What’s the True TAM of Search?

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

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


Part 1 – The TAM of Search Engines


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

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

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

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

And we are just getting started.

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

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

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

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

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

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

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

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

—- to be continued…


Liberty Interactive – Tracking Share Discount

In light of the stock price appreciation over the past few years, the original thesis hasn’t really changed. Maffei has said that despite the higher QVC trading multiples, leveraged share repurchases will continue. Now with the e-commerce businesses shifted to the Ventures Group, the QVC Group has become “much cleaner” to analyze. I believe the fact that this is still a relatively obscure tracking stock with hidden equity investments and irrelevant consolidated GAAP reported financials is the main reason behind the mis-pricing. Very few tracking shares exist in the market today, and due to the inherent complexity in managing additional business groups with their own stock currencies, many corporate management teams simply shy away from them. In fact there have only been a few opportunistic capital allocators that have really used them in the past including Dr. Malone and Charlie Ergen.

The main asset remains QVC. This was a business that was run by media mogul Barry Diller for a while, was owned in a joint-venture between the Robert’s and Malone’s Liberty Media until Malone acquired Comcast’s ~57% stake at quite a high transaction multiple. Like virtually almost all of Dr. Malone’s related companies, QVC is extremely well-managed. I also believe that if cord-cutting were to accelerate, the effect on QVC would be minimal. Unlike the cable networks’ lucrative affiliate and advertising fees that are at risk from unbundling and over-the-top, home shopping networks like QVC have a different model; they pay carriage fees (which I will go over in further detail below) to the Pay-TV operators that are net of gross sales. So even if their customers slowly transition to consuming their content online either through an existing bundle with “TV-Everywhere”, a skinny bundle or maybe even perhaps directly from QVC’s website, their revenue model will not be at risk. Essentially their model resembles more of a retailer than of a cable network, except they generate superior free cash flow compared to brick & motors. Finally, they have an attractive core customer base that are middle-aged women from wealthier households that are less likely to “cut the cord”.

QVC earned ~$960 million in levered free cash flow in 2014. They’ve been hit over the past few years by the weakness in the Yen from their Japanese business. I think this year they will earn ~$1,000 million in fcf, and afterwards this will grow at 5% per annum over the next 3 years, driven by 2%-2.5% top-line growth and a bit of operating and financial leverage. The business doesn’t have much operating leverage since most of the cost structure is captured in COGS, but the business is very predictable, has a favourable customer base with near 90% repeat purchases and operates in a virtual duopoly with HSN in the home shopping network category. I basically view this business as a steady long-term GDP+ grower.

On the capital allocation front, Maffei has said that he’s going to continue to shrink the equity. Backing out the other pieces of the QVC Group tracker, QVC’s implied fcf multiple is currently slightly less than 14x. Assuming the share price continues to appreciate, they should be able to buy back ~17% of the float over the next few years at a 2.5x leverage ratio. So their levered fcf per share growth should be a little over 10% per year over the next few years. On 2017 numbers QVC should be earning around $2.80 fcf per share. I would value QVC at 16x-18x this number or a 5.5%-6.25% yield; so the QVC piece alone is worth $45-$50 per share by 2017. For such a high-quality business with predictable growth across the entire cycle and really high returns on tangible capital, I think these multiples are justified. For reference, they’ve recently issued a 10-year note at slightly less than 4.5%. I think QVC’s equity will very likely grow at a faster rate than 4.5% over the next 7-10 years. Also, I think QVC is a better business than some of these comparable large-cap consumer staple stocks that trade at less than 5% earnings yields but generate a lower return on capital with similar or lower growth prospects. So I think a 16x-18x multiple is very reasonable for this business.

For HSN, it’s also a decent business and I think it’s slightly undervalued given their under-levered capital structure. It currently trades at roughly 9x this year’s EBITDA, and they have almost no net debt. Management recently distributed a $200 million special dividend and I think they should be on the cusp of a material capital return plan in the near future. On the more aggressive side, if they leverage up closer to QVC’s leverage ratio of 2.5x, they can easily return nearly $1B of cash to equity holders. If they choose to reduce the float, they can buy back up to nearly 30% of all shares outstanding at today’s market value. For our purposes I’ll conservatively value HSN at current market values, so at their 38% stake it’s roughly worth $3.50 in per share value.

I assume that the value of the Group’s Chinese JV will offset the minority interest from their 60% stake in QVC Japan. There are currently more than a dozen competitors in the China, and the Chinese JV hasn’t reached minimum efficient scale yet. These 2 pieces really don’t move the needle on valuation, and if the Chinese JV really takes off, that’s just additional free upside.

In terms of eventually combining HSN and QVC, Maffei has said that there won’t be much cost synergies from leveraging the combined production studios. The only large cost synergies that I can think of is increased scale from combining their distribution networks and bargaining power with logistics firms, and potentially reducing the carriage fees they pay to the multi-channel video programming distributors (MVPDs); basically guys like Comcast and DirecTV. Currently QVC pays 5% of their gross retail sales as a carriage fee to the local MVPDs that distribute their channels to their subscribers, and (I think) HSN pays this rate as well. If by combining the companies they can potentially negotiate a lower carriage, and take back some of that gross margin. Just this cost synergy alone can create quite a bit of value without any execution risk. The combined companies’ US businesses generated ~$9.6B in total revenues for 2014, so even a 100 bps of gross margin savings would equate to $96 million which will flow straight to pre-tax income and be ~10% accretive to fcf per share. But I think for now Maffei will be content if HSN continues to return excess capital to shareholders with share buybacks and dividends. Whatever they decide to do with their HSN stake, you can be rest assured that it will be done extremely tax-efficiently. Knowing Dr. Malone’s deep hatred for paying taxes, this is a given.

If we add up all the prices – HSN’s equity value based on today’s market price, and QVC’s value – Liberty Interactive is worth $48-$54 by 2017. At the mid-point of this valuation range, the stock should generate a 2-year IRR of 35% if you can buy the shares around $28. I’ve noticed that sometimes that the more illiquid B shares trade at a discount to the A shares, which they shouldn’t as these are the super-voting shares. So much for efficient markets.

