Yahoo’s time as an Alibaba proxy is running out

I get the Yahoo Inc. ($YHOO) Sum Of The Parts (SOTP) story, I really do. I have shared it, acted and profited from it, I just believe its time has come. I am by no means a Yahoo hater. (I’m a Yahoo Finance Contributor now, so how could I be?! ;-) )

Having said that, we all know that Yahoo’s core business is nothing like Alibaba, it is not even like Yahoo Japan. The epic rise in its stock has all (plus some) to do with their Asian assets.

I wrote this post a few months ago, on how it is crucial to know why investors are doing what they are doing. Keep this in mind as exposure to Alibaba can be had (later this week) without owning Yahoo.

It’s pretty obvious that Yahoo has been trading like an Alibaba proxy over these last couple of years. It has been the case ever since they sold their first stake in Alibaba back in 2012. If most of the investors in Yahoo only invested into it because they wanted exposure to Alibaba, which based on recent reports there seems to be plenty of investors desperate for some exposure, why would they own it come this time next week?

Michael Santoli wrote this great piece on “proxy stocks” late last week. While he highlighted many different examples of these proxy stocks over the years, in my previous post I compared Yahoo to GSV Capital ($GSVC) and GSV’s run-up to both the Facebook ($FB) and Twitter ($TWTR) IPOs.

There are obvious reasons of why I think the GSV comparison is best. Not least of which is that Facebook (& Twitter) are decent comps for Alibaba. We are also talking about stocks that have gone public in the same (liquidity driven) bull market. (Facebook’s IPO was in 2012 and Twitter went public last year.)

One of the major differences – and this does not bode well for Yahoo investors – is that as a percentage of their entire Net Asset Value (NAV), Yahoo’s current stake in Alibaba is even larger than GSV’s stake in Twitter. Yahoo’s stake in Alibaba more closely resembles the GSV’s Facebook stake pre Facebook’s IPO, and as you can clearly see from the chart below, the larger the stake the more people held it for the proxy and this resulted in a much larger drop when the proxy wasn’t needed.


I think it is important to realize that most of the time, there is a “holding company discount” with these types of companies. Leading up to a liquidity event, especially in a hyped sought after name, that discount not only shrinks, but there could be so much demand for the stock that it drives the stock to a premium to its parts.

When the event occurs however, just like the stock overshoots on the upside, it can overshoot on the downside as well. GSV not only saw selling pressure as both Facebook and Twitter went public, it continued falling well below its NAV in both cases in the following months. The fall in absolute value is even more impressive when considering that Twitter did extremely well at/after their IPO.

Back in early-mid 2013, my twitter followers may recall that I became quite bullish on GSV. The stock fell to sixty cents on the dollar in the aftermath of the Facebook IPO, and many of our clients benefited from that irrational sell-off and the subsequent hype buildup leading up to the Twitter IPO. I think there might be a similar opportunity with Yahoo in the not too distant future.

Yahoo core is undoubtedly worth more than zero. They make real money and have many attractive assets. However, supply and demand will move the stock in the short term, and I can’t see how it wont fall at or very soon after the Alibaba IPO. My main question, is how far will it fall? Will value investors scoop it up at a price that their core business will equal zero, or will it take a GSV-like dive and become significantly undervalued until another catalyst emerges?

The beginning of this week might very well see one more push higher in shares of Yahoo, but I truly believe this will be one of those cases where many will say “it was so obvious” after the stock pulls back. Saying it after the fact won’t really help any current investors, I hope this post will!

– Aron

Twitter: @MicroFundy

Know the Why.
Buying Yahoo to play Alibaba? History hints at future moves

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Malone bringing the flowers to $FTD

FTD companies ($FTD) has pivoted in a very interesting way.

The old pitch/bull thesis on $FTD (aside from a very attractive valuation) was that their business model was “asset light”. Most of the company’s revenues and the highest margin part of their profits came from commissions and fees from local florists. This is as opposed to selling actual flowers to end customers.

This business not only carries higher margins, it also has many more barriers to entry. They have a network effect that really curbs the ability for others to enter the market. What florist would sign up and pay money to a company without an existing large customer base? Alternatively, what customer would order flowers from a company without florists that can deliver the product?

(Of course they do have competition from online sites that deliver actual flowers from warehouses, $AMZN etc, but that is, or was, a separate business model.)

