.S., Japan, Germany and the U.K.), so the potential for growth is quite massive.

Such expansions tend to have very low risk, due to the low amount of capital invested, and high potential, due to the strength of the QVC brand and supplier base. Factoring in QVC’s low capital intensity model, this growth source will likely produce very high incremental returns on investment. Management’s execution has also been excellent, in Italy and more recently China, both growing sales at high double digits and expected to be EBITDA positive by next year.

CNRS (Chinese JV):

CNRS, or CNR Home Shopping, is a TV home shopping joint venture with China National Radio, a Chinese state monopoly in broadcast radio. QVC owns 49% of this property, which is now connected to over 62 million homes in China.

The total number of households with access to subscription TV in China is 196 million, or 3 times CNRS’s current penetration. Management believes that CNRS has no problem getting access to 100 million homes in a few years (similar to QVC’s current U.S. penetration), so this is potentially a very valuable asset.

CNRS has a few unique advantages in China:

1. It is the only home shopping/infomercial service that has an official state-owned brand. Most competing services tend to be regional and poorly received by consumers, due to misleading marketing practices and poor selection of merchandise. CNRS has the most legitimate brand in the space and is well positioned to take market share from weaker competitors.

2. Even though the Chinese have a lower average income, they love Western brands and spend a disproportional amount of their income on them. With access to QVC’s large international vendor base, CNRS can cross-sell more Western products to the Chinese market.

3. Many of QVC’s products are made in China in the first place so the logistics are a ready synergy to be realized.

Valuing this asset is more art than science since the JV is still in its first year of operations. CNRS already generated over $100 million of revenue in 2012 and management is confident that this will grow multiple folds in a few years. CNRS’s carriage fees/programming costs are largely fixed so any incremental gross profit basically flows directly to the bottom line. Realistically, I think the value of CNRS is lower than QVC U.S., but higher than QVC Japan (the growth assumptions required seem heroic but really aren’t if you consider that this asset is in the best position to transform the massive Chinese market into a winner-take-all situation). If you assign CNRS the same valuation as QVC Japan, which I will value at HSN multiples (10.5 x EBITDA), QVC’s 49% is worth $1.3 billion. I expect the long-term value of CNRS to far exceed this.

Valuation Considerations:

QVC is a high quality, free cash flow generating machine with an above average growth prospect and easily deserves to trade at a premium to the market as a whole. However, if you value LINTA’s other assets conservatively and isolate the QVC stub, it is trading at roughly a 10% free cash flow yield, which compares with a sub-6% yield for the S&P 500.

Below are my assumptions for calculating QVC’s sustainable FCF and implied stub trading multiples:

1) TTM EBITDA of $1,838 million.

2) Future interest of $210 million annually, based on QVC’s subsidiary debt profiles. This number is expected to go down in the next few years as QVC refinances a large portion of its outstanding + 7% interest debts at a lower interest rate.

3) TTM taxes of $318 million.

4) Management has said in past calls that the level of maintenance Capex for QVC is in between $200 to $225 million per year. To be conservative let’s call it $240 million.

5) Working capital averages a little over 9% of sales. A modest 5% sales growth results in $40 million of WC being consumed.

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These assumptions get me an unlevered FCF of $1,030 million for the QVC stub:

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If you value LINTA’s e-commerce assets at 15 x currently depressed levels of EBITDA, you get a little under $14 billion in implied enterprise value for QVC, or 7.6 turns of TTM EBITDA. Implied free cash flow yield for the QVC equity is a little over 10%. QVC’s lower quality cousin, HSN, is currently trading at a 4.5% equity free cash flow yield and 10.5 turns of EBITDA.

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HSN itself is a very good quality business as well, with an ROTCE of 72.6% over the last three years and reasonable domestic growth prospects. HSN at 20 times earnings power (free cash flow) does not seem excessive compared to 17 times for the S&P, which is arguably a fair valuation (at least Warren Buffett thought so – see CNBC interview on September 20th). John Malone also seems to agree with this assessment as he continues to support HSN’s share repurchase program. He wouldn’t if he thought HSN overvalued.

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I think QVC is an even better business than HSN and deserves an even higher multiple to cash flows. Consider the following comparison:

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Also, approximately one third of HSN’s profitability comes from its Cornerstone segment, which is a collection of home and apparel brands sold through catalogue and physical retail channels. This is a good business but not nearly the same quality as the core home shopping business. QVC, on the other hand, is a home shopping pure play with a sole focus.

My QVC Valuation:

1. Low case: I value QVC at the same 10.5 EBITDA multiple as HSN. This is very conservative given that QVC has a much higher FCF/EBITDA conversion rate.

2. Base case: I value QVC at a 6% FCF yield, or basically a 17 multiple of earnings power. This is consistent with the current S&P 500 valuation, which is still conservative since QVC is a far above-average business.

3. High case: I value QVC at a 5% FCF yield, implying a 20 multiple. I think this is the multiple that QVC deserves if LINTA spins off QVC as a stand-alone company. This is also more consistent with HSN’s equity FCF yield.

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Another way to think of QVC’s valuation is that John Malone purchased 57.5% of this asset from Comcast in 2003 for $7.9 billion, partially using Liberty Media stock, which I’m sure you know has gone up many times since then. This valued the enterprise at $13.7 billion in 2003, which is more or less the implied EV that I estimated for QVC today ($13.9 billion).

To claim that QVC is fairly valued today would be the equivalent of saying that John Malone was stupid enough to buy an asset in 2003 that has generated no returns for ten years using valuable Liberty shares. This is clearly not true if you examine what has happened in the last ten years:

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E-Commerce Assets

LINTA also owns a diverse portfolio of e-commerce assets, all fast-growing leaders in their respective markets. This portfolio took a long time and a lot of capital to assemble. Total cost of the assets is not available as many deals were done at an undisclosed amount. Most estimates put the portfolio’s cost at over $1 billion, which is reasonable given that Provide Commerce alone cost close to $500 million.

