Spirit AeroSystems – Too Hated?

The aerospace supply chain is decimated. Everything has stopped. Airline fleets are parked, Boeing and Airbus have dramatically reduced production schedules, and uncertainty is high.

Spirit AeroSystems has been particularly hard hit. The company supplies 70% of the structure on the 737 Max, which represents ~50% of the company’s revenue. Critically, the company is absolutely integral to Boeing’s supply chain. Therefore, Boeing supports the company when needed. This is important because it indicates that Spirit isn’t Boeing’s whipping boy and there is a symbiotic relationship.

Here is Tom Gentile, Spirit’s CEO, discussing the company’s current problems at the Morgan Stanley Virtual 8th Annual Laguna Conference:

“Our biggest program is the 737 MAX. We’re proud partner on the MAX, but obviously
that’s been a difficult situation. We make 70% of the structure on MAX, and historically
represents 50% of our revenue. So when that got grounded last year, after the second tragic crash, it was very difficult situation for Spirit. Boeing suspended deliveries at that
time, but we kept producing at 52 aircraft per month, until in December, Boeing actually
stopped production. At that point, we faced at Spirit, a very significant challenge, because
it did represent half of our revenue. So, we negotiated a new record with Boeing at 216
aircraft for 2020. Which was about a 60% reduction.

Then when the pandemic hit, obviously that was another challenge, and we renegotiated down yet again to 125 aircraft. In June we agreed a third production change with Boeing at 72 aircraft for 2020. But the pandemic also impacted widebody production, particularly because of international travel, and so the 87 program is gone from 14 aircraft per month, It will be 6 next year and 777 is gone from 5 aircraft per month last year, to two next year. And of course, this is not just Boeing, Airbus is also impacted and they’ve reduced their
production by 40%. So, the combination all of the production I guess and cuts really
impacted Spirit.

In the first quarter, our revenue was down 50%, in the second quarter, it was down 68% and we’ve earned a lot of cash from both of those quarters, particularly since some of the working capital, the inventory was already on order and we couldn’t turn it off fast enough, so it accumulated. It will burn off in the future, but with production rate slow right now, it’s burning off less fast.”

So much for an aerospace “super cycle!” Surely the market remained rational and realized this is a “temporary” problem. Surely the market valued Spirit on a long term basis because rates are so low. Right? Wrong!

There is no doubt that Spirit Aerosystems common equity was impaired by the pandemic. Depending on the assumptions, it’s pretty easy to see how the equity was impaired by 40-60%. That said, $2.1Bn is 27.6% of $7.6Bn (perhaps implying this equity price overshot it’s impaired value).

Moreover, it’s possible the world changed forever and pandemics will occur regularly. If that’s the case the impairment may be justified. In fact, the equity may be worthless. However, if 2020 is a unique case it’s possible the period from 2009 to 2019 is a more appropriate time period to determine “normalized” cash flows. Over that time period, Spirit generated an average of $236.6mm of free cash flow.

The current equity is valued at $2.1Bn. If 2009-2019 is a reasonable proxy for normalized cash flows the free cash flow to equity yield now exceeds 11%. In 2017 the outlook was rosy. At that time the common equity traded for almost $10.0Bn. While that valuation may have been egregious, it shows how excited market participants once were about this entity. At $2.1Bn, market participants might be just a little too negative on this entity.

Therefore, this could be worth a research project for anyone looking for a reasonably priced common equity.

Disclosure: SCG recently established a small position in the common equity of this entity.

Qurate Retail Group


2020 has been an interesting year. In a time of many unexpecteds, this may take the cake. Sullimar Capital Group decided to acquire a minority interest in Qurate Retail Group (hereafter “Qurate”); the entity that owns QVC and HSN. Yes, you read that correctly.

Tech stocks are racing. The world is moving to the future. Our accountant is even commenting about all the money to be made in the stock market. And our path to wealth rests on QVC & HSN; both tied to a legacy TV distribution machine. Meanwhile, people are “cutting the cord” en masse. Given my recent pronouncements that I would focus on quality businesses with the potential to grow, communication is warranted.