With $FTD’s purchase of $LINTA’s Provide Commerce business, the company now has both their traditional florist model as well as a business where they are going to be shipping directly to customers from their own warehouses.

This not only makes the model as a whole more risky and subject to more competition, it also poses a risk to $FTD’s existing cash cow. Florists have to be wondering worryingly about orders which would typically be sent to them for fulfillment, perhaps now being filled by the company directly. The company obviously aware of those concerns, sent this email to florists the day after the merger was announced assuring them share of the bigger pie.

So why would $FTD want a worse business model along with risk of annihilating their source of so much of their profits? I can’t speak for management, but I think it was a combination of several factors.

First and foremost, the amount of florists continue to decline. Management has stated on prior calls that overall florists in the US have declined approximately 4% a year in the last decade. So while the company continues to make money from florists, they have relied on making more per florist in order to achieve growth in that segment. There is only so much they can milk from the same florists.

Another point is expansion. $LINTA’s Provide has other businesses such as, Shari’s Berries, and RedEnvelope – businesses that enable the company to grow outside of flowers as well.

As an investor there are another two key benefits.

One, shareholders are getting one of history’s best investors as their largest shareholder. After the deal closes, $LINTA will become $FTD’s largest shareholder with 35% of shares outstanding. If past Liberty deals are any indication, capital allocation will be pristine with $FTD going forward. Whether $FTD does more acquisitions or Liberty sticks to the typical and buys back enough stock over the next couple of years so that they become controlling shareholders without even contributing anymore outside capital, whatever the method, it should end up being beneficial for all shareholders.

Lastly, the company will probably get a lot more coverage by both sell-side and buy-side, and their shares should become a lot more liquid. Until now the company was a ~$600M spin-off where (up until last week) you couldn’t even access their SEC filings by searching EDGAR by symbol. Now it is a $1B company with Liberty as its largest shareholder.


There are definitely both positives and negatives to this transformational deal. The market so far has voted that they like the deal as the stock rose 13% on the day it was announced and it is currently trading close to its highs for the year.

A similar deal was done today by $FLWS and their stock is up 19% which is even more proof the the market likes this type of diversification although, the model is becoming more risky.

I think it raised both the risk and the reward, so while the equity might have been suitable for more risk averse value investors in the past, now it might be better suited for inclusion in a bit more risky portfolios.

– Aron

Twitter: @MicroFundy

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Fiat and the Prisoner’s Dilemma

“The prisoner’s dilemma is a canonical example of a game analyzed in game theory that shows why two purely “rational” individuals might not cooperate, even if it appears that it is in their best interests to do so.” – Wikipedia

Two people are arrested and placed in solitary confinement with no means of speaking to or exchanging messages with the other. The police admit they don’t have enough evidence to convict the pair on the principal charge. They plan to sentence both to a year in prison on a lesser charge.

Simultaneously, the police offer each prisoner a Faustian bargain. Each prisoner is given the opportunity either to betray the other, by testifying that the other committed the crime, or to cooperate with the other by remaining silent.

Here’s how it goes:

  • If A and B both betray the other, each of them serves 2 years in prison
  • If A betrays B but B remains silent, A will be set free and B will serve 3 years in prison (and vice versa)
  • If A and B both remain silent, both of them will only serve 1 year in prison (on the lesser charge)

Because betraying a partner offers a greater reward than cooperating with them, all purely rational self-interested prisoners would betray the other, and so the only possible outcome for two purely rational prisoners is for them to betray each other.

The interesting part of this result is that pursuing individual reward logically leads both of the prisoners to betray, when they would get a better reward if they both cooperated.

However, in reality, humans display a systematic bias towards cooperative behavior in this and similar games, much more so than predicted by simple models of “rational” self-interested action.

I hope this is the case with Fiat (F:IM $FIATY) shareholders and arbitrageurs. On August 1st Fiat shareholders had a vote and approved the merger – of the already purchased - Chrysler.

Because Fiat’s registered office will be transferred outside of Italy, it’s stock delisted from the Italian exchange, and the company reorganized in another country, the Italian Civil Code states that certain cash exit rights are provided to those shareholders who voted against the merger. In Fiat’s case there were 100.1M (~8%) shares who voted against.

These shareholder receive a put option which can force the company to buy their share at the average price of the last 6 months. In the case of Fiat, the 6 month average price is 7.727 per share (or $10.33 per ADR).

However, if 64.7M or more of those shareholders exercise their put option, crossing over a €500M liability to Fiat, the entire merger falls apart, and importantly, those put options can not get exercised.