The Americans are Coming

CSU’s shareholder base

Latest Holders
Holder Common Stock Equivalent Held % Of CSO Market Value (CAD in mm) Change in Shares
Fidelity Investments                                                 2,734,037                                               12.902                                              1,151.0
OCP CSI Investment Holdings Inc.                                                 2,069,623                                                 9.766                                                 871.3
Mawer Investment Management Limited                                                 1,982,531                                                 9.355                                                 834.6
Leonard, Mark (Founder, Chairman and President)                                                 1,433,482                                                 6.764                                                 603.5                                             431,259
Pyramis Global Advisors, LLC                                                    811,300                                                 3.828                                                 341.6                                              (1,900)
Neuberger Berman LLC                                                    663,242                                                   3.13                                                 279.2                                            (33,500)
Ruane, Cunniff & Goldfarb Inc.                                                    257,168                                                 1.214                                                 108.3                                                    368
Salna, Dexter (President of Constellation Homebuilders Operating Group)                                                    236,097                                                 1.114                                                   99.4                                                    155
Aune, Jon Brian (Former Director and Member of Audit Committee)                                                    208,328                                                 0.983                                                   87.7
Leith Wheeler Investment Counsel Ltd.                                                    207,150                                                 0.978                                                   87.2
Akre Capital Management, LLC                                                    166,518                                                 0.786                                                   70.1                                               29,518
Canada Pension Plan Investment Board                                                    161,000                                                   0.76                                                   67.8
Symons, Barry (Chief Executive Officer of Jonas Operating Group)                                                    160,098                                                 0.755                                                   67.4                                                      13
Canadian Imperial Bank of Commerce, Private and Investment Banking Arm                                                    150,646                                                 0.711                                                   63.4
BlackRock, Inc. (NYSE:BLK)                                                    148,134                                                 0.699                                                   62.4                                              (1,213)
Anzarouth, Bernard (Vice President of Mergers & Acquisitions)                                                    146,234                                                   0.69                                                   61.6                                                      28
The Vanguard Group, Inc.                                                    124,005                                                 0.585                                                   52.2                                                 2,148
BMO Investments Inc.                                                    120,650                                                 0.569                                                   50.8                                               32,877
Norges Bank Investment Management                                                    114,890                                                 0.542                                                   48.4
IG Investment Management, Ltd.                                                    104,931                                                 0.495                                                   44.2
Bender CA, Jeff (Director and Chief Executive Officer of Harris Operating Group)                                                    103,883                                                   0.49                                                   43.7
Industrial Alliance Investment Management Inc.                                                    102,275                                                 0.483                                                   43.1
TD Asset Management, Inc.                                                      97,004                                                 0.458                                                   40.8
William Blair Investment Management                                                      94,219                                                 0.445                                                   39.7                                               94,219
Miller, Mark Robert (Chief Operating Officer, Director and Chief Executive Officer of Volaris Operating Group)                                                      85,755                                                 0.405                                                   36.1
Metlife Advisers, LLC                                                      83,220                                                 0.393                                                   35.0
Calamos Asset Management Inc. (NasdaqGS:CLMS)                                                      83,200                                                 0.393                                                   35.0                                            (30,500)
Manulife Asset Management Limited                                                      81,923                                                 0.387                                                   34.5                                                    728
Montrusco Bolton Investments Inc.                                                      80,330                                                 0.379                                                   33.8
EdgePoint Investment Group Inc.                                                      79,883                                                 0.377                                                   33.6

Constellation Software – Reverse Engineering a Past Thesis

One of my core beliefs in becoming a better investor is a willingness to learn from past mistakes, whether they are from someone else’s or my own.

Roughly 2 years ago when I was still in school, I wrote-up Constellation Software, which I believe to be one of the best managed businesses in Canada and on the planet (sorry Valeant fan boys). The track record certainly speaks for itself. (Please see the appendix at the end of this write-up.) I recently noticed that the company had a rights offering and were raising capital with debentures. According to my Capital IQ, Mark Leonard recently purchased ~430,000 shares last month, raising his total stake in the company to nearly 7% which is valued at almost $600MM. If my CapIQ is right, he is currently the third largest shareholder. I can’t confirm the purchase 100% as I can’t find the associated public filing. But that’s still a lot of stock and an extremely bullish signal from an extremely astute capital allocator that models his company under the Berkshire model.

Below is my write-up and a blast from the past.

Exchange: TSX   |   Ticker: CSU.TO   |   Stock Price: $123.40   |    Market Cap: $2,615MM   |   EV: $2,618MM

Introducing Constellation Software – Canada’s Outsider 

Company Overview

Constellation Software Inc. is a global provider of mission critical enterprise software solutions serving a broad range of distinct vertical markets. The company’s strategy is to acquire and manage vertical market software businesses that serve clients in over 40 different verticals ranging from public transit in the public sector to golf clubs in the private sector.

Constellation is simply an exceptional business that is trading at a reasonable price. Not only does the business possess excellent economics, it is headed by one of the best corporate management teams in the country in terms of allocating capital. A suburb track record of intelligent capital allocation decisions and a history of strengthening acquired businesses organically have yielded average returns on invested capital of 20% for the past decade and strong maintenance revenue growth in excess of 20% for the past several years[1]. Given the large market opportunity, the high predictability of future earnings and management’s proven track record of executing value accretive acquisitions, Constellation is well positioned to compound its intrinsic value at an above average rate of return for many years to come.

Industry Analysis/Competitive Analysis

Constellation’s clients are small to medium-sized enterprises that generally have less than 1000 employees. These vertical software markets are highly fragmented with many small competitors that lack the capital resources and long-term orientation necessary to provide their customers with an adequate suite of software solutions tailored to meet their specific needs; product development lead times in the VMS (vertical market software) space can last up to 7 years, creating a barrier to entry for potential new entrants.  Relative to the rest of the software industry, these are niche markets and almost every vertical market imaginable requires mission critical software in order to run their daily business operations.

Constellation’s strategy is to acquire the number 1 or 2 market leader in selected vertical markets for attractive prices and then to grow these acquired companies through organic initiatives and/or “tuck-in” acquisitions – whichever strategy yields a higher return on invested capital. These acquisitions usually come with management teams in place that are extremely knowledgeable about their specific vertical niche, and understand the specific needs of their clients well. With support from senior management in the form of capital and other resources, the ultimate goal is to strengthen these vertical businesses through scale and expansion into adjacent markets. Tuck-in acquisitions make a lot of sense in a very fragmented industry and the decentralized management structure of Constellation allows the VMS management teams with deep industry expertise to successfully pursue tuck-in acquisitions to grow their operating businesses at an accelerated pace with scale.

This industry structure is very favourable for Constellation’s strategy. Larger software vendors have a limited presence in vertical markets given the small size of these markets and the mismatch between their relatively expensive enterprise resource planning solutions versus the specific needs of customers in small vertical markets. And as mentioned above, smaller competitors are usually in a weak market position given the large initial investment outlays required for successful long-term penetration. Although Constellation possesses almost every quality imaginable that makes it a fantastic business, it can be summed up by three main points below.

  • High Switching Costs for Customer

One of the keys to Constellation Software’s competitive advantage is its focus on providing proprietary software solutions that are mission critical to its customers. Because of the nature of these products, customers have high switching costs yielding attractive economics to the vendor and result in a very stick relationship with the customer; the time, training and financial resources required to be spent on IT staff and departments in order to have them switch over to another software provider is considerable. Moreover, the mission critical nature of these software solutions exacerbates this opportunity cost since the specific software is needed for the smooth functioning of daily business operations and without this type of software in place, these businesses would simply not be able to conduct normal operations. New software packages introduced by competitors would likely not be cost effective for customers, unless they provided a substantial boost to the productivity or efficiency to the business that would offset the high opportunity cost by a large margin.  And given Constellation’s product policy of providing clients with free software upgrades for life and a strong commitment towards post-installation maintenance services, this is unlikely to happen. Arguably, public organizations are even less likely to consider competitor software replacements, given that they do not have to compete in the marketplace and thus are more lenient towards the higher overall costs of sticking with their current provider vs. possible costs savings from switching to another vendor; approximately 74% of Constellation’s 2011 EBITDA was from the public sector. Finally, the company also dominates the competition by being the market leader or #2 player in each vertical market, thus providing them with scale advantages for R&D and a broader product suite over smaller competitors. These factors make it extremely difficult for competitors to steal market share away from Constellation.