Summary of Conclusion:

We purchased a minority interest in Qurate Retail Group because:

  • This is one of the most habit forming retail businesses we’ve ever seen.
  • There is a complex financial transaction that will make the common equity simply too cheap on a proforma basis. Proforma equity, while highly leveraged, will trade at 3-5x free cash flow available to common equity. The leverage is a concern, but this business will be able to service its debt obligations going forward. Further, the recent refinancing of the notes due 2022 is evidence that the 2023 notes will also be able to be refinanced. That mitigates some of the near term concern for free cash flow uses.
  • Qurate Retail Group has a capital allocation dream team. Greg Maffei controls the capital allocation. He is one of the best capital allocators alive and this financial transaction is the most shareholder friendly move we’ve ever seen.
  • Analysts that cover Qurate Retail Group point to a lack of buybacks as evidence that Dr. John Malone, the controlling equity owner, doesn’t believe in the entity. Those analysts are misinterpreting the current situation.
  • The entity has an incredibly resilient, and adaptable, business model.
  • This business is cheap, misunderstood, and carries a fair amount of leverage. Moreover, even investors that understand the business are afraid of the stock because they’ve been burned over the past 3 years. If we are remotely correct in our analysis our downside is very limited and we have a decent chance to make very satisfactory return.
  • The entire thesis rests on the stickiness of the business. This business has users that absolutely love the product. They use it as habitually as many consumers use far more well known brands. The issue here is the user base is generally women, aged 50 and older. They are the retail equivalent of Fly Over Country. Thus, Wall St. ignores them.
  • The market is worried about Qurate’s terminal value. At this valuation, that question is not the primary concern for entering shareholders. If this business is stable entering shareholders will do just fine. And, it is stable. Importantly, the financial transaction referenced above is evidence that EVEN IF Qurate is an ice cube, Greg Maffei, the man who controls Qurate’s capital allocation, will return capital to shareholders. Therefore, the potential for large losses is mitigated.
  • This is a low downside, high upside bet. The market thinks it is the opposite. And that’s exactly why the odds offered are so attractive.

Risks And Mitigants

  • Primary Risk – Leverage creates a fragile financial position under a business that is, at a minimum, not currently growing. Future cash flows have to be diverted to debt paydown and free cash flow available to common equity is minimal. This scenario would extend the investment duration into an uncertain (at best) future. This risk is mitigated by the:
    • Quality of existing customer relationships, especially among best customers. Even if the business did not grow going forward, these customers’s habits put a floor under how poorly the existing business can perform.
    • Debt market’s insatiable appetite for yield. Qurate recently refinanced it’s debt maturities due in 2022. According to trusted colleagues, the appetite is there to refinance the 2023 notes as well. However, the timing is not ideal because the notes trade at a premium to par and the underlying business is sound. Qurate will refinance at the right time.
    • Greg Maffei controls the capital allocation and knows what he is doing.
  • Secondary Risk – Qurate is disintermediated. In the short to medium term this risk is overstated. Qurate needs to navigate a shift to online. As of today, that migration is beginning but leaves a lot to be desired. Nevertheless, the company has an intimate relationship with its best customers and has continued to demonstrate an ability to acquire new customers with reasonably good economic characteristics. Further, Amazon tried, and failed, to recreate the Qurate experience. Long term, this is a risk to watch but the immediate threat is minimal.
  • Tertiary Risk – Qurate is a “melting ice cube.” This risk is mitigated by an objective analysis of the data as of today. More importantly, Greg Maffei controls Qurate’s capital allocation. He and his team just announced a financial transaction that strongly indicates they will get our money back to us if Qurate, is indeed, a melting ice cube.

Investment Case:

Who Qurate Serves

Qurate Retail Group’s 2018 and 2019 10-Ks claim 55% and 44%, respectively, of the company’s customers were women aged 35-64. Reports, though dated, suggest the average customer is ~50 years old. https://digiday.com/marketing/nrfdigitalsummit2015-how-qvc-got-its-customers-to-shop-on-mobile-and-tablet/#:~:text=QVC’s%20core%20customer%20group%20ranges,age%20clocking%20in%20at%2050. Based on what the 10-Ks don’t say, it’s probably fair to guess somewhere around 40% of customers at any given time are women older than 64.