First off, it is imperative to understand that Fiat already bought Chrysler, that isn’t changing. This is all about combining both subsidiaries into a new – Netherlands based – entity to be called FCA. It is important for a new tax structure, a new listing here on the NYSE, and for issuing new convertible bonds to help fund expansion.

While it is an important step, many in the media have portrayed the consequences of the “deal falling apart” as Fiat not being able to purchase Chrysler. There is nothing further from the truth. From an operational perspective, the companies have already merged, and nothing will change that.

Having said that, it still would be a setback, and it will delay several important steps of Marchionne’s 5 year plan.

Back to the game theory, if all of the 100.1M shares decide to put their stock to Fiat – and play the role of a rational prisoner – the merger gets delayed and nobody gets to put their shares or get the 7.727. With the stock trading today at 7.17, and it’ll probably fall further on news of a delay, I sure hope at least 35.4M choose a cooperative behavior and remain silent.

– Aron

PS. This post could have been a bit more timely if I posted it last week alongside this tweet

as $FIATY was a full point lower at that point.

It is still a good 25% off it highs from a few months ago, and while there is plenty of risk in the name, I do think that this is an attractive price for long-term oriented investors.

Also, if you haven’t yet, check out @GWInvestors full bull thesis here.

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Clips from Benzinga’s PreMarket Show

I had the pleasure to be interviewed yesterday by Joel Elconin, host of Benzinga’s PreMarket show.

Here are the clips on…

$TIVO: Is it time to press play?



$BKS: Is Barnes & Noble the next Gamestop?



REITs: opined on some REIT conversion plays ($IRM, $AMT, $CCI, $SBAC, $LAMR, $CBSO, and $EQIX).



Thanks for listening!
– Aron

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$TIVO: Is it time to press play?

It is not easy for a mature established company to successfully pivot and change business models. When they do however, it takes a long time for the stock market to reflect the change in their model and re-price it accordingly. This tends to create opportunities for patient investors.

I believe $TIVO fits this bill.

$TIVO has gone through two main stages in the last decade, first as a hardware company, selling actual TiVo boxes, and later as a litigation company, battling the likes of $DISH, $T, $VZ, $GOOG, & $CSCO in courts. The first stage has been a declining business for many years. As more and more cable and satellite companies or Multiple Service Operators (MSOs) have incorporated most of the TiVo benefits directly into their own boxes, fewer and fewer people found the need to pony up and pay for another box and additional monthly fees. The second stage is also done for the most part, but the benefits of all the settlements and licensing deals will run through the company’s balance sheet and income statements for years to come. The company received or is guaranteed to receive close to $2 billion in total payments from all of these settlements.

Over the last couple of years, the company has been transitioning to a third stage. While they are still committed to maintaining their high-end hardware business (evident in Roamio’s success), their primary focus is now gaining subscribers through relationships with MSOs.

Two years ago, $TIVO’s hardware – TiVo-owned – business generated approximately 2/3rds of the company’s non-litigation revenues vs. less than 44% this past quarter – and that number is falling. The company once known for their hardware has increasingly become a software and cloud based solutions company.

The battle for the living room is still up for grabs, but if one thing is certain, it is that internet TV / smart TVs / IPTV – whatever you choose to call them – will all have to include powerful operating systems. It is safe to assume that $TIVO will play major role in this evolution. Unless you are the size of a $DTV or $CMCSA et al, you can’t expect many of the MSOs to be able to afford the R&D to build powerful systems that can operate in today’s cutting-edge world. The OS will need to be able to suggest to users what they should watch, it needs a powerful DVR that has cloud storage capabilities, it needs to have access to over-the-top providers like $NFLX & YouTube etc.

$TIVO has targeted and achieved to sign on many of the tier 2 MSOs in the US (companies that have several hundred thousand to a million subscribers on average, e.g.  Suddenlink, Mediacom, RCN, and Atlantic Broadband). These companies compete directly with the tier 1 MSOs who spend lots of money in building out their box capabilities. They also won huge contracts internationally and signed up hundreds of thousands of subscribers through deals with Virgin Media and ONO.

It is true that ARPU per MSO subscriber is a fraction of a TiVo-owned subscriber (~$1 vs. ~$8), but it does come with higher margins. It only costs $TIVO several hundred thousand dollars to set up a US MSO. Also, the potential subscriber base – from a realistic perspective – is so much larger than what the retail business would be otherwise. So far, the company has only signed up 5% of the subscribers signed with current partnering MSOs. (MSO ARPU will also increase (closer to $2) the more the business shifts to the US from international.)

