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?

$TIVO

 

$BKS: Is Barnes & Noble the next Gamestop?

$BKS

 

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

REIT

 

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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A Discount Rate fit for a KING.

$KING’s IPO yesterday was the worst first day performing IPO in 15 years for a US IPO raising at least $500M (via @IPOtweet)

For value investors and people that believe that equity prices reflect the value of earnings and cash flow of the company discounted back to today, this had to be real concerning.

There were so many huge IPO winners over the last few months, a few triple-digit winners in the biotech space, a few monster technology winners, and many more entering the pipeline. Many of these companies have little profits, if any. Some were subsequently trading at multiples of revenues that would normally be considered fair… if they were multiples of profits.

Then came $KING, with over $500M in FY ’13 profits, and their stock crashes? The stock closed today (the day following the IPO) at less than a $6B market cap and now trades at only 10.6x TTM earnings. Has the whole market gone haywire? (Don’t answer that please.)

DCF Basics. Why Discount Future Cash Flows?

One of the principals of fundamental analysis is called “DCF“ or “Discounted Cash Flow”.

An asset should be worth the money it will pay you over its lifetime. For example, a 5yr – 5% annual bond is straightforward. You know (assuming no credit risks) you will receive a payment annually for the next 5 years, and then at the end of the 5th year, you will receive the last interest payment as well as your principal back. So say you put in $10k, you will receive 5% or $500 each year, and then at the end of the 5th year, you will get the last $500 as well as the “original” $10k.

Now, although you are getting $12,500 in total, you will never pay $12,500 for those cash flows today. That is because there are many risks associated with you receiving those cash flows. There’s credit risk, (will the company / government / municipality have the ability or willingness to pay you) interest rate risk, (the higher interest rates go, bond prices will decline, all else equal,) inflation risk etc. You therefore have to “discount” all the money that you are expected to receive. The rate that you will discount the cash flows is called the “discount rate”. This rate should be comprised of all of the risks associated with receiving the cash flows. So say you want to discount the above cash flows (5yr bond) using a 7% discount rate, you plug it in your faithful BAII and you will get today’s current fair value of the bond… = $9,179.96.

The discount rate is an extremely crucial variable in the equation of finding the fair value of a security. In the above example if you were to change the discount rate to 3%, the current fair value would rise to $10,915.94.

Back to real life, people are currently willing to pay over 30x cash flow for certain investments (a 10 year Treasury bond), yet are unwilling to to pay less than 5x FCF for others.

The Treasury bond’s cash flows are guaranteed to come to you, you’ll get the interest payment every 6 months for the next 10 years, and you also know that the principal at the end will stay constant. So you only have to discount that money coming back to you for interest rate risk and inflation risk, but not for the risk that the cash won’t be there.

I recently read someone questioning why $AAPL has lower multiples than $MSFT. It actually makes a lot of sense. Even when you include the ecosystem $AAPL has built, $MSFT’s business is still way more predictable and certain.

Back to $KING, their profitability is undeniable. Their future profitability is what’s being question here. I believe they deserve a king’s size discount rate.

As a value investor – since it’s all about discounting future cash flows – many times a non-profitable company might actually be worth more than a currently profitable one.

If a company is currently non-profitable because they are investing in their business and building competitive advantages, a moat, barriers to entry etc. then their future earning – because of these current investments – are actually more reliable and predictable. This causes investors to discount these future expected earnings by a lower discount rate.

$KING on the other hand is in the business of creating hit games. 78% of  2013 Q4′s gross bookings came from a single hit game (Candy Crush)! Add their second and third highest grossing games and you accounted for 95% of the companies Q4 gross bookings!

Look at $ZNGA and their Farmville franchise, look at OMGPOP and their Draw Something game which $ZNGA paid $183M for only to shut it down a little over a year later.

(I owned $ZNGA in the past, we began to recommend it to clients when it was trading at a tiny premium to their cash and RE value. We were paying almost nothing for their “hit” potentials, so it had tons of optionality with little downside risk from a margin of safety perspective.)

Make no mistake, this is a fickle hit driven business! How can anybody with any kind of certainty, conviction, or even a high level of probability predict what $KING will earn in 2 or 3 years, let alone 5 or 10?!

Off the top of my head, I can’t think of any other business / business model that builds so little in regards to protecting its future.

Even $FB – who crushed MySpace, the then overwhelming leader, who supposedly had built a moat via its network – even they have created a real entrenched business. I would wager that a majority of all websites have code written into their sites with Facebook in mind.

Looking at content creators (movies, shows etc) at least have relationships with writers, actors, production sets, equipment etc. not anybody off the street can come in and start producing quality movies.