Many people perceive the QVC customer to be somewhat unsophisticated. According to the slide below, she is far from an unsophisticated consumer:

Image used to demonstrate customer sophistication.
Source: 2018 Investor Presentation

At the May 22, 2018, investor day, Mike George, Qurate’s CEO, described the Qurate customer as “above average income, above average household wealth, [she has a] very engaged life….[she is] more likely to be involved with [her] community, church, hobbies; [she’s] just a very engaged person. And not surprisingly, she’s an avid shopper.” See Bloomberg (hereafter “BBG”) transcript of May 2022 Investor Day @ page 7.

Shows consistency of customer behavior
Source: 2018 Investor Presentation

Her relationship is deep and predictable. She consistently returns to watch her favorite hosts. The existing customer data in the slide below gives a sense of the overall stickiness of the customer base.

Image shows importance of existing customers
Source: 2019 Investor Presentation

Qurate does not employ a hard sell strategy; though it does use typical sales tactics to create the pressure to buy. The company’s strategy is to provide her with video entertainment in order to help her discover useful products she didn’t know she needed. By doing so, Qurate adds value to her life by sifting through all the potential options and delivering suggestions to her. And, she appreciates that service. Which is why she returns.

She is likely at a time in her life where she has more disposable income, more time, and enjoys looking for

  • ways to improve her home,
  • gifts to her children/grandchildren, and
  • unique products and deals that make her feel good.

The hosts at Qurate offer her suggestions for how to solve those needs.

Yes, the slide above shows pretty poor conversion from new customers to retained and existing customers. While improved conversion would be very nice, this business doesn’t require strong conversion. Instead, the business requires converting 33,000 of 2,300,000 of new customers (1.5% of total funnel) into best customers. Then it requires retention of these best customers.

Simply put, Qurate’s super users are addicted to the retailer. As of 9/30/19, this population was 17% of Qurate’s user base and accounted for 70% of trialing 12 month (“TTM”) sales. They watch the company’s content regularly and are by far Qurate’s most important customers.

Super user habits drive the business outcomes
Source: 2019 Investor Presentation; NOTE the bottom right of this slide showing conversion from new to best.

It can not be overstated how habit forming 33 web visits per month and 18 visits to a QVC TV property per month are. Is that Facebook, Apple, or Google type habit formation? Clearly not. But it’s not too far off from Starbucks habit formation. And that says something.

As of today:

  • The transition from new to best customer is remarkably stable.
  • Super fans are retained at 99% through 9/30/19, and 97% through 6/30/20. There may be seasonal changes that drive the 2% difference. We will be watching these retention numbers like a hawk. If they change meaningfully then we are wrong.

The reactivated part of the sales/lead generation funnel acts much like new customers (although almost certainly at a lower cost per sale). It may sound odd, but those customers really aren’t all that important to the business. The key to this business is super fan interaction.

The Current Funnel of Customers Is Healthy

Qurate’s legacy lead generation funnel is dependent upon television distribution. Qurate gets distribution by paying cable distributors a commission on sales. Some agreements have commission guarantees. These guarantees are applicable when television operators make concessions such as:

  • committing to deliver a number of subscribers,
  • giving enhanced channel placement, and
  • promising QVC advertising slots.

Generally speaking, QVC’s distribution costs are variable. In this way, Qurate aligns incentives with video distributors. This strategy helped them gain desirable channel placement when bundles exploded with options. Today, they are offering similar win/win solutions in order to help secure distribution with the new video providers.

There’s a credible argument that Qurate’s customer funnel is still tied to the bundle. The current iteration of the business has ~2/3 of customers coming organically and 1/3 coming from performance marketing. Needless to say, the legacy TV bundle is not something with a positive long term outlook. However, it’s unlikely that the cable bundle unravels over the next 5 years. Given the valuation, that’s all we need to avoid a bad outcome (assuming Super User retention is stable).