I think this thesis is great, it is so easy to see why people overlook $TIVO, but what about valuations?

This is where so many people go wrong. You cannot count $TIVO’s cash receivables from past settlements both as a current asset on their balance sheet – providing a margin of safety, as well as a revenues in the income statement – helping show positive cash flows and EBITDA. You have to choose one or the other.

When $TIVO settled these law-suits, they received a majority of the money up-front, but the remainder of it they received, and will receive, in installments paid out over several years.

Many look at this money – $365.5M due as of the end of last quarter – and add it to $TIVO’s already huge net cash balance of $569.6M or $4.96 per share, and declare that $TIVO has almost $8 per share in net cash. That’s fine (setting aside not discounting the cash) as long as you don’t also bring in those cash payments when looking at the income statement – as management does – and also declare that $TIVO is going to do > $100M EBITDA this year.

If you could double count those cash flows, you have a slam dunk. $TIVO’s “net enterprise value” is only $558M, they are also growing nicely, they are “extremely profitable”, and yet they only trade at ~5.5X EBITDA! Let alone the margin of safety purchasing it with all of that cash/future cash/patents/NOLs etc.

You have to pick one side and stick with it.

What would the business look like without these promised funds (which comprises most of the company’s “technology revenues”)?

Not that pretty. By my calculations, TTM Adjusted EBITDA would go from a positive $92.4M to a negative $67.3M!

How about the other way around?

These receivables are going to stay solid through at least 2018. Is it fair to look at the income statement and derive a conclusion/value of the business based on numbers from ’14-’18? Not unless you give the entire business after that a zero terminal value. In which case you have 4 years of $100M+ EBITDA, falling to zero after that, is such a business worth more than $558M? – and actually, since we are looking at these receivables in the income statement, we cannot use it again on the balance sheet, so their real enterprise value is $877.5M. Are 4-5 years of $100M+ EBITDA worth that much if after that the business is worthless?

So why am I bullish on the company?

First off, you have to look at the company’s cost structure. While operating expenses as a percentage of revenues have consistently declined in past quarters/years, there is still so much more room to go. Said differently, if another (larger) company were to purchase $TIVO, the profitability would look a lot different.

More importantly, I believe that the company will become profitable – very profitable – even without the litigation revenues.

From a subscriber metric standpoint, it costs $TIVO $186 to acquire a TiVo-owned subscriber vs. close to $8 in monthly revenues. That converts into a now all time low of 16.6 months to break-even. With churn down at only 1.42%, that’s a nice business model.

The MSO business is worth even more. This is a business that has gone from almost nothing a few years ago to 3.6M subscribers. With only 50% tier 2 MSO penetration, and of the existing MSO deals they are only 5% penetrated, there is obviously tons of room to grow.

The company also has patents, and unlike many of the multi-hundred million dollar patent deals in the past ($INTC, $GOOG, $MSFT all come to mind), $TIVO’s patents have been tried, proven, and utilized in court to the tune of ~$2 billion! Keep in mind, they operate in the living room – an area that has yet to declare a winner. $TIVO’s IP can become a huge asset for a larger player.

Also, the fact that the next several years are going to show hugely positive results, even if it might be priced-in, it does help the actual balance sheet of the company. This will enable $TIVO to continue to buyback stock (the company recently increased their share buyback from $200M to $300M), as well as enable the company to do further tuck-in acquisitions. They purchased digitalsmiths earlier this year which helped the company expand vertically – digitalsmiths is the tech engine behind most of even the larger MSOs search and predictive engine. When including digitalsmiths’s customers, $TIVO now counts 18 of the largest 25 MSO’s as clients.

In conclusion, while $TIVO is not the “no-brainer” as some make it sound, they are wisely shifting their business model, they do have lots of takeover appeal, and a nice margin of safety to boot. If you overlooked it in the past, rewind, and have another look ;-)

– Aron

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Intersections: A cheap $LOCK

Intersections ($INTX) is an $80M microcap with a strange combination of a dying legacy identity theft protection business, Identity Guard, a bail bond industry software business, and wearable computing – for dogs.

I came across the company as a comp in a short presentation of one of their competitors (LifeLock, $LOCK). At that time the stock had a 8.5% yield and was trading at less than 4x EV/EBITDA. It obviously intrigued me and entered my watch list.