  • High predictability of future revenue streams

As mentioned, Constellation’s client base consists of thousands of small to mid-sized businesses, providing the company with a diversified stream of revenues through the large number of customers in more than 40 different markets; this also means that the bargaining power of customers is very low. Historically, customer retention has been extremely high with customer attrition rates of ~4% which is much better than the average software company and implies that the average customer stays with Constellation for 25 years. Ultimately, customers pick Constellation as their software vendor given the company’s deep understanding of their specific needs and a confidence in Constellation having the financial resources to strongly commit to support and maintenance services through offering a “software for life” policy; this is essentially a commitment in providing free software upgrades. As a result, maintenance contracts are typically renewed on an annual basis by customers, which provide Constellation with a high quality, recurring revenue stream. These maintenance and professional fees are a majority of Constellation’s revenue streams (~80%), and are very high-margin and stable in nature. Historically these revenue streams have also been a very stable proportion of Constellation’s revenues, and should remain that way in the future given the large demand for these services.

  • Untapped Pricing Power

Constellation has a very long runway for growth given the large market opportunity in many vertical markets that are currently underpenetrated by the company. In the North America alone there are over 500 viable “tuck-in” acquisition candidates in different verticals for the company to consider in order accelerate market share growth; there is also a similar opportunity in the rest of the world. Moreover, there is a large opportunity available to expand into new vertical markets where large platform acquisitions are possible.

Strong pricing power is possible based upon the points made above about the company having a very captive customer base and the high barriers to entry that exists for new entrants. In addition, Constellation’s software solutions are also a very small part of customers’ overall costs (~1% of customers’ revenues). Over the long-term, the company’s pricing power should remain intact given the necessity for their products and services, the weak bargaining power of customers and the low cost of these services relative to the customer’s overall cost structure.

Management Assessment

Constellation’s success has largely been derived from exceptional capital allocation decisions made by the senior management team; they have had a suburb record of growing the company by strategically consolidating niche vertical markets at a high rate of return. As mentioned, the company has many operating subsidiaries in different verticals, and operating managers in these subsidiaries recommend acquisitions or reinvestment opportunities to the senior management based upon a return on investment threshold. Within this capital allocation framework, capital is either returned to the main corporate holding company if there is a lack of attractive investment opportunities or is allocated to operating subsidiaries with attractive opportunities; this rigid framework ensures that capital is always allocated to the highest return on investment opportunities.[2]

Another aspect of Constellation’s success is its decentralized management structure which creates an optimal incentive system for managers in VMS operating subsidiaries to focus on value creation. A decentralized management structure allows the operating managers to focus on what they do best, and not have their performance constrained by overreaching bureaucracy. Many of these operating managers decide to retain their position heading their respective operating subsidiaries after being acquired by Constellation, thus preserving the deep industry knowledge and customer relationships critical to the success of the overall company.

In terms of compensation policy, the majority of performance-based bonuses are linked to ROIC and net revenue growth, and at the operating level, is based entirely on that operating subsidiary’s performance; this is a fair compensation scheme that does not reward or punish an operating manger’s performance based on the performance of another subsidiary. The management team is very disciplined in setting a minimum after-tax IRR as a hurdle rate for all new projects and major platform acquisitions to ensure that there are adequate returns on capital deployed. Management at all levels of the organization are compensated based on two main criteria: profitability and growth. Also there is a strict requirement to invest 75% of an officer’s after-tax incentive bonus into shares of the company which are held for a lock-up period for several years. In addition, a hurdle rate of 5% is used for a minimum rate of return or no performance bonus is paid out, which is usually absent in other corporate compensation schemes. Overall, employees and management are compensated to think like “owner-operators” and the executive management team and board of directors collectively own 42% of fully diluted shares outstanding as of the latest proxy, which is considerable and helps align their interests with shareholders.

The President Mark Lenard was a venture capitalist for 11 years giving him a solid background in capital allocation and experience in the operating side as well; this is rare to have in a President as many corporate executives lack the capital allocation skills in order to maximize shareholder value. Although there is little information available regarding his past track record as a venture capitalist, as illustrated below in the APPENDIX, he headed Constellation as the company continues to grow at an impressive rate with high returns on invested capital. He also writes candidly to shareholders about the economic realities of the business in his letters and does not promote the business aggressively to potential shareholders.
 * Note from the Present: In fact when I first emailed Mark asking for a meeting and my interest in investing in the company he told me that the current margin of safety in the shares wasn’t large enough * – Now how many CEO’s running public companies even know the 3 most important words in investing and speak this candidly to potentially interested investors????  Mark Leonard is one of the most impressive CEOs that I have gotten to know. Unfortunately Mark is a phenomenal value investor and I placed nearly 100% of my trust and analysis on his advice to not invest at the time. Perhaps he was like me and being overly conservative on the intrinsic value of the business, but he certainly knows more about the business than I do, so of course I listened to him. *

The company recently put itself up for strategic review in March 2011 and in light of the situation, management looked after minority shareholder’s interests. At the time, shares were trading for less than$70 and several minority shareholders voiced out their concerns about selling the company at an undervalued price level. It is interesting to note that the PE firms Birch Hill Equity Partners and OMERS Private Equity in aggregate controlled half of the board seats at that time, with similar ownership in the company’s stock. The likely reason for the strategic review came from pressure from the PE firms looking for a liquidity exit for their massive stake. Management could have easily succumbed to the pressure of the larger PE stakeholders and sell the company at a clear discount to intrinsic value, but decided not to, demonstrating an interest in looking out for minority shareholders.


Given the high growth rate of the business, the key question becomes, is it sustainable for the next 5-10 years? I believe it is given management’s successful track record, the long-term stable cash flows of the business and the large market opportunity that remains ahead; albeit it will be at a slightly slower pace given the increased difficulties of sustaining the high growth rate as the company size increases. EBITDA margins should also be increasing based on scale and further synergies from acquisitions, although at a slower pace than before.

In addition, the business should be able to grow through the business cycle as 1) takeover targets are likely to sell at more attractive valuations during recessionary environments[3], and 2) VMS businesses and public organizations are not significantly impacted by lower business spending given the mission critical nature of the service and the stability of maintenance revenues.  Looking back to the period of the last great recession of 2008/2009, the business comfortably grew revenues and EBITDA at greater than 30% levels due to the large amount of growth attributed to acquisitions that helped offset the slight slowdown in private sector organic net revenue growth.

On an owner’s earnings multiple, Constellation currently trades at ~18x my estimate for 2013 owner earnings and ~11x my estimate for 2013 EBITDA which unfortunately doesn’t provide a large enough margin of safety at the current price level. I have a 1-year target intrinsic value range of $132.56-$150.69 based on a blended multiple valuation of 13x 2013 EBITDA and 20x 2013 Owner Earnings. I have also run a conservative DCF that results in an implied valuation of 13.33x 2013 EBITDA and 22x 2013 Owner’s Earnings. My estimate for 2013 EBITDA margins is 22.2%.

The company deserves to trade at a premium multiple to the broader market

Firstly, adjusting for amortization expenses make sense given the high likelihood that the economic value of the intangible assets of the business have actually been growing instead of declining over time; these intangible assets came purely from acquisitions made by the company. Since the company has been able to grow their maintenance revenues organically, even during the great recession, the value of these intangibles have likely increased rather than decreased. Economic goodwill should also be increasing over time as accounting goodwill is not representative of the economic realities of the business.

Secondly, the company’s true earnings power has also not been realized yet. Near term earnings and EBITDA margins are likely below normalized levels given the amount of time it takes for synergies to have a sizable effect on business performance. For example, margins are likely to improve from the PTS acquisition done in 2009; right now, PTS is at a 19% EBITDA margin; Company-wide EBITDA margins have been expanding over the past several years from 14.2% in 2005 to nearly 22% as of 2011.