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Most of these websites operate in niche markets, where they are among the leading brands. Provide Commerce, which I mentioned in my UNTD write-up, is a good example of this.

These assets have been growing sales at solid double-digit rates, though EBITDA generation was poor last year. This is mainly due to multiple leadership changes (one-time charges related to compensation) at a few of the subsidiaries and aggressive discounting at some others. Margins should improve next year in the absence of non-recurring events.

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E-Commerce Valuation:

On the low end I will value the e-commerce assets at $1 billion, or my estimate of the historical cost of acquiring these businesses. In my base/high cases I value them at 15 x / 20 x TTM EBITDA, which is currently understated by one-time items. I think there is a very strong possibility that management will spin-off this portfolio, given 1) the limited synergy within the current conglomerate structure, 2) valuation of these high-growth assets is being overshadowed by the much larger QVC which is perceived to be maturing. CEO Greg Maffei also confirmed in LINTA’s Q2 call that a separation of the e-commerce portfolio from QVC was “something that (they)’ve talked about in the past as potentially something (they) would execute on.”

As a stand-alone business this portfolio should trade at similar multiples to other high growth e-commerce stories (high teen multiples of EBITDA).

HSN Stake

Valuing this is fairly straight-forward. HSN is publicly traded and should be valued at market. Even if you think HSN is overvalued you can short the stock proportional to LINTA’s exposure to hedge.

LINTA’s ownership of HSN is 38% and has a fairly sizable unrealized tax liability in the stake. However, Malone the master of financial engineering solved this problem by pledging some of the HSN shares to an exchangeable bond deal recently, which allows LINTA to borrow at an interest rate of 1% (!) straight into 2043 and essentially offload HSN shares without having to pay a capital gains tax. I expect more deals like this to follow until all deferred tax liabilities are neutralized.

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My assessment of HSN, as outlined in my QVC valuation, is that it is more or less fairly valued. Even a fairly valued asset should generate a long-term return equal to the running off of the discount rate (call it 10% for simplicity) so I am comfortable with market value here.


LINTA’s management is consisted of world class capital allocators. Chairman John Malone returned for his shareholders 30.1% a year from 1973 to 1998 before selling TCI to AT&T for $60 billion, giving it the best 25 year track record among public companies during this time. In comparison, Berkshire Hathaway returned “only” 28.6% during the same period.

Since Malone’s return in 2001 following Liberty Media’s spin-off from AT&T, the rate of compounding has not slowed at all. The main Liberty vehicle has since spun off various assets (Liberty Global, Discovery, Liberty Interactive/Ventures, Starz, Directv, etc.), now totaling over $100 billion in market value.

CEO Greg Maffei is Malone’s right-hand man and widely considered to be his successor. Maffei worked for Bill Gates as Microsoft’s CFO in the late 90s, and joined Malone in 2006 after quitting as the President of Oracle. Maffei has doubled as the CEO of Liberty Media (NASDAQ: LMCA), and his track record speaks for itself. Among other deals, Maffei:

1. Helped initiate a share buyback program at Directv and execute its eventual spin-off from Liberty. Directv holds the record of buying back the highest % of its share count (over 60% as of 2013) among all companies in the S&P 500 since 2006 and has been a multi-bagger.

2. Negotiated the bail-out of Sirius XM in 2009 with a $530 million Liberty loan, in exchange for a 40% equity stake that is now worth a whopping $10 billion – a 20 bagger in just four years.

Management is financially aligned with shareholders. Chairman John Malone and his wife own 3.1 million shares of Class A and 27.2 million shares of Class B stock, for a combined market value of $720 million. The last time I checked his net worth was in the $6 – $7 billion range so this is a very material holding for him. CEO Greg Maffei owns 2.6 million Class A shares with a market value of $62 million.

The difference between Class A and B shares is that each B has 10 votes vs. 1 vote for each A. John Malone owns most of the B shares and has 34.5% of the total votes, making LINTA effectively a controlled company. I’m not concerned about the super-voting structure here; given Malone’s track record the best thing a shareholder can hope for it for him to maintain full control over the company – there is nothing so sweet as a benevolent dictator.

Maffei also made it clear during the Investor Presentation that management’s priority in capital allocation for LINTA was to raise LINTA’s trading multiples to peer levels using buybacks.

Tracking Stock – “It Has Always Worked for Us”[3]

LINTA’s obscure capital structure is part of the reason for its undervaluation. LINTA is set up as a tracking stock of the broader Liberty Interactive Group, consisting of two subsidiaries, Liberty Interactive (LINTA, LINTB) and Liberty Ventures (LVNTA, LVNTB). Investors in a tracking stock are technically not owners of the company (in this case the consolidated Liberty Interactive Group), but are only entitled to the earnings of the subsidiary that the stock is designed to track. This is because under the structure, both tracked subsidiaries (Interactive and Ventures) share the same balance sheet, same board of directors and top management team, as they are technically the same legal entity, even though they have separate sets of assets/liabilities attributed to them.

The tracking stocks are designed to reflect the economic performance of two subsidiaries with different economic characteristics. The benefit of this structure is mainly tax efficiency. Among the two subsidiaries, LINTA is the stable cash cow with reliable free cash flow generation and predictable growth, whereas LVNTA is a collection of public stakes and tax assets and is run like Maffei’s public hedge fund. LVNTA generates taxable losses from its corporate overhead and tax-driven investments (in renewable energy assets), which are then used to shield some of LINTA’s taxable profits.