The common equity is so “cheap” because there is a lot of debt on the balance sheet and the market is fearful that Qurate’s legacy distribution advantage is eroding under its feet. It’s important to note the debt maturities are well spread out and manageable. See the distribution below:

Debt distribution is well engineered
Source: Bloomberg. Note – the orange line represents debt expiring in the last 2060s.

Despite the structure of the debt, the market is wary Qurate can service it’s obligations. Further concerning the market, the company’s performance since the HSN integration has fallen short of expectations. QVC acquired HSN in 2017 despite horrible customer attrition at HSN. In our view, Qurate underestimated the problems at HSN and paid too much. In investing parlance, HSN was a value trap.

As if that wasn’t bad enough, Zulily, once considered the future, saw sales decline in every quarter of 2019; resulting in a $1+Bn impairment. Qurate argues these trends are turning; but it did it’s best to serve Mr. Market a healthy dose of confirmation bias. Qurate’s management team points to a healthy customer funnel to rebuke the market’s assessment.

Customers "beginning" to trend younger.  Will that translate to a brighter future? TBD.
Source: 2019 Investor Presentation

It should be noted that the slide above doesn’t tell us much about the current customer make up. Notice how the “overindexing” applies to new customers. It would be more useful to see current customer distribution. From this, all we can really infer is ~22% (2.3mm new customers out of 10.6mm total customers in 2019) of the customer base is getting younger. This is a bit of a blessing and a curse. On one hand, younger customers have longer customer lives. On the other hand, they are arguably less sticky. Time will tell how they season.

An anecdote further provides some comfort on the quality of the new cohort. According to an expert, interviewed on the Stream platform:

“…[Qurate] is constantly experimenting…they will find ways to continue to be relevant to the audience. It’s interesting because over time, many pundits have said, ‘well, what’s going to happen when all your customers die?’ Well, the interesting thing is that the average age of new customers has never been younger and the average demographic of the customer base hasn’t aged a year...it’s starting to get slightly younger because the business is able to constantly generate a very, very large number of new customers and then get them to behave…largely as older classes of cohorts…have behaved.”

Let’s assume the average customer is closer to 55 rather than the 50 year old number cited earlier. She still has at least 20 years of consumption in front of her. Yes, today’s 55 year old woman is probably more likely to comparison shop than the typical QVC customer was. QVC is trying to combat this pressure with improved merchandising. We think this comment from the QVC message board (discussing whether people price shop QVC) is close to today’s Qurate customer’s “truth:”

“I can be a little picky about what I buy as far as size, color, fabrication etc etc so when I find my exact item, I then don’t spend time with price comparison. I shop mostly outlets. But if I find something I really want on Q, I’ll buy.”

While the cable bundle may unravel over the next 20 years, there is a reasonable possibility Qurate is able to pivot. For instance, skinny bundles would help Qurate immensely. The Roku app is showing signs of promise; though not enough to satisfy the market. But, given the behavior of Qurate’s customers, the probability of a near term unraveling of the customer base is very low. Therefore, Qurate has time to introduce her to its new technologies while she visits her favorite hosts.

Note: Mike George cited the average customer relationship as 35 years at the May 2018 Investor Day. See BBG transcript; 2018 Investor Day; @ pg 7). 35 years feels high but demonstrates the stickiness of the relationship. It is our view that Wall Street overlooks this customer base because it isn’t sexy. These 33,000 women per year are the retail equivalent of Fly Over Country. We are happy to partner with a company serving them.

What About The Future

The issue on everyone’s mind is whether Qurate can (a) continue to acquire customers and (b) pivot to the future. In a world that’s ever changing perhaps it’s just better to look at what is happening rather be definitive about what may. To that end, customers have come into Qurate’s funnel in the recent past:

Lead funnel is consistent
Source: 2018 Investor Presentation

But isn’t Qurate dependent upon the bundle to deliver new leads? In the short term, yes, Qurate depends on the bundle. Over the long term, the picture is less clear.