Thirdly, the company can grow its revenues organically with little to no incremental capital and with extremely high returns on net unlevered tangible assets deployed. VMS businesses such as Constellation tend to operate with negative working capital as a result of the collection of maintenance payments and other revenues in advance of the performance of these services.

Lastly, I believe my valuation is slightly conservative despite using premium multiples. I’ve assigned a normalized tax rate of 35% despite the fact that around 20% of the business is outside North America and subject to lower tax rates; also there should be continued tax deductions from goodwill created by future acquisitions. I have also used positive working capital assumptions for the business to maintain itself into the future, taking into account a trend towards higher hardware based sales.

In summary, I recommend purchasing shares near $100[4]. At that price you can obtain an extremely high IRR business at 65 cents on the dollar with intrinsic value growing comfortably between 12-15% longer-term. You would also be buying into a company with great economics, probably one of the best capital allocation teams in the country, ample growth opportunities well into the future, and at a nice discount to intrinsic value which is growing at double digits year after year. Under these circumstances, it is very difficult to envision a scenario that would lead to a permanent impairment of capital.

Why is the business undervalued?

-Complex structure such as a colgomorate with many small VMS businesses operating in 40 different verticals

-Still relatively underfollowed by large institutional investors and long-term potential overlooked by sell-side

-Long term growth potential still underappreciated by the market

-little float in shares traded


-Higher buyout valuations are necessary for larger platform acquisitions due to a more limited set of decent larger companies and more competition from PE and other firms; however, many VMS markets are still highly fragmented and there is still much more room for growth before considering larger buyout candidates; average consideration for a tuck-in acquisition is around a few million dollars at the moment

-As the company continues its high growth the corporate structure will grow increasingly complex for senior management to deal with as they have to keep track of the performance and investment opportunities for the many operating subsidiaries and also have to keep an eye out for potential platform acquisitions; Although they have been able to successfully execute this “many verticals” strategy from one vertical market to now over 40


csu record

[1] maintenance revenue growth is a reliable proxy for the growth of the company’s intrinsic value given that Constellation can grow its business with little to no incremental capital

[2] An example is that they acquired Public Transit Solutions (PTS) from Continental AG in 2009 for a mere $3MM in cash; Since the acquisition, PTS has contributed $33MM in operating cash flow.

[3] Although this was not exactly the case during the recent great recession, as many VMS businesses were quite resilient

[4] Implies valuation multiples of 8.88x 2013 EBITDA and 14.6x 2013 Owner Earnings


Obviously you can tell from my valuation work that I didn’t invest in the company at the time. WHAT A HUGE MISTAKE! 

Hindsight is always 20/20, and I always view investing through the lens of a “probabilistic world”, but I’m pretty certain looking back now that my valuation was overly conservative. If we do the math the 2-year IRR of this investment would have been ~87%. Even if we assume constellation is 50% overvalued today (highly unlikely and laughable), this was a terrible mistake of omission. In fact it might even be a great buy today.

The Lesson: simply be willing to pay up for exceptional businesses run by exceptional management – the Outsiders 

I think what happened here is that I underestimated the upside because I wasn’t willing to put that “premium” on the stock for an exceptional CEO and an exceptional business. The trick here is that, there simply aren’t that many “Outsider” CEOs in the first place, so when I did my typical analysis of this company, I did a bad job of assessing the long runway of this business and the future cash flows. This was probably a lapse in my judgement since I take the view that the vast majority of good to great businesses are typically richly priced and trade close to full value (a cheery consensus with not a lot of uncertainty), and I lumped Constellation into this “category”. As a value investor I try to not be overly optimistic in projecting business performance, as I believe it’s in human nature to be optimistic with projections. In short, I didn’t think hard enough about the margin of safety and realistic upside scenarios for this particular case. This is why valuation is much more of an art than science as there are always many moving parts to consider and not just simply slapping a multiple on a business without much thought. In fact the most important piece of valuing a company is understanding the nature of the business, not adjusting figures in the 20th tab in an excel model. There may be only a handful of these types of publicly-traded companies operating in the world today, so if you’re confident that an extremely high-quality business is going to compound intrinsic value at 35%+ for many years to come, don’t just slap on a 20x multiple like I did. I think 30x+ made much more sense. With this type of business run by a great capital allocator, I should have been much more confident about predicting the future cash flows of the business. Let’s just say the “tail risk” for the bull case was much more fat than anticipated. Enterprise software is also an extremely scalable business model. Constellation is a compounding machine, and I don’t think these past 2 years have changed this fact. Another thing, although probably a bit more minor, was taking into account the incremental value from recent acquisitions. Constellation is an extremely acquisitive company that closes small deals every few weeks (reminds me of Malone rolling up rural cable systems during the TCI days) so the GAAP reported numbers are always messy. But if you believe the management team are extremely savvy and disciplined in capital allocation (it’s all about the target return on capital), then you can be confident that these acquisitions will be extremely accretive. I certainly would rather own this business over Valeant, but that’s just me and my circle of competence.

Buffett has always said that his biggest mistakes were errors of omission rather than commission. I think this is a great example of myself making that mistake.

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.

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Thoughts about Risk and Portfolio Management

I once watched a video of a very old speech Buffett gave to MBA students. In it he talked about the failure of Long-Term Capital Management (LTCM) – formerly led by a notable team including 2 Nobel Prize Winners.

Here’s the link:


In this speech he explains a simple risk management concept in investing by using the game of Russian roulette as an analogy.


Let’s do a quick thought experiment. Suppose we have a once in a lifetime potential investment with a 99% chance of 1000000000000% upside and a 1% chance it goes to 0 in 1 years’ time. Some (or many) of you may think I’m crazy or stupid but I would allocate maximum only 10% of my book in such an idea. Why? Because any more than that then I may be at risk of failing to reach my long-term return goal. I can probably afford to have 1 bad year, but I definitely can’t afford to be out of the game permanently. Some people may look at the risk/reward and say “but that’s crazy, that’s an amazing risk/reward, you should definitely put 50-100% of your book in that idea”. If you’re thinking to put somewhere between 50-100% of your portfolio in such an idea, you run the risk of losing everything or at the very least setting yourself up in an almost unrecoverable position. My point is that no matter how miniscule the probability is, in reality the 1% chance can happen. In order to build a great long-term track record, these situations always have to be sized appropriately. I think it’s safe to say that LTCM took outsized risk.


How this applies to my favorite investment heroes Buffett and Malone:

Buffett could have easily used more leverage in Berkshire and become even richer than he is today, without increasing the probability of a permanent impairment of value. He simply chooses not to use more leverage. Back to Buffett in a later point.


Many value investors might not like Malone’s use of substantial leverage in his companies, but I do. Malone is a genius in applying just the optimal amount of leverage. This doesn’t mean he doesn’t consider having a large margin of safety when using the right amount of leverage. He understands his industry incredibly well, including the nature of the business and the financial structures of all the major players involved. Even in a realistic worst case scenario, he knows that the equity will not be permanently impaired in value. He is, after all, typically the largest shareholder in his companies. Malone is probably greedier than Buffett today. He typically likes his companies undervalued so that they can buy back more stock at cheaper prices and at a discount to intrinsic value. (I hope he doesn’t see this because I love him and should have sent him a Christmas card over the holidays).