Many investors assign this structure a large NAV discount, the main arguments for which are:

1. LINTA shareholders are not legally entitled to LINTA assets – the counter-argument here is that ownership of assets in the case of LINTA is meaningless because LINTA has very few assets and a negligible liquidation value relative to its going-concern value. LINTA’s value fully derives from its earnings power, to which the tracking stockholders are contractually entitled.

2. LINTA owners are responsible for debts of LVNTA in the event that LVNTA cannot pay them off. This is a more legitimate concern. However, considering that LVNTA currently owns stakes in public companies with a market value of over $5 billion versus $2.1 billion of outstanding corporate-level debt, and that it has already entered into forward contracts/2043 exchangeable bond deals to offload some of its public stakes at fixed prices, it is extremely unlikely that the debt level at LVNTA will ever become a concern for LINTA shareholders.

John Malone has been using the tracking stock structure for two decades, starting with TCI and the early Liberty Media in the mid-1990s, and continuing with the various Liberty vehicles since 2001. All of the tracking vehicles have been carefully structured and prudently capitalized and shareholders of these stocks have been generously rewarded with remarkable long-term outperformance. In a recent talk at University of Denver, Malone also confirmed that the tracking stock structure has always worked flawlessly for his public shareholders.

NAV discounts are usually only warranted when management of a public company is perceived to have value destroying tendencies with respect to capital allocation, which clearly is not the case here with LINTA. Given Malone’s track record, I find the NAV discount here very difficult to justify.

Consolidated Valuation / Share Repurchases

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I think LINTA is currently worth between $32.92 and $44.11 a share, implying an upside of 38.9% to 86.1%. However, this does not capture the upside of the full thesis, a significant portion of which is attributable to the highly accretive share repurchases that will be done in the next two and half years.

In the 2012 Investor Presentation, Maffei laid out a plan to repurchase $4.2 billion of shares from 2013 to the end of 2015. As of Q2 2013, there is still $3.7 billion of repurchase remaining, which at today’s stock price is roughly equal to 30% of LINTA’s shares outstanding.

Most of the repurchases will be funded with QVC’s free cash flow, while the remainder will be funded with long-term debt. Management’s target leverage is 2.5 times EBITDA, which implies a comfortable cash interest coverage ratio over 6 times. QVC recently issued bonds maturing in 2043 with a 6% pre-tax borrowing cost and exchangeable debts with a 1% interest rate, locking into the benefits offered by the record low interest rate environment.

Below shows my buyback model:

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Here I assume a 15% annual appreciation in the stock price. Buyback figures were provided by management and I expect them to follow through. Assuming a modest 6% annual growth in sustainable FCF through 2015, no growth in the value of e-commerce and the Chinese JV assets, and valuing QVC at equity free cash flow yields of 7% (low case), 6% (base case), 5% (high case), I get the following:

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Combined with the repurchases, this gets you $45.67 to $64.11 a share in fair NAV by 2015, or a 2 year upside of 92.7% – 170.5%, without making any heroic assumptions.

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Other than the massive repurchase program, there are also multiple catalysts that can lead to value realization at LINTA:

1. Spin-off or sale of e-commerce assets as a stand-alone entity.

2. Discontinuation of the tracking stock structure, through a traditional separation of LINTA from LVNTA.

3. Significant synergies can be realized if QVC merges with HSN. Management has discussed the possibility but is unwilling to execute on an acquisition since HSN is trading at a much higher multiple than LINTA and share buybacks currently represents a much better use of capital. I expect, however, the merger to take place once LINTA’s multiples are raised to HSN levels. Anti-trust concerns are not material since both QVC and HSN face significant competition from other retailers.

Everything About It is Amazing

LINTA is the one non-special situation idea in my portfolio with which I have the highest degree of confidence, simply because it checks every box on the list of an enterprising value investor.

Business quality: fabulous, check.

Valuation: very cheap, check.

Capital allocation: superb, check.

Management: John Malone & Gregg Maffei, check check.

What more can you ask?


For small accounts, there also exists a B class super-voting shares (10 votes per share vs. 1 vote per share for the A) which usually trades at a slight discount to the A. These are the shares that Malone owns and there is a very limited float. The B trades by appointment but represents a slightly better value than the A and should trade at a premium in a perfect world.

If Malone decides to cash out in bulk or dies, I expect these shares to be bought out at a premium by the company or successive management. Neither event is likely in the next few years, fortunately. I have the B shares in my personal account.

Material Risk

1. Multiple potential macro headaches which CNBC does a much better job of explaining than I, though in the event of a global recession I expect QVC to tough it out much better than most others given how it performed in 2008.

2. Exchange rate risks in QVC’s international markets. The recent devaluation in the yen made a very visible dent on QVC Japan’s performance, even though figures in local currency were quite healthy.

3. Acceleration of cord-cutting in core markets as over-the-top competitors continue to take subs away from pay TV distributors. I think this threat is not as dire as many perceive it to be. QVC’s programs can be viewed online; its viewers go to QVC for the quality of its content, which is extremely difficult to replicate due to the general exclusivity of QVC’s products and the frequent use of celebrity appearances. This is evident in QVC’s growing customer base in the U.S. despite marginal cord cutting in recent years.

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 4. Failure of margin improvement at the e-commerce segment.

5. Failure to manage international growth in Italy, China, and new markets.


Useful Links

1. QVC’s SEC filings:

2. 2012 LINTA Investor Presentation:

3. 2012 QVC Investor Presentation:

4. John Malone Interview (reference to tracking stock structure):

5. LINTA will be doing its Annual Investor Presentation on October 10th, which will provide a wealth of new information on the company’s fundamental development. I will do an update piece on that.



The author of this write-up owns shares in the company mentioned (NASDAQ: LINTB) 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.