The main reason why the stock was trading so cheaply was that most (almost 70%) of their primary business’ revenues derived from large US financial institutions. Bank of America itself accounted for ~45%.

For years $INTX relied on these financial institutions (Bank of America, Chase, Capital One et al) to help advertise / cross-sell their identity theft protection business. After the Consumer Financial Protection Bureau (CFPB) fined some of these companies for deceptive marketing, one by one they terminated their agreements with $INTX, leaving that legacy business in a major decline. In most cases the company just saw new subscribers come to a halt, in others, they even lost all their existing customers.

The company committed to service the remaining subs and is trying to maximize the cash flows from the business. But even with low churn, there is little doubt that this business is in a perpetual decline.

(Their Canadian business is also mostly via these type of agreements, so although revenues from that business have been stable at $32-33M/year, there are lots of risk to that business as well.)

Identity Guard is the company’s direct to customer offering (think $LOCK) that has had decent growth over the last few years. ~41% of the company’s 2013 new subscribers were related to IG (or other consumer-direct brands). The company grew IG revenues by a compound rate of 21.5% over the past four years with very little marketing spend.  The company projects that IG will exceed $100M in revenues (from 2013’s $42M) by 2017.

The companies pet health monitoring platform – called Voyce – is a zero now, but provides large upside optionality. Voyce won “Best of CES 2014″ awards and has attracted lots of media attention. The company plans on selling their dog collar device for $299 with a $15 monthly fee for ongoing monitoring and platform access. It’s obviously impossible to value a business like this at this stage, but with 83M dogs in the US, even a tiny piece of the market would be huge. (1% of market = revs of ~$250M + $12.5M/month.)

When investing in companies with optionality for the upside return, it is crucial to have a margin of safety. $INTX has $21.5M in working capital, $18.65M ($1 per share) of cash, $8.4M in a private investment (White Sky), and only $5M in long term liabilities. Importantly, even with the decline in their existing business, they still generated $5-$6M in operating cash flow in each of the last three quarters.

Their Identity Guard business is where I think any valuation conversation has to begin. IG is about a tenth the size of $LOCK. $LOCK has 3.2M subscribers vs. 324k for IG. With $LOCK’s market cap at a little over $1B, just $INTX’s IG business could be worth $100M. (Note that this is more than their entire current market cap.)

I think you have to value their legacy identity theft protection business (including the Canadian business) as a runoff.  There is little reason to assume this business will be around in the long run, the key question is how long will it be around. I estimate that this business generated $54M of revenues and $7M in operating income this past quarter. Even if you assume an accelerated deceleration, I think it is not far-fetched to say it is worth $50M (especially since the Canadian business has – for the time being – remained stable).

If you back out numbers from management’s guidance, I think they are convinced their pet project (pun intended) will be a $100M business within two years. I’m going to take a more conservative approach and value Voyce at zero. I think it should be thought of as pure optionality.

On a consolidated basis, management guided revenues to trough in 2014 at $260-$275M and return to growth in 2015, 2016. (2015 @ >$300M and 2016 approaching $400M.) Most of that growth is expected to come from IG and Voyce. In the 3 years between 2010-2012 when the company generated $347M-$370M in revenues, they did $48M-$58M in adj EBITDA and the stock traded as high as $23. Again, the company’s EV today is around $70M.

There are some risks here as well. While the company has no current borrowings, they just amended their credit agreement because of non compliance with coverage ratios. Their new Bank of America credit line: $1 (one dollar).

Insider ownership exceeds 51% of the shares outstanding. Thomas Kempner (board member) owns (most via Loeb Holding Corp) 38%, Michael Stanfield (CEO) owns 6.5%, & other directors and executives own a combined ~6.6%. While this might be a positive in a sense of aligned interest, it does enable the management team to run the company as a quasi-private (self dealing) corporation. For example, in this year’s proxy, they only received 47-50% of the votes for their compensation and stock incentive plans. ($8M compensation to the top four execs is pretty excessive for an $80M co’ imo.) They also have had many – non-related – pet projects and investments over the years (most of which end up being transferred to discontinued operations).

Since November of last year short interest has over doubled from less than 1.3M shares to a current 2.6M. While that might not be so much on an absolute basis, it does equate to 20x the stock’s average volume, 14% of shares outstanding, and 35% of the float (when you exclude management’s & Osmium’s shares).