Buffett obviously has superb portfolio management skills. In his earlier days when running his private investment partnership he would have 40%+ positions, and he was ultimately right. If in reality the “right” weighting for a certain investment in a portfolio is 25%, Buffett would probably figure that out and allocate somewhere between 24-26% of his portfolio in it – that’s how good he is.


I think portfolio management is much more of an art than science. Most professional fund managers diversify in over 100 names because they probably think that makes a much “less riskier” portfolio. They certainly teach you this bullshit in business school. According to modern portfolio theory these idiots (oops, pardon my French) tell you that the greater number of names in your portfolio, the greater the diversification and the less “riskier” a portfolio is. This is obviously wrong, because the right definition of risk is the probability of a permanent impairment of capital. In order to avoid a permanent impairment of capital you need to buy – at the right price – shares in a business at a deep discount to intrinsic value. To arrive at a business’ intrinsic value involves conducting intensive, deep, fundamental research, especially for industries and businesses with a lot of moving parts. See where the art part is coming from?


So back to my original point: How the fuck is any portfolio manager supposed to know the risk/reward in over 100 portfolio names, especially in this complex, ever fast-evolving capitalist economy. The answer is he/she doesn’t, because as far as I know we as humans can only store a limited amount of knowledge in our brains at any given time (doesn’t mean we can’t compound general knowledge over time). If you don’t know the risk/reward in all of your portfolio names, well then guess what? Maybe your portfolio is riskier than you think it is. Remember, the price you pay is the ultimate factor that decides your margin of safety. My point is that I think the chances that one investor finds over 100 great investment ideas at any one time is pretty close to 0 – especially in today’s ever increasing efficient stock market. If one day you wake up and know the risk/reward in over 100 public companies given their current market prices, you might have turned into a super intelligent alien. The last time I checked, Sir Isaac Newton was still dead. Maybe Elon Musk is a candidate.


“Diversification is a protection against ignorance” – Warren Buffett


Michael Mauboussin, Howard Marks and Thinking about a Probabilistic World

I think the art of winning in poker has a lot of similar aspects to being a successful investor. Poker, like investing, is largely a zero-sum game. In poker, you have to know how to size your bets, and you absolutely have to understand risk management. The best portfolio managers know how to best size a position – whether it should be a 30% or 10% weighting for example – and they definitely know what they know and know what they don’t know. As value investors we should be obsessed about the downside. I personally ask myself before I make any investment: what can go wrong? Like it or not, I think this point is even more important for concentrated investors. As concentrated investors we may hold only a handful of names at any given time. Let’s just say if we’re wrong on any of these names, we can potentially get fucked. I talked about how having over 100 names in a portfolio can be risky, but what can potentially be even more risky is a concentrated bet with a miscalculation of the downside. I see a ton of fund managers in Canada that seem to have a love with investing in resource-based companies because they think commodities will go to the moon. I’m no commodity expert, but even I’m smart enough to know that if the underlying commodity tanks – which it easily can, or certainly there’s a real probability of it happening – your gold or gas or oil or whatever project can become permanently uneconomic. These fund managers probably aren’t stupid, but don’t properly control risk. On the other hand you have to know when to bet big when the odds are clearly stacked in your favor. If you think in the worst case scenario you’ll still make money then you should clearly size the position as a top holding. I don’t think it helps if you’re constantly scared of losing money. I think the best investors, like top poker players, probably have some sort of “desensitized” relationship with money. You have to think rationally to perform your best. In essence when you transact it’s an act of arrogance, as Klarman says, and you better not be the sucker at the poker table. It’s hard and often it takes “second-level” thinking, especially for well-followed, liquid companies.


One in a Million
My final point is that there are tons of very smart, great analysts out there who can regularly find great investment ideas. But only a tiny fraction of these guys will ever achieve legendary-type returns (if they attempted to) because of poor portfolio and risk management. I really don’t know if you’re “born” a great investor or not, all I know is that it’s pretty fucking hard. Of course achieving great returns is waaaaay easier said than done, and a lot of it has to do with having the right temperament and psychology. I’m not talking about just beating the S&P for 100-200 bps by the way (which most people fail to do), I’m talking about 20%+ annualized over a 20+ year period. The best we can probably do is to study the great investors we admire, reverse engineer their best investments, apply their lessons and mistakes learned in your own portfolio by developing your own theses, and in time you’ll start developing pattern recognition skills. Did I mention that you should read a shit ton of annual reports?


I think on both ends on the spectrum (being concentrated versus being “widely diversified”) there are lessons to take away from this. Personally I’m a concentrated investor and will likely remain that way for the rest of my life. I seem to have a style that is a mix of Malone, Buffett and Greenblatt. I love to dive deep into companies and industries and learn the most important things and key drivers I need to know to have an edge over the person on the other side of the trade. I also think it’s important to identify catalysts that will unlock value or else it’s a value trap and I won’t know what the fuck I’m doing. It’s important to discern whether you’re catching a falling knife from the 30th or 2nd floor right? And that’s why I love this field. It’s more of an art than a science, and if you want to compete with the very best analysts out there and generate legendary-like returns you will be constantly intellectually stimulated. Hopefully in this blog you’ll see what I’m talking about.


So the next time you’re thinking about putting on a huge weight on a company that has even a slight chance of going to 0, think about that revolver with a million chambers in it, but with 1 bullet, and pointing that at someone you deeply care about, or at yourself.


Back to reading eBay’s 10-k and learning about John Danahoe’s brilliance.




Some New Ideas

This caught my attention:


Any publicly-listed CEO that mentions Buffett as a role model typically catches my eye. The stock doesn’t look cheap at the moment but I haven’t dug deep into this one yet.

This is definitely an industry I want to study more in-depth in the near future. Bandwidth demand will only grow exponentially over the next decade – both on the enterprise and consumer side. The continued proliferation of data-intensive devices, both outside and inside the home, is just one driver of this trend.

There are many ways that you can play this big data trend – directly or indirectly. I like the cable firms, and in particular, Charter. Charter may look expensive on an EBITDA basis (currently trades at a 2015E 9.59x EBITDA multiple as per my Capital IQ), but you have to take into account that the majority of their growth CapEx cycle has recently been completed, at least on the residential side. Charter recently finished a multi-year CapEx program of transitioning their footprint from analog to all-digital, so their CapEx was very elevated. That was a major sunk cost. Going forward, I expect their total CapEx will continue to shrink, until their capital intensity is ~13-15% of total revenues, which I still think is conservative on a maintenance CapEx basis; 1) They’re going to continue to grow their higher-value subscriber base which will further spread their fixed costs, 2) the cost of set-top boxes will come down dramatically, 3) upgrading their broadband speeds to maintain their competitive advantage on the high speed residential data side will only require changing a few electronic pieces in the plant. They are, however, pretty aggressive in capitalizing their subscriber acquisition costs; they include the cost of labor in this figure. I don’t think this is too big of a deal, since I think their churn will continue to improve as subscribers now have a much better video product, and are offered a very competitive triple-play bundle. Its been shown in the past that every incremental service added to the bundle improves customer lifetime.