[1] John Malone comment on QVC

[2] Wells Fargo did a very good study on this in their initiation piece, where they show that Macy’s and Amazon charge on average 21.6% and 5.2% more for identical products sold at QVC. QVC is able to generate such material savings to consumers because 1) aired items enjoy much higher sales volume per SKU than department store merchandise, giving QVC more bargaining power over suppliers when negotiating pricing discounts; 2) QVC does very effective national advertising for suppliers through its promotional programs; vendors “pay” for this advertising by offering to supply merchandise at a cheaper price.

[3] John Malone Speech at the Cable Center, University of Denver (Link:

DirecTV – A Share Cannibalizer

Ticker: DTV / Stock Price: $58.38 / Market Capitalization: $32B / TEV: $48.6B / Idea Style: Long Equity


As a background to this post, I first discovered DTV after reviewing Berkshire’s public holdings, and after noticing that both of Berkshire’s new fund managers Todd Combs and Ted Weschler held rather large positions in DirecTV, I decided to dig deeper.  Weschler has been a long-time shareholder of DTV, having held shares comprised of roughly 25% of the long-side in his hedge fund if you look at Peninsula Capital Advisors’ SEC filings dating back to inception. We think Weschler is an extremely talented investor in his own right, having returned 1236% over a roughly 11-year period running his hedge fund. We like to track the holdings of great, long-term investors that tend to have extremely concentrated portfolios with high conviction ideas as a source of idea generation. Although we do not need confirmation from great investors for the development of our own investment theses and conviction, we still take comfort that other great investors may be seeing the same value as we do. Weschler also appears to be a big fan of John Malone, and he has consistently invested in Liberty Media shares in the past and for Berkshire currently. As a side note, we believe that he is well capable of becoming the next “Buffet”, and certainly is qualified to takeover the investment duties at Berkshire as a successor.

Now back to DTV. The DTV story is interesting, as the company was originally part of Hugh’s Electronics Corporation, a subsidiary of General Motors. John Malone’s Liberty Media eventually acquired a controlling interest in DTV, after negotiating a swap for their 19% interest in News Corp. Shortly after, DTV was spun off in a Reverse Morris Trust transaction in 2009. Despite much of the recapitalization process being completed, we still believe DTV shares are attractive going forward. The business has demonstrated that it offers a superior video product to subscribers and the large share gains mostly taken from cable that it has achieved over the past decade support this case. Today, the company sits on a crossroads amidst industry shifts in how consumers are viewing their content, and management have elected to focus the company on its core video business, which is a stark contrast to Charlie Ergen’s DISH focus on entering the wireless industry.  Despite Malone’s public comments on the importance of broadband and high speed data for the future (which we agree with), we believe DTV will remain a significant player in the Pay-TV industry and will position itself has being broadband agnostic as the company has national scale with exclusive content and an ubiquitous presence.

Company Overview

DirecTV is one of the fastest growing Pay-TV operators in the world with a ~$32B market cap. DTV is comprised of two business segments: a mature, free cash flow generative U.S. business which is currently the second largest Pay-TV operator in the country with 20MM subscribers and a fast-growing Latin America business with ~13MM[1] subscribers. The Pay-TV industry in the US is largely mature (~87% penetration) and is most likely in a slow, secular decline. There are currently ~100MM Pay-TV subscribers in the US and ~50MM in Latin America.



1)      DTV’s U.S. business should remain sustainable for the long-term despite gross margin compression. The market currently under-appreciates the resilient cash flow generative capabilities of the highly recurring, (customer contracts are fixed 2-year terms with high renewal rates), stable US business segment. DTV benefits from a higher-end customer base vs. competitors (DTV’s entry-level subscription package is $61 vs. Dish’s $25), holds the premiere brand and leading technology offering (“TV everywhere” and advanced HD set-top boxes with time-shifting functions for eg.), and award-winning customer service (DTV has won more industry customer service awards than any other competitor). Despite the pay-TV industry slowly shedding net subscribers, DTV should be able to at least maintain their 20% market share largely from maintaining their respective share in new housing starts and benefitting from a rather sticky customer base. By my conservative estimates, the US business will only start slowly losing net subscribers after 2015-2016 and has demonstrated real pricing power by raising prices 3-4% annually and growing ARPU[2] steadily (nearly 5% CAGR over past 7 years). Moreover, DTV holds exclusive content (NFL Sunday Night ticket for eg.) which has been a large differentiator in terms of offering a premium video product and this should help reinforce the upward trajectory in ARPU growth within low-to-mid single-digits longer-term. Despite the fact that cable has long held the advantage of offering a competitive triple-play (video, voice, broadband) bundling package, DTV has still been able to steadily grow its market share by 200 bps from ~18% in 2008 to 20% today. I believe this can largely be attributed to cable focusing on cross-selling to its existing subscriber base, rather than stealing share from competitors, but it is also a testament to DTV’s superior video product and competitive positioning. I believe churn[3] will also remain stable given DTV’s top-tier customer service and higher customer loyalty resulting from increasing sales of advanced products such as HD DVRs, pay per view, and premium channel programming.

2)      Latin America remains largely under-appreciated by the market. The region has an extremely long runway for growth as Pay-TV penetration is still very low at ~34.1% region-wide and should reach closer to 60% by 2020 powered by a growing, middle-class. I believe Pay-TV service is one of the core, basic entertainment services that is purchased by consumers as they advance within the socio-economic ranks given its superior value proposition vs. other basic entertainment options. As the premier Pay-TV brand in Latin America, DTV has a superior competitive positioning all across Latin America including Brazil, Pan America, and Mexico with market shares ranging from 11-44% depending on the country. The business has sustainable competitive advantages due to regional scale (which provides the company with considerable bargaining power when it comes to securing the best content and hardware equipment on favourable terms), the premier brand, superior customer service, exclusive content and technology that have been easily leveraged through the successful practices developed in the US business. This is in contrast to many cable operators in the region that are limited in their operations at the country-level, thus limiting their scale. Several key factors also differentiate the L.A. competitive landscape from the US one which should benefit DTV in the long-run.