The most obvious question to ask is whether Facebook and Amazon can disintermediate Qurate. Isn’t the world moving to a world where influencers aggregate attention and link to products? Won’t they simply displace the need for Qurate? Moreover, isn’t Amazon the place to go to purchase everything? Why does Qurate need to exist?

Qurate needs to exist, for a small percentage of the population, because they love it. And, within the niche customers, they don’t want to leave. According to the same Stream interview cited above:

“What’s absolutely impressive to me, as somebody that’s been inside the business, is the parity of customer metrics across market[s]. The average age swings a little bit…but it’s relatively tight. But as far as the customer loyalty metrics and average number of units purchased…its just amazing to see how constant those numbers are across markets...It’s just one of those things in the model and how QVC operates to build that customer loyalty and takes a customer-centric view…[that] engenders great loyalty once they decide that QVC is a place they enjoy spending time with. A retailer they enjoy spending time with in discovering great products, new products, new inventions, and really spending time with. Interestingly enough, the customer views QVC as a part of their family.”

Think about that. Part of her family. Last time I checked a family can have more than one member in it.

In fact, one could argue Qurate will be even more important to her as her attention becomes even more disaggregated. Qurate’s average customer already shops at Amazon. She goes there when she knows what she wants. But, she is also smart enough to know that Amazon is The Everything Store. Sometimes “Everything” takes way too much mental effort to siphon through. Sometimes she just wants to be entertained and discover something.

She also goes to Facebook’s properties. But again, she is bombarded with choice. She is intelligent enough to know that an influencer will sell anything. And, while she may buy things from influencers, like with Amazon, she still enjoys frequenting her trusted “family” at a virtual department store/entertainment experience. This habit occasionally results in a $50 purchase.

Importantly, that $50 purchase can come with an installment plan priced at 0% interest. So, she can burn some time, peruse some items, feel a connection, be entertained, and part with a mere $10 today. Note – Qurate sends the product as soon as the first installment is made. Some customers refer to the plan a layaway without the wait.

Will she buy more on the internet in the future? Undoubtedly. Does that mean she will stop using Qurate? Doubtful.

It’s noteworthy that Amazon attempted to recreate Qurate and failed. Amzon’s attempt, called Style Code, was a daily online show. Interestingly, the “channel” used celebrities and influencers to aggregate attention. But, it seems as though recreating a home shopping network may be harder than it is in theory. See https://econsultancy.com/why-did-amazon-s-online-video-shopping-channel-fail/. Might Qurate be a strategic asset for Amazon one day? Stranger things have happened.

Facebook May Even Be an Opportunity

Let’s take a step back for a moment. As stated above, Qurate is looking to convert ~33,000 people every year into best customers. As of today the conversion ratio is a paltry 1.5% of new customers. What if Facebook and Google improve the customer funnel and help Qurate increase conversion?

Potential conversion ratios

It’s impossible to predict where the ultimate conversion factors end up. Thus, it’s hard to know how many leads will be needed in order to generate the necessary annual super fan cohort. But, it’s also impossible to deny that the consensus opinion is Facebook, Google, and Roku are going to help deliver targeted, measurable results.

Mike George highlighted Qurate’s performance marketing strategy in the 2019 Investor Day.

Performance marketing is more of a focus

Market participants don’t seem to care very much about this slide. They are focused on the legacy bundle distribution. But if Mike George isn’t outright lying when he repeats, over and over again, that Qurate is able to target these cohorts with a payback period of only 1 year, then this could be quite an opportunity for them. That said, the size of the opportunity may be inherently limited by the niche nature of Qurate’s offering.

Mike George’s answer on the 2q19 earnings call acknowledges how niche his offering is: “I guess a pretty tight set of return metrics to that [performance marketing] spend, has to kind of pay back within a year and we are focused on sort of needle in the haystack of how do we find customers that could become really great core QVC customers as opposed to one and done…There are pockets of these digital customers, especially those who come in on more engagement platforms like social media, media marketing that are coming into the ecosystem and becoming pretty high value pretty high frequency customers right away.”