Now if we look at their free cash flow generation, everything else is moving in the right direction. Currently they hold a lot of high-yield debt that was raised coming out of the bankruptcy period, so even if we assume rates will go up, I think their long-term cost of debt will only go up modestly or even remain flat as they grow their subscriber base (taking back share from DBS and increased subscriber penetration). I believe their average pre-tax cost of debt is around 6% right now (could be wrong, too lazy to check), and they’ve been raising long-term at more attractive prices. With the large NOL, they’re probably not going to pay any cash taxes until 2018/19, and there’s real potential to further increase their tax basis via more M&A. CableOne which will be spun-off from Graham Holdings, Brighthouse Networks are potentially targets. Of course there’s also Greatland Connections longer-term which Charter will have a 33% stake post the Comcast/TWC merger. If you want to be fancy you can do a pair trade and short Cablevision – I think Malone is too smart to buy them out at this price, but I could be wrong. The cable networks remain stuck in a tragedy of the commons, and continue to leverage their hoarded content rights to raise programming costs aggressively, so I don’t think these sub-scale cable firms will remain independent for much longer as their video margins continue to get squeezed. Charter is the only viable consolidator, as Comcast/TWC will have close to ~30% of the total US pay-TV market, a cap set by the FCC a long time ago. I’m not even sure they’re going to be able to push their deal through without more concessions. But you never know, I’m sure they have an ARMY of lobbyists in Washington, fighting against title II and for pushing the deal through. If Charter isn’t going to do more M&A, then they’re probably going to buy back a shit ton of stock. Malone and Maffei are directors and hold a large stake via liberty broadband, so it’s almost guaranteed that they’re going to shrink the equity. I rather have a leveraged equity shrink capital return strategy than a dividend. As for Rutledge, he’s by far considered the best operator in the industry, and has track record of improving subscriber level economics.

So it’s not hard to see that their free cash flow per share is going to explode to the upside and I think they’re going to create a ton of value over the long-term, regardless of whether title II caps their broadband pricing. The great thing is that valuing Charter is not simple because of all the moving parts and pending transaction – a typical “Malone thing”. This is why I think the shares remain undervalued today. Institutional managers can keep buying TWC since it pays a dividend, and ignore Charter. I will keep buying Charter and Liberty Broadband shares.

Here’s an excerpt from my letter to investors:

“Prior to Mr. Rutledge coming on board in late 2011, Charter was a mis-managed, over-leveraged and under-invested asset. Due to these factors, Charter was a victim of substantial subscriber share losses mainly to direct broadcast satellite (DBS) players with superior video offerings[1]. We believe that this competitive trend will continue to reverse – as it already has for the past several quarters – with Charter taking back the vast majority of incremental subscribers from DBS and local DSL operators. Our view is that Charter is still in the early to middle-innings of a complete turnaround into a premiere cable asset with a superior upgraded video and broadband product relative to competitors. Despite the market’s concern of credible industry-wide headwinds such as absolute declining video subscriber numbers and programming cost inflation, we believe these negatives will have a light impact on Charter’s ability to generate substantial FCF over the coming years. Contrary to common belief, the US broadband industry remains a secular growth story as ~30% of US households still don’t have a broadband connection. Charter’s current broadband footprint remains under-penetrated at ~40%, and we believe this figure could approach closer to 50% over the next 5 years. As opposed to Charter’s video business which has been experiencing declining gross margins due to programming cost inflation, the broadband business’ economics are much more attractive; gross margins are typically greater than 90% and the cost to transmit bandwidth in cable pipes is literally pennies on a per gigabits basis.

Charter’s competitive position in the US telecommunications industry is a very attractive one as it owns a de facto local monopoly on residential high-speed data services in the majority of its footprint. The major Telco competitors have limited fiber overbuilds in Charter’s rural and Tier II city-focused footprint; AT&T’s U-verse and Verizon’s FiOS are currently present in ~34% and ~3% of Charter’s footprint, respectively. Post TWC-Comcast transactions, these figures will come down to ~30% and ~1%. Aside from Verizon’s superior fiber-to-the-home FiOS product[2], no other service in the market today, including U-Verse, can match Charter’s broadband product. In order to match cable’s hybrid fiber coaxial (HFC) network’s ability to provide broadband speeds of up to 100 mbps or greater, the Telcos will have to overbuild their entire copper-based network, replacing it with fiber optic cable. This is an extremely capital-intensive and time-consuming process, and the returns don’t look enticing to say the least. To illustrate, if we take into account the typical gross margin for an average triple-play[3] AT&T U-verse or Verizon FiOS subscriber, which we believe should be around $60-$100 on a monthly basis[4], the payback period can easily stretch to 6 years.[5] Based on these challenging economics, the Telcos have only focused on overbuilding in the most affluent, densely populated US cities in order to generate a satisfactory rate of return; these urban areas are a very minimal slice of Charter’s total footprint.

In addition, cable’s HFC network provides the most cost-effective infrastructure to provide higher broadband speeds. With DOCSIS 3.1 technology, Charter can easily provide data speeds of up to 1 gbps or more with very little incremental capital.[6] With the continued massive proliferation of data-intensive devices such as smartphones, technology wearables, and tablets, speed requirements will only grow exponentially. Charter and the cable industry are best positioned to cost-effectively fuel the insatiable demand growth for high-speed data services over the next coming decades. The bottom line is that Charter owns a captive growth market, with de minimis future competition.”

[1] Satellite Pay-TV packages typically include over 200 HD channels, exclusive programming, Video on Demand (VOD), “TV Everywhere”

[2] Charter’s Optimum broadband product can match FiOS in terms of download speeds, but not on the upload side

[3] Triple-play is a bundled broadband, video, and telephone package

[4] This is not taking into account the typical 2-year heavily discounted pricing promotional period

[5] We assume the total subscriber acquisition cost (SAC), including line installations and infrastructure investments for a new customer is on average $3,500; this is also taking into account that this is on an undiscounted basis

[6] In the upgrade process, several electronics are replaced in the Cable plants which is relatively light capital spending

Liberty Global: Think the C shares are worth somewhere between $60-70 in a year or so, assuming they trade at a leveraged FCF yield a few hundred basis points premium above their long-term pre-tax cost of debt, which I think is reasonable for the equity of a high-quality, growing cable business. I want to start accumulating this one aggressively if it goes to the low 40’s. They just closed the Ziggo transaction, and I think like the Virgin Media (which I think they stole) deal, the synergies are going to surpass their initial estimates. An interesting thing about Ziggo’s accounting is that they actually expense their set-top boxes so their EBITDA is understated relative to comps. That’s very conservative in cable land since these boxes can make up around 50% of a cable firm’s total CapEx in a modest growth year. I’m sure Malone noticed that and paid the right price for this asset. The Netherlands was one of the markets that was having trouble over the past year or so for Global, because of KPN’s aggressive pricing and FTTH roll-out. Now with Ziggo merged with UPC Netherlands, they’re going to cover most of the country’s footprint, not to mention benefiting from the enormous cost synergies. The Netherlands is one of the densest population zones in Europe I believe, along with Belgium. To be quite frank I can’t believe the local regulators allowed them to even do this transaction. Perhaps they think KPN’s FTTH roll-out will provide adequate competition. What’s most important is that in all of Global’s major European markets, the incumbant Telcos will most likely price rationally longer-term in order to generate a satisfactory rate of return. A duopoly or 3 player market that continues to raise prices on consumers, now that’s an attractive industry I want to be in. The next leg in this story is continued share shrink. Management said that they will return ~$3.5 billion via share repurchases until 2015YE which is around 10% of the market cap today. If you factor in operating cash flow growth of mid to high single digits, they should be able to achieve leveraged free cash flow per share growth close to 20% if not higher for the next several years. They remain way ahead in the technology product curve in Europe relative to the US, and have the luxury of bundling mobile, improving subscriber lifetime values, and a large B2B market opportunity. They also don’t have to deal with programming cost inflation in the high-single digits, as the media ownership remains quite fragmented in Europe and they don’t have to pay enormous re-transmission fees to the local broadcasters. Also Netflix is a catalyst for broadband growth as they continue to expand in this continent.