1) Direct-to-home satellite operators were early entrants in the region along with cable and telecoms, unlike being a late-comer in the US after cable enjoyed a multi-decade runway of growth establishing subscriber bases. I think this is rather significant as video is typically a sticker service relative to voice or broadband given the more differentiated nature of the product. Market share trends in L.A. have been extremely favourable as DTV and satellite in general continue to steadily take share from cable which mostly offer lower-quality, inferior analog video services. Moreover, there are no meaningful fiber optic overbuilds in the region, thus eliminating an additional competitive threat.

2) Programming fees are more controlled because of the lower-quality cable networks in the region. There is also the absence of broadcast retransmission fees and RSNs (regional sport networks) which have been a major source of programming cost inflation in the US.

3) Despite dominating the high-end, DTV provides services across the entire customer spectrum in L.A. and have implemented a successful segmentation strategy that has been yielding subscriber-level IRRs between 40-70% depending on the segment. Competition mainly focuses on the low-end but DTV has successfully responded with a competitive pre-paid package offering as evidenced in Mexico.

4) Broadband service is underpenetrated in Latin America and competition remains weak, providing DTV a market opportunity to establish a competitive broadband and video bundle longer-term. DTV has been opportunistically deploying fixed-broadband service based on LTE technology in selective underpenetrated areas in Brazil that should yield high returns on capital. All these factors mentioned have led to a higher-margin (30% EBITDA margins vs. 24% in the US) L.A. business that should be able to comfortably continue taking share in a rapidly growing market.

3)      Share buybacks are key. Since 2006, management have opportunistically employed a leveraged buyback strategy of repurchasing over ~$26B worth of stock and plan to buy back $3.5-4B a year going forward while maintaining a 2.5x gross leverage ratio[4]. In my model I conservatively forecast continued buybacks going forward at a 20% yoy share price appreciation assumption while maintaining the 2.5x gross leverage ratio. I believe the buybacks are currently the optimal capital allocation decision in light of other strategic options available and are tax-efficient compared to dividends. Put another way, DTV is currently borrowing at a rate of less than 3.0% (DTV recently issued $650MM  of 2.75% senior notes due in 2023 in May) to repurchase shares yielding ~9-10% on a 2013 P/E basis; the ongoing buybacks should be very accretive to earnings per share given that shares are trading below intrinsic value. Although interest rates may start moving up over the next several years, I have already assumed a long-term cost of debt of 5% in my model, which should be reasonable given the recurring nature of the business.

4)     Conservative accounting obscures the true free cash flow and value of the business.

–          DTVs’ 41.3% equity stake in Sky Mexico is not consolidated in the financial results. I estimate Sky Mexico should generate at least $535 of EBITDA in 2013.

–          Leased set-top deprecation assumptions are rather conservative (4 years for a High Definition set-top box and 3 years for a Standard Definition box). In comparison, Comcast assumes 6 years for their set-top box depreciable life assumption. In economic reality, churn in the US business has been averaging 1.55% monthly implying an average customer economic life of greater than 5 years.


Market Consensus/Bearish Views:

Bearish Argument 1) Programming costs are rising faster than Pay-TV companies’ ability to pass on these extra costs to consumers, thus squeezing their gross margins.

Mitigant: Although I agree that programming costs will continue to increase at high-single digits for the next several years (I conservatively estimate US gross margins will actually compress to 34% by 2018 vs. 46% today), the large source of programming cost increases over the past few years has primarily been sports-related content which has been increasing at 9-10% annually for DTV. ~33% of all programming costs are on account of sports with the ESPN channel accounting for 75% of that. Given that ESPN already receives $5.04/sub/month vs. $0.24 for the weighted average of all other channels combined, upside in the future may be more limited and commentary from Disney’s CEO has confirmed this view as bidding for sports rights become more competitive for ESPN in the future. Several Pay-TV operators have already begun to hedge their contest costs such as Comcast by purchasing RSNs for example. Moreover, the large programming cost increases over the past several years were implemented by cable networks that negotiated for higher affiliate fees to help offset the cyclical downturn in their advertising fees experienced in the 08’ recession. Thus, I believe part of the large increases in programming fees recently were a response by the cable networks to cyclical weakness in advertising revenues and future increases may become more limited in scope versus consensus expectations.

Bearish Argument 2) Web-based video such as Over-the-top[5] (OTT) will be a major disruptor to the traditional Pay-TV model[6] as consumers continue to “cord-cut”.

Mitigant: I believe this is by far the most overblown fear for several reasons:

1) DTV’s customer base is skewed towards an older, higher-income demographic that are less likely to “cord-cut” versus younger, lower-income subscribers that have been fueling OTT adoption.

2) The economics of online advertising are simply not as attractive; the online model has yet to prove that it can command the large advertising fees necessary to secure high-quality, premium content in order to attract large masses of subscribers. Live sports content continues to command premium advertising rates over television and is unlikely to move 100% online given the current economics. Moreover, given the large amount of online inventory, all forms of media have historically faced deflationary advertising pricing pressure as they’ve moved online and this is unlikely to change.

3) Cable channels with premium content are incentivized to not disrupt the traditional Pay-TV ecosystem given the large affiliate fees that they receive from Pay-TV operators; Pay-TV operators also have considerable bargaining leverage over cable networks in terms of competing against new entrants. For example, Pay-TV operators can demand similar rights to air content on mobile platforms such as tablets and smart phones if new entrants try to secure similar terms, thus preventing OTT entrants online exclusivity on certain mobile platforms. Moreover, the scale required to build a profitable OTT business is enormous, and even for Netflix which currently has the largest online subscriber base is trapped in a low-margin business as it continues to pay enormous costs to secure exclusive content while having limited pricing power.