To be clear, changing the top of the funnel will add additional variable cost to the business as Qurate has to compete for eyeballs. However, it’s plausible that performance marketing ultimately enables a higher quality customer to enter the funnel. At this valuation we don’t need much to go right to make a satisfactory return. We do, however, need cohort stability.

The Future of Distribution

Qurate knows it is going to have to pivot the business over time. For now, the business appears to be making progress on its eventual pivot:

Engagement increased despite customer attrition concerns
Source: 2019 Investor Presentation

According to the slide above, 2.5 million Roku installations resulted in 480 million hours streamed; or 200 hours/install. It’s unlikely that all users stream equally. Therefore, it stands to reason at least some super users have turned to Roku. Moreover, COVID accelerated installations. As of August, Qurate announced they had a total of 3.6 million Roku installations. That’s 50% ytd growth on an OTT platform! Given how this business works, dismissing those installs as a transitory benefit is a mistake.

The following claim is unbelievable. It simply can’t be true. But it’s also way too important to leave out of a writeup. A different interview on the Stream platform contains the following statement:

“QVC…has got to be entertaining. It’s got to be able to bring the viewer back again and again. Mike once said to investors, it’s a hundred hours of viewing before somebody makes their first purchase. How many websites are you willing to sit on for 100 hours before you buy their product?” Emphasis added.

The idea that someone is actively watching QVC for 100 hours before a purchase is simply unfathomable. But, it’s likely that QVC is running in the background while she is at home. And if that’s the case, QVC is a part of the customer’s life. So, while we agree customers have had more time at home, we reject the premise that COVID is some one time bump. Quite the contrary, COVID was the catalyst to introduce a larger cohort into a life long relationship. That is, unless human behavior changes going forward, which is unlikely given the amount of data supporting habit formation and inertia.

Importantly, when these new cohorts come to Qurate, they are more likely to make a purchase on a digital platform. 81% of customers now purchase via e-commerce. See BBG transcript; May 2018 Investor Day; @ 7). That is (a) an incrementally positive sign and (b) probably a function of the current cohort of 50+ women being more and more comfortable with internet purchases. This is critical because Omni-channel customers spend far more than Digital and Traditional customers.

Habits of users

Over time, the business should continue to trend towards digital, but it will probably take longer than Mr. Market would prefer. Especially since ~32% of sales are still completed via telephone.

A Glaring Wart in The Business

It’s very important to be honest and acknowledge how atrocious HSN’s social media presence is. The only kind words to say about HSN is they partnered with Guiliana Rancic. That’s something, but not much. On average, their hosts have a mere 12,335 followers on Facebook and that is heavily skewed by Colleen Lopez. Take her out and they have an average of only 6,247. Instagram is even worse since Colleen doesn’t have much of a presence on The Gram.

By contrast, QVC hosts average 71,384 followers on Facebook. 4 of them have in excess of 100,000 followers. Moreover, QVC has relationships with Martha Stewart, Rachael Ray, RuPaul, and others. While they may not be the influencers to millennials, those people matter in the attention aggregation game.

This should have been a MUCH greater focus for the company already. That said, Qurate has been dealing with digesting a very complex integration with HSN. QxH, the division that houses QVC and HSN, reorganized recently and hired Leslie Ferraro as its group President in September of 2019. She has an impressive resume (below) but it’s unclear (a) why she left Disney and (b) whether her experience will enable her to execute Qurate’s pivot to the future.

CV of QxH President

Going forward we would really like to see Qurate fully lean in on social. We honestly believe Qurate could be the shopping method of the future. The business’ core competence is screen based sales. It gives entreprenuers an incredible distribution platform at a time when they are otherwise playing an ecommerce game that results in minimal return.

There is no reason why Qurate, with its rabid fan base, should not have a robust online community that acts as a meeting place. But, it must become a top priority. Thus far, Qurate looks to be moving too slow in that realm. It’s possible Qurate’s focus on profitability today will preclude the company from a true pivot to tomorrow. That outcome would not be ideal, but would also limit our downside in this investment IF our assessment of cohort strength is accurate.