Again, this is an extremely complicated entity, even more complicated than Charter, so that’s why shares are undervalued. I think I probably spent months studying the industry last year, but it was a very interesting project and well worth it.

Fox, BSkyB, DISH, DTV, Time Warner and Discovery: Looks like Murdoch is showing signs of becoming a more disciplined capital allocator. He didn’t chase Time Warner till the end of the Earth. I suspect that he wanted HBO, which is an extremely unique and valuable asset IMO. Premium channels aren’t supported by advertising fees, so I think their business models will be less affected in an unbundled world. In fact Time Warner has announced that they are offering HBO on a standalone basis without having to subscribe to a cable bundle. Pay-TV subscribers typically have a choice of upgrading to HBO in their packages for $15 at the retail price point, so I think even if HBO retails at $15 over the internet they should do OK and won’t canabalize much of their existing business. I actually don’t think many people are going to cut their cable package just because all they wanted to watch was HBO. What they’re doing is going after the same market Netflix is going after, millennials like me that don’t subscribe to a cable TV package. I’m not a huge sports fan so I don’t need to pay $100 a month for that entertainment.

Charlie Ergen knows this, and wants part of this market as well.


What’s interesting is that ESPN, the largest hoarder of exclusive sports rights, is included in this package, for just $20. Now this is a bit troubling for the Pay-TV ecosystem, in my view. I think sports has traditionally kept the bundle intact. DISH still has a DBS business but it’s becoming an increasingly less valuable component of DISH shares. So on one hand it could cannibalize their DBS business, but on the other hand he wants to start building an online streaming business for a growing OTT market. ESPN gets by far the highest affiliate fees per sub at the wholesale level out of all the networks, above $5 per month. Now if I were the ESPN guys, do I risk part of my ~$435 million or so in annual affiliate fees, and huge advertising fees as well within the bundle or do I think its a bad idea to be part of DISH’s streaming bundle? I think they’re playing a potentially dangerous game here, and if I were a distributor, why would I buy ESPN at the wholesale price and offer it at retail when subscribers can cut the bundle and just get their sports online? Either they’re really confident that the MVOs aren’t going to push back hard or Ergen’s a brilliant negotiator. I think it might be a bit of both.

The spectrum holdings in DISH are becoming increasingly valuable, IMO. Citi’s Jason Bazinet recently published an intriguing report on DISH, suggesting a move to spin off the spectrum assets and “light it up” at wholesale prices to a wireless partner. With 4 wireless players in the US that are starving for spectrum, this would be a viable move to avoid tax leakage. I don’t think there’s a chance in hell that Mr. Ergen is going to sell the spectrum and pay $10+ billion in taxes, which is more than the value of the DBS business if you put a 5-6X EBITDA multiple on it. He holds over half the shares and has a track record of compounding DISH at roughly 20% per annum. So I think he’s either going to do what Mr. Bazinet has suggested or sell the firm to Verizon or whatever option that maximizes shareholder value. The market’s still not comfortable because of the uncertainty with respect to the end game for the spectrum holdings, creating opportunity. At the end of the day there’s huge key man risk here, and you have to put a lot of faith in Mr. Ergen for this thesis to work out. Haven’t initiated a position but I think he’s a genius and I would put his track record on par with Softbank’s Son.

Discovery shares have taken a huge hit lately. I’ve read John Hendrick’s biography which gave me a good background on how Malone accumulated a large position in the company today. I like the business, a lot. They’re the world’s top non-fiction media company, period. The great thing about this type of content is that you don’t have to hire expensive actors like Brad Pitt to produce high-quality shows, and the shows easily transcend across languages, gender, age cohort and cultures globally. What gives me pause is the resetting of growth expectations and their exposure to the bundle. I have to dig deeper into these issues but noticed that they’ve been acquiring production assets in Europe such as All3Media, SBS, and Eurosport. Malone probably wants to increase Discovery’s exposure to production assets as the bundle slowly breaks and content gets re-priced higher. This is smart. I’ll get more interested if shares fall down to the mid 20’s.


Time Warner is also another business I would love to own at the right price. If you look at Jeff Bewke’s track record, it’s been pretty good. Spinning off AOL, TWC, and Time. I noticed in the latest K that they’ve sold their multi-billion dollar Time Warner HQ in NYC. I think these are small details that signal a CEO who is focused on maximizing shareholder value. The next catalyst is probably related to highlighting HBO’s value. I’m not sure what he’s going to do, but I would love to own this franchise eventually – at the right price. Will be interested at $70-75 per share.

DirecTV – Sourced the original idea from Ted Weschler’s pick at Berkshire. Still in love with this business, so I’m going to hold it until the AT&T deal closes or it goes to $100 per share.

I think it’s an interesting merger arb play right now, and I am only playing this since I understand the business pretty well so I won’t cry if the deal breaks.

This opportunity exists because:

1) AT&T pays a fat dividend, so if you want to hedge AT&T you have to pay this and the arb guys don’t like this

2) only $28.5 of the $95 per share consideration is in cash, and the rest is AT&T stock with a collar so you have considerable exposure to T stock

3) Market’s overly concerned with US pay-tv consolidation and the FCC/DoJ’s response, but I don’t think the TWC/Comcast deal should have any impact on the DTV/AT&T deal

4) There’s no reverse breakup fee in the deal. I think AT&T learned their $6 billion dollar lesson when they tried to acquire T-mobile in 2011. Lol.

Overall, I expect the deal to close without too much “hassle”. In pretty much 100% of the areas with competitive overlap between DTV and AT&T there should be at least 2 additional video competitors post this transaction – a local cable firm and DISH.

My edge here is that I’m relatively agnostic to whether the deal breaks or not since I like DTV longer-term, but still think the risk/reward is favorable with a higher expected value of the deal closing. Assuming in my base case scenario that T rallies back up into the collar in the next several months, you could be looking at an unlevered ~25% annualized IRR on DTV assuming the deal closes near the end of q2. Not bad for a low interest rate environment.

As for DTV longer-term, most satellite bears underestimate the resiliency of DTV’s subscriber base. Literally 40-50% of their US subscriber base is probably with DTV just for their exclusive sports programming. In fact this is so important that AT&T did the deal contingent on DTV extending their Sunday Night football contract with the NFL. Like I mentioned previously, Sports has largely been keeping the bundle intact, and if DTV can continue to offer exclusive sports content, they should be able to keep churn low for a very long time. At the same time they’re the largest Pay-TV distributor in the world, with more than 35MM subscribers. These subscriber relationships are very valuable, and I think most bears have ignored the fact that DTV can eventually offer exclusive sports content even on an online streaming platform. In fact this would be an extremely capital light business model – no more satellites, set-top boxes, broadcast centers, trucks, etc. Of course the economics of a streaming business would be different, but its definitely worth something. And management actually tried to buy HULU a year or 2 ago from the consortium of cable networks, so they’re probably thinking the same thing. I think the reason the NFL kept their relationship with DTV is mainly because they have the largest subscriber base out of all the MVOs, and know that they can maximize their revenues by signing a contract with a MVO with access to the largest number of high-value subscribers. At the same time, Latin America continues to grow nicely and has a long runway, and DTV has a massive competitive advantage there over cable. Factor in the accretive leveraged buy backs with management “arbing” the stock at a near 10% FCF yield with a sub 5% pre-tax cost of debt and you have a nice setup for sizable equity returns.