4) As the insatiable demand for bandwidth continues broadband providers can eventually move to a usage-based pricing model which will limit the rate of OTT adoption.

5) The issue of channel bundling is a large one as consumers currently pay for hundreds of channels that they may not even view, but if consumers want to watch the best content online via an a-la-carte model as opposed to viewing it on a channel, they will most likely have to pay more for one-time deals for premium, high-quality content vs. paying a monthly TV subscription fee for viewing the same content; I see this as unattractive for the consumer. Moreover, Pay-TV operators are improving and enhancing their user-interface platforms as they are moving towards cloud-based platforms, improving the customer experience by capturing viewer habits and developing more sophisticated platforms in general that would be competitive vs. OTT platforms such as Netflix, Hulu, or YouTube. One last point is that even if the Pay-TV model eventually becomes extinct in the future, the rate of decline will most likely be slow.

Bearish Argument 3) The mature market in the US will get increasingly competitive as Cable continues to upgrade their systems from analog to digital to HD and Telcos continue to roll-out their fiber overbuilds. DTV also has no broadband exposure which leaves them at a serious competitive disadvantage as consumers continue to consume more data online.

Mitigant: I agree that a lack of exposure to growing broadband is a major disadvantage and have already assumed declining net subscribers in my DTV US estimates; however, DTV’s competitive advantage in video should remain given their exclusive content and leading customer service and scale. Also, partnering up with the Telcos remains a viable option for DTV customers that want a broadband service. A large % of the US customer base (~40%) are located in rural areas where there is less competition from fiber. Also, the Telcos have largely completed their fiber builds with the exception of AT&T U-Verse adding several million more homes over the next couple of years with the long-term goal of having 50MM US homes passed nearly completed. I believe that despite the enormous financial resources that the Telcos possess, a nationwide fiber build is unlikely given the lower returns offered in more rural areas which compound the issue of already questionable returns on current projects. Therefore, as long as DTV can successfully position itself to remain broadband agnostic, high-quality satellite TV should remain relevant in the long-term competitive landscape.

Bearish Argument 4) Adverse foreign exchange and churn pressures in Latin America will dampen the growth outlook in the region.

Mitigant: This has been a legitimate concern, especially since the company has over $400MM trapped in Venezuela which illustrates some of the political uncertainty in the region as well, but longer-term these shorter-term pressures should stabilize as the region (ex Venezuela) is growing healthily and has a bright outlook. I believe the Street has also overplayed the recent higher levels of churn in L.A. and especially in Brazil. In the short-run, higher levels of churn may persist given the recent expansion into the pre-paid market and a mix-shift towards lower-income, middle-market subscribers. However, over the longer-term, churn should stabilize as DTV implements their best practices in customer loyalty and retention and ARPU should trend higher as DTV up sells advanced services to its subscriber base like it has historically.




DTV is one of the fastest growing Pay-TV companies that should compound EPS by at least ~15% a year for the next several years powered by aggressive share buybacks and solid growth from Latin America which will help offset slowing growth and margin compression in the US. Most sell-side analysts value DTV on an EBITDA basis. I believe this is the wrong metric as shares should be valued on a FCF basis with maintenance CapEx as the true proxy for capital expenditures needed to maintain the business’ competitive advantage going forward. Currently, I estimate growth CapEx comprises ~50-60% of total CapEx for 2013 due to the large spending in subscriber acquisitions in Latin America (~44% of total CapEx). DTV’s CFO has stated in the latest investor day that ~80% of DTV L.A.’s CapEx is growth-related. However, I also acknowledge the fact that some CapEx related to subscriber acquisitions should be considered maintenance CapEx as there is regular churn in the subscriber base and DTV needs to constantly add gross subscribers simply to offset these losses. Since scale is an overwhelming competitive factor in the Pay-TV business, maintaining a strong, stable subscriber base is key to having a sustainable competitive advantage. For the sake of conservatism, I have assumed that 70% of total CapEx is maintenance CapEx for my FCF calculation despite the fact that current CapEx is elevated and disconnected set-top boxes and satellite dishes can be recovered.[7]

Merger with Dish?

Although a rather low probability, there is also available the free option of a merger with DISH which would be massively accretive to earnings due to the realizable synergies simply from cost savings. I have not incorporated the upside of this scenario in my valuation as I believe regulatory hurdles will remain substantial. However, longer-term if satellite and cable video quality converges along with a wider adoption of online video, the more likely it is that regulators would approve a merger between DISH and DTV. The main justification for a merger would be the emergence of an additional competitive wireless broadband offering which would leverage DISH’s terrestrial spectrum rights to compete against the incumbent cable and telecoms offerings. The increased scale would also help constrain programming price hikes that are currently being passed on to the consumer. 

Management Assessment:

Management appears to be quite shareholder friendly given their track record of repurchasing shares largely at accretive valuations. The CEO is honest in recognizing the current competitive pressures and external threats the industry is facing in the US. Despite a challenging environment, I believe the management team have done a terrific job operationally controlling costs and churn in a competitive US market by focusing their strategy on customer loyalty and retention while rapidly growing the Latin America business sustainably by executing on distribution and marketing. -Compensation: longer-term compensation is primarily based on achieving realistic yet challenging targets in net revenue, operating cash flow, and EPS growth

-Track Record: DTV generates high returns on capital and has averaged 20%+ ROIC over the past 2 years which has been among the highest in the industry

Why are shares Mispriced?