2019: A Year To Forget

2019 was a bad year for Qurate. There’s no two ways about it. That said, throughout the year Mike George was candid about the issues the business faced.

In 1q19 Mr. George commented about the HSN integration taking focus off the merchandising teams. He also mentioned beauty weakness, which is something to monitor going forward. Critically, engagement on the QxH platform increased 4% in 1q19. Thus, customers stayed engaged. That will forever be the most important metric we look at because at its core this is an investment based on habit.

In 1q19 operational difficulties and pullbacks on promotion slowed sales. Large merger integrations are very, very difficult. This one is no different. Therefore, as long as customer engagement is increasing, short term business results are of limited concern.

2q19 was solid but 3q19 saw more problems. In 3q19 Mr. George walked through product mix issues and highlighted the closure of an HSN product line. He also mentioned a concerning 3% customer attrition rate. However, as shown above, new and reactivated customers are not this business’ engine. They are important to feed people into the best customer funnel, but losing some moderately interested consumers is not the end of the world.

To reiterate, the key here is determining whether the super fans are leaving. Losing 3% of “window shopping” customers is not good, but it isn’t horrible either. While customer count did decline, through TTM 9/30/19 Qurate saw increases of:

  • 7% in TV viewership,
  • 105% in digital livestream sessions, and a
  • 30% increase in HSN digital livestream sessions.

Thus, it stands to reason that the quality of Qurate’s customer base actually improved in 2019. But, it is odd that improvement didn’t result in higher sales despite the industry headwinds. The market doesn’t need much to spook on Qurate retail’s stock. 2019 gave it plenty of reasons to do so.

The COVID Bump – A Sustainable Boost

Fast forward to COVID-19 and Qurate is benefiting immensely. Why? Because people are stuck and home and have to watch TV. They can’t go anywhere so they are discovering Qurate en masse. Yet, the market discounts this as well. Sure, ecommerce is growing but that’s because people have no other option!

But here’s the thing, Qurate has actively avoided getting into price matching. Why? Because they are playing the long game and looking to cultivate strong, long term, super fan customer relationships. COVID enabled them to have more chances to convert women into super fans.

Total active users increased 14% at QxH. That’s ~5mm customers. Apply the 1.5% conversion factor to that number and you have 2+ years of super fan growth today. On the 2q20 conference call Mike George indicated the COVID cohort is behaving exactly as expected. That’s big news.

Even more impressive, the customers piled in despite Qurate pulling back on offering Easy Pay (the payment installment plan) in order to manage bad debt risk. To be clear, they still offer Easy Pay on all items but they were more stringent about who they extended the terms to. People that are dismissing this as just another ecommerce company benefiting from COVID are not deeply thinking about the relationships being built.

Qurate also demonstrated the model’s merchandising adaptability. They were able to quickly pivot and showcase items that were relevant to her. They ditched apparel, beauty, and jewelry programming and aired home, home office, and leisurewear programming instead. Thus, the pandemic provided a huge opportunity for Qurate to prove they put her needs first. Especially when it mattered most. It’s hard to dismiss that as a transitory benefit.

The pandemic also provided management with an opportunity to showcase prudent operations. They were cautious with their buying and managed supply chain complexity. That was no easy feat given how fast everything was changing.

Two Glaring Capital Allocation Questions

Qurate Retail Group acquired 100% HSN and Zulily to bolster scale, offerings, and tech competence. Neither acquisition has been a good one thus far. Strategic rationales at the time included increased scale for the HSN acquisition (TBD on synergies) and differentiated core competence at Zulily (recently written down).

Regardless of the Zulily outcome, it’s important to note that Qurate was attempting to pivot into a new, forward looking, business line. While bears may argue the failure (as of now) is evidence of a classic incumbent mistake, the effort is at least evidence that Qurate understands where the puck may be going. It would be easy for most public management teams to milk today’s cash cow and avoid tangential, riskier, business propositions.