The Tower Operators – Crown Castle, American Tower, SBA

Great Businesses, high barriers to entry, good pricing power, levered to secular growth in wireless data, good returns on capital. Too expensive.

Qualcomm – Potentially a good way to play the big data and mobile growth via their licensing business. I don’t understand the technology risk, so I’ll leave it at that. I know they have a giant cash hoard and it trades at a reasonable multiple if you back that out.

Carrier-neutral Data Centers – Equinix, Telecity, Interxion

Now this is a great way to play the “big enterprise data” trend. I’ve been studying this industry for the past year and am convinced that these guys will do extremely well over the next decade or so. There’s a lot of minor details that you have to dig through in order to get a good understanding of the business model but I’ll say this: The maintenance CapEx is way less than what the market perceives. Enterprise clients actually own the IT hardware themselves, so these guys don’t pay for that equipment. The real upfront CapEx is the building itself (growth CapEx), and minor stuff like cooling equipment and battery related equipment (maintenance). The big selling point for potential customers is the interconnection to other enterprise customers who share the same data center. The incremental margins for this business is close to 100% and there’s a real network effect for sharing a data center with other customers. This is a much better business model than on the wholesale side where pricing is much lower. So you have high barriers to entry, recurring revenues, strong secular growth, pricing power, and I think Equinix, Telecity, and Interxion are quite rational on the supply side, so I don’t see oversupply as a large risk.

US and Canadian Auto Retailers:

This is a main area of DD for me right now. Simple thesis that I’m developing right now is that I think you could see pretty out-sized upside on the parts & service segments of these businesses, along with considerable consolidation in the industry. If you look at where the real money is made in this business its in the auxiliary services like financing, insurance (where gross margins are near 100%) and in parts and servicing. I use to own an interesting subprime auto-lending business called Credit Acceptance so I know a little bit about the financing side. For the dealers, they take 0 financing risk when sourcing an auto loan, and simply clip a fee based on the size of the loan. Combined, these segments typically make up more than 50% of gross profits for an average dealer. Also I think we’re in a sweet spot in the automotive cycle where you’re going to see a larger portion of the fleet aged between 0-5, where the vast majority of vehicles get serviced under warranty. Another interesting fact is that there’s been a sizable decrease in the total number of dealerships in the US over the past decade or so, leading to increased profitability for current dealers in a less crowded market. If you think about it most dealers operate in local monopolies where they have geographic exclusivity to sell a particular OEM brand. I think this attractive industry structure should provide improving returns on capital going forward. Another leg of the bull thesis is consolidation. All together, the publicly-traded US auto retailers barely make up 10% of sales in the US market. There’s going to be a lot of mom and pops ready to retire or semi-retire soon that are looking to sell their family-owned businesses. The OEMs have become less stringent on public ownership of dealerships, and are actually encouraging more consolidation. This is quite a simple process, you buy a private dealer or group of private dealerships at 4-8x EBITDA at private market valuations (higher multiples for Japanese or German Dealerships), professionalize management, improve operations, leverage IT and overhead costs etc. and then you get a “awarded” a publicly traded 10x multiple – simple arbitrage right? Most private owners would prefer a clean transaction with cash, and should be willing to sell at these multiples to well-funded public companies that have the most attractive source of financing. In terms of the auto cycle, I’m not sure if we’re anywhere close to the peak. SAARs are at 17MM per year I think? Most sell side analysts seem to think the peak will be in 18′, I’m not so sure. All i know is that I would rather own a local monopoly where a large portion of the business consists of a recurring, higher-margin revenue stream in P&S, rather than own a super price competitive, economically-sensitive, unionized, capital-intensive OEM business. (Btw, I think Stevens Fiat idea is good but I’m a bit nervous about the CEO’s grandiose spending plans although I think the ferarri piece is very valuable). The great thing about these businesses is that they’re still small-caps, so big institutions can’t touch em. One last thing I should point out is that the floorplan financing that these auto retailers get shouldn’t be considered real debt, since its collatorized by the existing inventory, which I think is de facto OEM inventory – but its just really in the hands of the dealers as distribution points, so I would adjust the enterprise value for this debt. So I think there’s a huge market consolidation opportunity here, and I think these stocks should do well in the US. I’m most excited about the Canadian traded company, its the only publicly traded one in Canada with an even more fragmented industry. They have a fantastic management team so I’ll let you find out yourself which one it is for fun.

Guess who else sees this opportunity?


Altisource: Not very interested in this company, other than the fact that I don’t think Erbey is as ethical as some may think he is. Here’s what I said in an earlier comment:

“Personally after giving it more thought I find it strange that Erbey steps down after a regulator turns his company into a de facto government run enterprise. One would think that he would fight harder against Lawsky given his background. So lets think about this… apparently he worked 24/7, literally moved to Virgin Isles just to save the company taxes, and he had no kids etc. A large part of his life’s work put into Ocwen and its related companies, and amid these allegations, simply steps down? I would guess that there’s probably more behind the scenes here, and more skeletons in the closet. Apparently Lawsky has a reputation and track record for overstepping his authority. Check out the AIG case. But the private sector knows this, so I would think Erbey would at least dispute/countersue Lawsky’s ridiculous demands. But no, he just steps down. Looks like there’s too many “unknown unknowns” here.”

If they become a distressed play I’ll consider taking a closer look. Steven will provide an update post if he wants to. Always do your own DD.

End of rant.


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Interesting Links


Dear President Obama,

Who would want to provide higher broadband speeds if they can’t charge higher prices to cover the incremental capital invested?

If telecommunication firms aren’t incentivized to provide higher speeds then America would be worse off in the global economy.

Let’s keep capitalism alive.

2) http://blogs.wsj.com/digits/2014/12/10/germany-emerges-as-net-neutrality-antagonist/

Germany and net neutrality.

3) Charter’s CEO on net neutrality and the Pay-TV ecosystem



4) “Industry Lifer” vs. “Deal Maker”


The way I see it, Time Warner Cable has been an under-performing company and management has pursued a strategy of returning capital to shareholders at the cost of upgrading their systems to remain competitive. It’s no surprise that they’ve bleed a large number of subscribers over the past several years. I’m sure short-term oriented money managers like the dividend yield and the near-term capital returns.

5) FCC Chairman Tom Wheeler’s Blog Post:


6) Slides from Liberty Broadband’s investor day – these are not posted on their investor relations website.


7) Charlie Ergen is an underrated genius.

From the DISH 2014 Q3 Conference Call:

“….I think the spectrum you have could be worth as much as the entire market value of [Dish] presently.” – Leon Cooperman.

The reality is that wireless providers don’t have the bandwidth firepower to compete against a fixed broadband network infrastructure. Wireless spectrum is scarce and expensive. Cable companies with their DOCSIS based technology are best positioned to fuel the insatiable demand for faster and more high speed data more cost effectively versus the competition. Set-top boxes and associated CPE are also increasingly becoming more commoditized and thinner, which should yield substantial CapEx savings.

What do you think will happen to Charter’s levered free cash flow?

8) Keeping the bundle alive with “TV Everywhere”


I think most of the Satellite bears forget that DirecTV and Dish could potentially shift their subscriber base to a pure over the top model over the long-term, similar to what Netflix did with its DVD delivery service. The economics will obviously be different but those subscriber relationships are still quite valuable.