The current dividend costs the company $3.7M each quarter. It is very likely in my opinion that it will be cut or entirely suspended. It is hard to envision the company earning enough FCF as they shift to more of a “direct” model (IG) and ramp spending to roll out Voyce. If the stock does fall on an elimination or cut to their dividend, it might actually provide a good entry point into the equity.

Conclusion: Purchasing $INTX at these levels might be a decent investment even if it was just for IG, the fact that investors also get a still profitable runoff business as well as the Voyce optionality, makes this a real interesting opportunity.

– Aron

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Stop Beating on Apple

If $AAPL was on the way up to $700 per share (pre Sept 2012), I would also question the reported $3.2B Beats deal. $AAPL was owned back then by growth investors, momentum investors, and investors that hoped/dreamed that $AAPL will continue their astronomical growth that they achieved in the prior decade.

Today, $AAPL is predominantly owned by investors who care more about their profit margins, cash flows, buybacks, and dividends.

$FB was actually positive the day they announced their $19B WhatsApp deal. If $AAPL did that same deal today, for even half the $19B price tag, every value investors would dump the stock.

$AAPL has over $150B of cash, cash equivalents, and marketable securities on their balance sheet. That cash is earning close to nothing. It’s also being valued by the equity markets at far less than par. If investors thought there was a significant probability of it being spent on companies like WhatsApp, (which might be a great company but it generates no revenues, let alone profits,) they would discount that cash pile even more.

Current $AAPL shareholders would prefer larger buybacks and dividends, and if the company were to make a significant purchase, it almost has to be an accretive one.

$AAPL is the business of selling high margin hardware that’s supported by the perception of better and higher quality software. Beats fits that profile. It reportedly has 60% of the >$100 headphone market, and generated $1.2B in revenues last year. They are assumed to have huge gross margins and an attractive bottom line. With some decent synergies, it’s hard to assume that $AAPL won’t earn way more from Beats in the next 12 months (and for the long term) than what their cash would have earned sitting on their balance sheet.

Beats can also help $AAPL continue to build their ecosystem which is vital to their ability to sustain high margins. Their streaming music product, perhaps a new product to enter into “wearables”, Iovine’s marketing ability etc.

I will not defend the deal because “it’s only $3.2B, which is only ~2% of $AAPL’s cash stack” or “it’s only 3 weeks worth of their cash flow” etc. The company has a fiduciary duty to serve its shareholders no matter the size of the deal.

I’m defending the deal because I think this is what $AAPL’s current shareholders want. It’s a good fit, accretive, and might even help build their ecosystem.

– Aron

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Is Barnes & Noble the next Gamestop?

In my last post I explained why Malone selling most of his Barnes & Noble preferred shares did not really affect the bull case for $BKS. But what about valuation? What is $BKS worth?

I think it’s safe to say that even bulls understand that $BKS’s revenues are in a secular decline, and that it does not deserve to trade at similar multiples to that of more stable or growing companies. It does not mean however that the company is worthless. There are many companies that run their business for its cash flows and since they pay out substantial dividends and buyback significant amounts of shares, their stock not only provide investors with solid income, but capital appreciation as well.

A good example of what the $BKS bull case will look like is $GME. There are many similarities between the two. They both operate in retail businesses that according to conventional wisdom will not be around come this time next decade. Similar to $BKS, $GME has been one of the most shorted stocks in the market over the last several years, with an extremely simple and common short thesis.

Yet $GME has doubled in the last couple of years (at one point almost quadrupling off its lows), while $BKS (while it had some impressive short term swings) is at the same basic level for the last 5 years.

The biggest difference between the two is what they did with the cash from their cash cow businesses. $GME initiated an $.80 div in 2012 and increased it twice since. They have also repurchased ~$950M worth of shares since 2011.

(Another example is $GRMN, who just hit a 6 year high today. The company’s revenues peaked in 2008 at $3.5B and have declined 25% since. But gross profits and net income have been really stable while the company bought back lots of stock and have a handsome dividend.)

$BKS on the other hand used their cash flow to invest in the Nook.

In the 52 weeks ending 4/28/12 $BKS ex Nook had $440M of EBITDA while Nook lost $262M. The following year $BKS ex Nook did over $487M while Nook lost $480M. If $BKS would have instead taken that money and used it to pay a nice dividend and bought back some stock, I think it’s safe to assume their shares would be trading considerably higher.

