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

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

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

Posted in General | Tagged , , | 1 Comment

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