From $KING’s F-1: “We face significant competition, there are low barriers to entry in the digital gaming industry, and competition is intense.”

The only game I’ve been hearing about the last few days is this 2048 game that was written by a 19 year old just a few weeks ago! A few months ago it was all about Flappy Bird, a game that was created over a span of just two to three days by a single developer! There are absolutely no barriers to entry, no start up costs, no patents, nothing.

Will $KING stay profitable? Very possibly. They are investing so much more money than their competitors so it’s so much more likely they will have at least a few hits each year. Will these hits be the size of Candy Crush? I doubt it.

If the past is any indication, it’s just a matter of time before gamers churn away from Candy Crush and $KING’s MAUs fall off a cliff along with 78% of the company’s revenues.

- Aron

Posted in Micro | Tagged , , , , , , | 4 Comments

Know the Why.

When it comes to investing, “the only constant is change”.

When I was studying for my CFA exams (2007, 2008, & 2009), I used some videos from Kaplan’s Schweser. Some of their instructors would recommend using memorization in some of the subjects covered (specifically in Quant, Swaps, & some FSA). I found this to be a huge waste of time. When memorizing something, you’ll “know” that one thing – the end result, and while it might help you pass an exam, that’s about as useful as it gets.

Alternatively, if you analyze & understand what drives any given conclusion, why things are the way they are, and how they make sense etc. then even if one (or more) of the variables in the equation change, you’re not thrown off because you actually understand the concept.

When I was studying in Yeshiva, I mostly studied the Talmud (or Gemara). The Talmud is not like the Jewish Code of Law, where you learn about the actual laws and customs for each day etc. The Talmud is the epitome of analysis.

From Wikipedia:
“Much of the Gemara consists of legal analysis. The starting point for the analysis is usually a legal statement found in a Mishnah. The statement is then analyzed and compared with other statements used in different approaches to Biblical exegesis in rabbinic Judaism (or – simpler – interpretation of text in Torah study) exchanges between two (frequently anonymous and sometimes metaphorical) disputants, termed the makshan (questioner) and tartzan (answerer). Another important function of Gemara is to identify the correct Biblical basis for a given law presented in the Mishnah and the logical process connecting one with the other: this activity was known as talmud long before the existence of the “Talmud” as a text.”

Either way, this helped formulate my passion for analysis and my drive to always understand “the Why”. Memorizing or just listening to what supposed to be done isn’t enough. Something will change – it always does, and if you only know what to do in that exact scenario, you are left without the ability to adapt to any changes.

When I create an IPS (Investment Policy Statement) for a client, it is based on current conditions. One of the most crucial parts of any IPS, is updating it as the client’s risks and/or objectives change, whether it is because of volatility in the markets or because of changes in their own individual circumstances.

The same is true when I build a portfolio allocation for a client, it is essential to know why we are holding what we’re holding, so that when the circumstances change, we can easily adjust the portfolio to reflect those new factors.

This is equally important when it comes to selecting and investing in individual equities. Numbers change. Fundamental change.

A perfect example is $YHOO. Most $YHOO longs over the last couple of years are/were long for the Alibaba Group exposure. Check out the correlation between $YHOO and $SFTBY over the last three years:

$YHOO $SFTBY 3yr chart

Since September of 2012 when $YHOO sold half of their Alibaba stake at a ~$40B valuation, the reported / speculated Alibaba valuation has skyrocketed, so have these two “tracking stocks”.

The key is, once Alibaba does go public, in which $YHOO will be forced to sell 40% of their remaining stake, who is going to purchase $YHOO? People that want Alibaba exposure can buy it directly. (See $GSVC after both $FB and $TWTR IPOs)

Know why things are happening, know why you own what you own, so that when things change, you can adapt accordingly.

- Aron

Posted in General | Tagged , , , , , | 2 Comments

Welcome to MicroFundy.com!

MicroFundy.com is a Blog on Micro Fundamental Analysis.

I intend to use this platform to share some of my thoughts on specific company fundamentals. Some of the time I will focus on trends in specific company metrics - Margins, EBITDA, Cash Flows etc. Other times I will try to analyze the overall value of a company based on the company’s Balance Sheet, Business Units etc.

There are many inefficiencies in our markets. I feel that by getting to understand a company from the inside and knowing both the Bull and Bear case, this enables investors to take advantage of opportunities when they arise.

I definitely have a value approach when it comes to investing. I like to focus on Risk from a “Margin of Safety” perspective, and typically forgo the extreme upside for better risk/reward ideas.

If you have followed in the past, thanks! and do not expect much to change. If you are new, please feel free to provide feedback, comment on posts, follow me on twitter, and/or subscribe to the blog.

- Aron

Posted in General | 3 Comments