$GME currently trades at an Enterprise Value of ~5.25 times their EBITDA. They have a 3.33% dividend yield and still have over $400M remaining on their share buyback plan.

I don’t have any strong opinion on $GME at its current valuation, but now that $BKS’s Board of Directors approved a plan to “rationalize its NOOK business”, the bull case’s path is one that $GME traveled over these last couple of years.

My base case is $BKS cutting Nook EBITDA losses to $35M/quarter. (The last three quarters have averaged $54M in EBITDA losses.) I estimate total company EBITDA to be in the neighborhood of $300M/Year.

Once the company stabilizes the Nook business, I expect them to initiate a substantial dividend and buyback policy. If similar to $GME’s there is no reason the company can’t trade at a similar multiple to $GME which would equate to $26.85 per share.

It would be tremendously accretive if $BKS can succeed in purchasing significant amounts of stock prior to the stock trading up to those multiplies, and in that case I believe we can see the stock trading well into the $30s. ($GME repurchased almost $700M or 25% of their current shares at an average cost of $20-$21 per share back in 2011-2012.)

There are a couple of other possible bull case scenarios, but they have recently become less probable. If the company can sell or spin off Nook Media (which includes their College business) then not only will it not drag the valuation down, it can actually provide cash for the remaining Retail business. Based on my SOTP analysis, such scenarios get me to a minimum of $30 per share.

– Aron

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Barnes & Noble, better off without Nook & Malone.

Understanding both the bull and bear case – the theses of why other investors are positioned the way they are – has to be one of the most crucial principles of investing.

Every so often I read a press release or a headline that on the surface seems bullish/bearish for a specific equity. While it might be true on the margin, understanding what the bulls/bears are looking for might make that specific news relatively meaningless. This enables short term investors to trade and benefit, and even long term investors can “trade around” their core position and profit from this as well.

$BKS is a perfect example. In early February with the stock trading in the low teens, multiple news sources were reporting about how the company was laying off employees in their Nook division. I saw many people commenting on these articles that without the Nook, $BKS will become the next Borders or Blockbuster etc. $BKS’s supposed only shot of survival was their digital business, the future of books.

The reality however: For at least two years now $BKS bulls have wanted the company to wind down, sell, or spin-off the Nook. Why? Check out these two charts.

First let’s look at $BKS as a whole…

Barnes and Noble

Now, let’s see what happens when you take out Nook Media…

Barnes and Noble ex Nook Media

(A couple of points on the second chart. Barnes & Noble ex Nook Media also excludes the ~22% of BKS College that is owned by $MSFT & $PSO through their respective Nook Media stakes. Also, Retail revenues would be lower without the Nook business (as they sell nook devices in their retail channel, the company reports this as “elimination” in their filings), margins however would have actually been higher and the last two years of revenue declines would have been smaller.)

Without a doubt in my mind, this event, which was later confirmed in the company’s 10-Q, that the Board approved the move to “rationalize its NOOK business” on February 3rd – not coincidentally the day the stock bottomed – was not only a not a negative as many highlighted, it actually strengthened the bull case. (The market obviously agreed, and the stock went on a tear, rising 72% in the following month and half.)

Last Thursday, there were more headlines about $BKS. This time about Liberty Media “folding on their $BKS wager” and dropping one of their board seats. The stock fell over 20% in three sessions, as many in the media were saying how $BKS is done – even their largest outside investor (and most probably their wisest – Liberty is controlled by John Malone) is selling etc.

It’s OK to be uninformed,  it’s fine to just state facts, but why opine about the facts and how it relates to the company/stock if you have no clue? Actually, that’s fine too, it’s what makes markets inefficient and creates opportunities for the informed and educated.

Here are Malone’s comments on Liberty’s $BKS investment back in 2011…

“It would be a bit of a flier for us, on whether or not Barnes & Noble can play competitively with the likes of Apple and Amazon in the digital transformation”

On an absolute basis, I would be the first to admit, it’s hard to twist Liberty exiting as a positive, but is it a huge negative like people are saying? No, not in my opinion, and not at all for the upside of the bull case.

The bulk of Malone’s assistance to the bull case was for downside protection. He ensured that Riggio & Co would not do anything stupid or try to buy retail at too steep of a discount. (Liberty’s preferred shares came with veto power on any asset sale.)

Once it became clear that the Nook was winding down, why should he stick around? This wasn’t his style of an investment to begin with.