Partly because of the bear arguments outlined above, but I believe the company is trading on a depressed multiple because it has elected to buy back shares over paying a sustainable dividend which does not attract yield-oriented investors. DTV also doesn’t have a natural shareholder base that are either value or growth because of the two separately growing businesses – a mature, free cash flow generative US business and a fast-growing Latin America business. For catalyst-oriented investors, an initiation of a dividend or spin-off of the Latin America business can unlock substantial shareholder value. However, I see both options as unlikely for the time being given management’s clear preference for share buybacks and the expected loss of some synergies that the two operating segments currently share if a spin-off were to occur.

Another way to look at valuation is to look at a break-up value of the entire business. If you assign a ~12x EBITDA multiple to the Latin America business which I believe is reasonable given the DTV’s superior competitive position and long runway for growth as highlighted above, you’re only paying 4x EBITDA for the US business, which is quite attractive. I believe this valuation is unwarranted even under draconian scenarios, and the downside risk here is largely priced into the market.









FCF Yield




Additional Risks to Thesis:

-mostly comes from a higher rate environment as DTV has levered up its balance sheet to a 2.5x leverage ratio; however, virtually 100% of DTV’s debt is fixed and more than two-thirds of the company’s senior notes mature after 2018

-a more competitive environment in L.A.; Dish may look to enter into other lucrative LA markets such as Brazil with a low-priced entry level product

Disclosure: The author of this write-up owns shares in the company mentioned 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.





Consolidated Company DCF Valuation: Base Case scenario and 2018 as exit year

In my financial projections, I differ from the Street mainly in attributing a lower value to the US segment and a higher value on the LA segment. Key business drivers are ARPU, Churn, Net Subscriber Growth, and Programming Costs.valuation


Sum-of-Parts Valuation: (TEV estimates and multiples based on separate DCF analyses for DTV US and DTV Latin America Segments)


Management Track Record:

I believe operational track record is important in assessing management’s capabilities. Below is CEO Michael White’s track record during his tenure as President of Pepsi International:


U.S. Pay-TV Industry Data:

Top 10 Pay-TV Providers in the U.S.
YE2012 Subscribers (in thousands)






Time Warner Cable


Verizon FiOS


AT&T U-verse










DTV Latin America Market Data (excluding Mexico):

DTV Latin America Market Data YE2012  
Country Subscribers Market Share Country Pay-TV Penetration
























Puerto Rico








Total Subscribers




[1] Includes DTV’s share of Sky Mexico Subscribers

[2]ARPU: Monthly Average Revenue Per Unit

[3] Churn: Subscriber disconnections, usually measured on a monthly basis

[4] Gross Debt/EBITDA

[5] Over-the-top is defined as broadband delivery of video and audio without a multiple system operator being involved in the control or distribution of the content itself

[6] The traditional Pay TV model is based on content creators selling rights to cable networks who in turn aggregate the content into channels and then charge an affiliate fee per subscriber to a multichannel video programming distributor (MVPD) such as cable television systems, direct-broadcast satellite providers, and wireline video providers

[7] Set-Top boxes should also become less hardware intensive longer-term, thus helping reduce capital intensity

Automodular – A Liquidation Play

Ticker: AM.TO / Stock Price: $1.61 CAD / Market Capitalization: $32.4MM / TEV: $4.71MM  / Idea Style: Special Situation / Liquidation

Note: This is a simple idea that can be easily valued on a piece of napkin. Since the business is being wound down I’m not going to post complex spreadsheets of operating performance.


Automodular (TSE: AM) is an auto sub-assembly contractor in Ontario, Canada. On May 14th, Ford, the company’s only customer, informed AM that it intends to insource the sub-assembly service and not renew the contract, which is scheduled to expire in the second half of 2014. The stock fell over 50% on the news, creating an opportunity to invest at a price substantially less than liquidation value.

For $1.50, you are getting $1.38 in cash ($1.02 cash net of all liabilities), $0.62 in accounts receivables from Ford, at least $0.90 in free cash flow generation in the next six quarters, tons of NOLs and capital loss carry-forwards (which by the way can still be monetized in Canada), no debt, a shareholder friendly management and two free options that have the potential to re-rate the stock to upwards of $3.00 a share.


Business Model

AM’s business model is built upon its ability to leverage lower labor costs than original OEMs. AM’s labor cost is about $19 – $21/hour; add $7 – $8 for transportation and AM’s gross margin, the effective cost is a few dollars lower than OEMs would otherwise incur had the sub-assembly been in-sourced. The spread in labor costs has fallen substantially in recent years, due to a combination of OEM restructuring and changes in state labor laws (right-to-work legislation in Michigan, etc), so it would not have come as a surprise that the company would lose its business to in-sourcing.

The contract gave AM very advantageous terms on the Capex side, with the majority of Capex spending subsidized by Ford. Earnings and free cash flow generation has been surprisingly strong in the last three years and return on invested capital reached as much as 45% so it’s not hard to see why in-sourcing this business at a slightly higher labor cost could be highly accretive to Ford.

Exit Scenarios

I think there are basically three exit strategies now that the company’s only business is scheduled to wind down in 2014.

1) Liquidation of the company’s assets to shareholders.

2) New business contract: AM performed a ten-month sub-assembly contract for a wind turbine project for Vestas, who was apparently quite pleased with the service. The contract ended in Q4 2012 and resulted in a double digit IRR for AM. In a May 14th press release, management indicated that “the company is starting to see some additional traction in its business development efforts in the wind energy space”. Management has also hired an external consultant at Deloitte to look for new business opportunities, potentially outside the component sub-assembly space. The main skill-set of the management is in contract management so their options are not entirely limited to the sub-assembly space; in an investor presentation we received last year, management highlighted over 15 potential areas for new opportunities, including warehousing, vehicle inspection & repairs, security services, facility maintenance.

I think this is currently the most likely scenario.

3) M&A: the company currently has more than $27 million in cash and I estimate that it will generate another $18 million before the Ford contract expires. The CEO told me that the board will consider making an acquisition to leverage their skillset in the event that no organic growth opportunities can be found.