Having said that, Liberty did well on the deal. Their 185k preferred shares that they sold cost $1,000 each or $185M in total. They were receiving 7.75% in interest annually and they sold them for $1,355. My rough calculation says that’s about a 58% return in a little over two and a half years for a “failed” investment – the Nook optionality did not pan out as planned. Not too shabby.

On the other hand, think about the buyer. This was not a secondary offering where the company or existing shareholders sold these shares to the public. This was a privately negotiated transaction where on the other side someone actually plucked down $250M to buy these preferred shares. Their break even? $23.04 per share. (Each preferred share is convertible into 58.8235 common shares.) It wouldn’t surprise me if Daniel Tisch of the $L fortune was involved. He was the second largest shareholder at 8.4% (adding slightly to his shares according to his last 13G).

From the bear case perspective, the wind down of the Nook was a horrible development. They would rather see the company squander its cash in hopes of battling $AMZN / $AAPL etc. Malone’s exit is a win for them, I’d admit that, but it does not strengthen their long term bear case at all. Bears believe that the company is in a secular decline, where fewer and fewer people will buy physical books, so even the Retail business won’t be able to sustain its profitability. On that front nothing has changed. Malone was never there to milk the retail business.

Bottom line, not every press release, headline, report, or article, even if when isolated and on an absolute basis is actually a positive/negative, it still should not persuade action on its own. Know and understand the bull and bear theses. As investors, data and facts that change those are what really matters.

– Aron

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Uncertainty, another source of leverage.

In my last post on $KING I highlighted why current profitability isn’t necessarily king (pun intended). Today,  I thought I’d follow up and expand on a few points of differentiation between profitable companies and non profitable ones.

First a couple of superficial benefits of being a non profitable company vs. one that’s profitable.

Firstly, companies without profits have PE ratios and other profit multiples that are “NM” or “NA”. This can force investors to look further out to the future and to focus more on the potential of the company. Alternatively, this can also cause investors to focus on alternative metrics, whether it is DAUs / MAUs (daily or monthly active users) or TAM (total addressable market) etc. and focus on those metrics relative to others in an all relative valuation game.

Contrast that with a company that might be barely profitable, now you might have a 50x or 100x P/E ratio or an EV/EBITDA that’s 3 or 4 times that of the market’s, suddenly it’s an expensive company, and now investors can and do focus on FY ’14 or FY ’15 numbers.

A second broad point about non profitable companies is that since their earnings are negative they will report shares outstanding without including stock options or RSUs – even in their diluted numbers. The reason – as @herbgreenberg pointed out here – is that if the company included these options then it would have “spread out” the losses over more shares – hence shrinking the loss per share.

The rub and in this case – the superficial benefit – is that this causes these companies to seem smaller (in Market Cap or Enterprise Value) than they really are.

Contrast this with profitable companies which are forced to include these options and RSUs in their diluted earnings per share – which will show the lower EPS number – because this assumes that option holders will exercise to “get” those earnings and dilute the shares.

While these two points are superficial because investors have to focus on real profitability (even if it means modeling years out) and real diluted market value, I think it does have an effect at least on the margin.

What I really think is happening here, is that investors who are chasing performance especially in “risk-on” environments are bidding up the non profitable names.

These companies typically have higher Betas. Why? Because of the same uncertainty that works against them in “risk-off” times.

As I wrote in the $KING post, uncertainty is bad because it means a higher discount rate. (In the case of $KING – the likelihood of future hits are very uncertain, so that higher discount rate causes lower current fair values for those future expected cash flows.) The uncertainty can however work for these companies valuation as well.

A bond, because its cash flows are certain, no matter how low the discount rate will be – say it somehow has no risks, no uncertainty on timing , no reinvestment risk etc. still, you will never be able to get any higher cash flows than what you are currently expecting. Likewise with those stable and easy to model equities, yes, those cash flows warrant a lower discount rate, hence increasing their current value, but the higher potential upside from higher future cash flows and earnings are a much lower probability.

The higher risk equities however, including many currently unprofitable ones, while they do deserve higher discount rates to discount the current expected cash flows, they do have the benefit of being more likely to achieve even higher cash flows than investors are currently discounting.

Bottom line is, uncertainty is a form of leverage, so when markets are in a “risk-on” mode – investors bid up non profitable companies to use the leverage in their favor. When the markets switch to “risk-off” though, investors run pretty quickly to de-lever from uncertainties.

– Aron

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