Management has made it clear that diversification is currently the top priority of the board, and that they prefer new business (2) to an acquisition (3). Liquidation (1) is also an option should AM be unsuccessful with the diversification effort but is not the management’s focus.

Management has had a decent value creation track record, particularly with the two most recent contracts (Ford, expected to expire in Q4 2014 and Vestas, expired in Q4 2012), both generating a double digit IRR throughout their respective contract periods. Note that outsourcing contracts that AM engages in are normally non-capital intensive in nature (OEMs tend to subsidize a substantial portion of the Capex spending) and high return on capital. New contracts typically consume some cash in the form of initial investments but as long as projected IRR is higher than the cost of capital, a dollar of investment can create more than a dollar in value. The thesis here is that if management is able to secure a similar contract, it is reasonable to conclude that the stock is worth more than its liquidation value. A potential new business is best viewed as a free option on top of the asset (liquidation value) backing.

I view the acquisition scenario as the only real risk to this idea. Management is reasonably well compensated for a company of this size (CEO got paid 400k – 600k a year for the last two years). Even though they own some shares (~5% market cap), they are still quite incentivized to keep the business running. Many dying businesses make dilutive acquisitions to keep managements employed and I certainly can see that as a possible outcome, but I find it quite unlikely considering the impressive capital allocation track record of the management. Coincidentally the CEO had M&A experience while working as an accounting partner before he joined AM so he probably has a decent idea what to look for in case they can’t find a new business contract.



Chris Nutt became the CEO of the company in early 2012. He was previously the CFO from 2003 to 2011. I had a meeting with him last year and found him to be quite candid about the challenges the company was facing. Nutt is an accountant and has a strong financial background, which gives us some comfort with regard to new project acquisitions.

Management has demonstrated itself to be very shareholder friendly in the last few years, having paid out $0.96 a share in regular and special dividends since 2010 (compares with today’s stock price of $1.50) and has been consistently buying back shares. The current repurchase program amounts to 6.5% of shares outstanding. I did not model this into our valuation but given that the stock trades severely below liquidation value the buyback will likely be very accretive.

Management/board owns a little less than 5% of the company and there has been some heavy insider buying of the stock since the Ford contract announcement.



My analysis suggests roughly $2.64 a share in liquidation value, using fairly conservative assumptions. This does not include the potential value of the two free options I outlined earlier.

Critical assumptions:

1) The Ford contract is extended until Q4 2014, at which point the operation will be liquidated

2) Accounts receivable: since Ford is the only customer, A/R is essentially equivalent to a short-term Ford senior note. Unless you think Ford will default on its senior obligations in the next year and half, the A/R is worth 100 cents on the dollar.

3) PP&E: the net carrying value of the equipment is $8.8 million, which is only a fraction of the gross carrying value of $37.7 million. This is due to very aggressive depreciation using the diminishing balance method so the real disposal value is likely materially higher than the net carrying value. Ford will most likely buy back the equipment in its in-sourcing process so it’s not crazy to assume that at least 20% of the net carrying value can be realized under a liquidation scenario. Realistically I would not be surprised if AM got more than $8.8 million for the equipment but here we will just be ultra-conservative.

4) I estimate that the company can generate $3 million per quarter in free cash in the next six quarters, net of changes in working capital. FCF generation has been very steady in the last three years at roughly $15 – $22 million a year so I’m basically projecting that the company will earn less in the next six quarters than the average of last three years. Also note that AM did not disclose when it will close down the plant in Q4 2014, so it is possible that the company will perform the contract for more than six quarters. It is likely that AM will generate more cash than my projections given the recovery in U.S. auto sales and the relative strength of the Ford brand. This estimate is net of changes in working capital as I listed the working capital assets as separate items being converted into cash.

5) The company mentioned in its May 14 contract update that the total charge related to the closure of the Oakville plant will amount to $6 million. Roughly $600k of this is already sitting on the balance sheet as an exit provision. The company will have $4.4 million of operating lease outstanding by Q4 2014 and most likely has a cheap exit option with the landlord. The rest of the exit costs will probably consist of employee severance and facility clean-up costs.

6) AM is currently suing GM for $25 million for early termination of a contract in 2010. AM worked on a GM sub-assembly contract for a number of years as its main business, producing overhead panels for three vehicles. GM cancelled the contract and awarded it to a competitor for AM’s claimed lack of price competitiveness (CEO told us that the competitor, who undercut AM on pricing, could not lower costs enough to make a profit so the deal ended up costing GM just as much as AM would otherwise).

As a result, AM incurred roughly $8 million in closure costs and tens of millions in lost profits. I’m treating this as a free option and did not model out the expected value, though I expect that AM will at least get something given that they do have a fairly credible case. A $10 million settlement, for example, will be worth $0.50 on a per share basis.

7) AM has $8.2 million in NOL assets that it carries till late 2020s. Note that AM is a Canadian company and NOLs can still be used in change-of-control situations in Canada (I believe this is no longer the case in the U.S.). Some of this will be used in the next six quarters so it is appropriate to take a large discount on the NOL value.

8) AM also has $17.2 mil in capital losses that can be used to offset future capital gains.

AM valuation

Note that even if not a penny of FCF is generated in the next six months, you are still getting $1.75 a share in just asset value so the downside here is very limited. If AM gets a decent settlement from the GM litigation or finds a new business, I can easily see the stock at $3.


1) Announcement of a new business contract

2) Announcement of a special dividend

3) Favorable GM litigation result; should be concluded this year

4) Ford buying back AM equipment and hiring employees from the Oakville plant (will decrease exit costs for AM and enhance liquidation value)


The author of this write-up owns shares in the company mentioned (TSE: AM) 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.