The “why’s” behind Qurate’s missteps differ:

  • HSN – It’s still too early to call the HSN acquisition a failure since the business is not fully integrated into Qurate’s supply chain. That said, HSN had major customer declines at the same time Mr. Maffei cited valuation as a reason to make the acquisition. There is a real case to be made that Qurate purchased a value trap (bears would argue that’s exactly what we are purchasing today).

    Regardless, the objective truth here is QVC and HSN merging is not an easy integration. As of today, projected synergies are $400mm annually. If those are realized, the proforma market cap is < 10x incremental synergies. Meanwhile, Qurate is incurring integration costs, which are depressing current cash flows while the market doubts it’s future. That fact pattern on a leveraged capital structure equals multiple implosion.
  • Zulily – Zulily may not fit within Qurate. While this might be hindsight speaking, it was also somewhat foreseeable. Fundamentally, Qurate is a relationship driven business. Zulily, on the other hand, is more transactional because it drives behavior through promotion. Promotion is inherently price sensitive and less sticky. Thus, it’s plausible Zuilily was a big swing and miss; evidenced by Qurate’s $1.0Bn 2019 Zulily impairment.

    On the other hand, the acquisition did add some important technical expertise. Further, the Zulily team brought an innovative eCommerce ethos into Qurate. Going forward, Zulily has a pretty impressive new management team and has refocused it’s marketing efforts. So, maybe Zulily can turn around and the impairment was overly conservative. Regardless, as long as Zulily doesn’t drain cash flow that acquisition won’t matter at this market capitalization.

Capital Returns

Many analysts point to Qurate pausing it’s buyback as evidence that Dr. John Malone and Greg Maffei don’t believe in the entity. I have a very different view. If you’d like to see a management team that believed in the entity way too much look no further than Bed Bath and Beyond.

From 2012-2017 Bed Bath and Beyond repurchased ~$7.0Bn of stock. The current market capitalization is $1.6Bn. Look at the market capitalizations of Bed Bath and Beyond throughout that buyback:

Bed Bath and Beyond destroyed shareholder value.

Above is an example of completely atrocious capital allocation on behalf of minority shareholders. Yes, there is some Monday Morning Quarterbacking in that statement. That said, it wasn’t hard to see Bed Bath and Beyond lighting minority shareholder capital aflame for at least some of that time period.

On the other hand, think about what Greg Maffei has done within Qurate over the past 18 months. Mr. Maffei talked candidly about the business uncertainty and capital return decisions over this period:

  • “We’re going to hold off or be timid at least for a period, [on share repurchases], and try and gain visibility and certainty around the success of [investments in the QxH integration, reassessment of fulfillment centers, and internal purchasing departments] and the ongoing direction before we lean in on some of these things like share repurchase...I think we favor the public, one keeping them as our partners and leading them with share repurchases. As you have noted, we have large free cash flow, we have balance sheet capacity. So the opportunity to do share purchase when we see visibility and confidence in the results is there.” See 1q19 Earnings call.
  • “The reality is that our power is that TV channel…those traditional customers, we’ve probably had less viewership reduction than many might think. Cord-cutting is less relevant to our customers…[which] is not to say we don’t suffer from it, but [our customer base is less impacted]. Nonetheless finding growth in that environment is not easy.” -MoffettNathanson 6th Annual Media & Communications Summit; May 2019. Note – Mr. Maffei was likely referring to gross viewers since engagement has actually increased according to the 2019 Investor Presentation.
  • In 2q19 Mr. Maffei said “We are going to be opportunistic on our share buybacks, we had increasing confidence during some of the results of the quarter as Mike and Jeff outlined and I would note there was a substantial pull back in the share price during the quarter, which made the share repurchase a more attractive option.” See 2q19 Earnings Call. Note – The average purchase price in this quarter was $12.94.
  • “We have been tried to be consistent over the last several quarters with the view that our capital allocation philosophy, which has been primarily focused on share repurchase over the last several years. It has been somewhat disappointing in light of the results we’ve had in the performance of the stock. So, we’ve tried to become more opportunistic and buy less on an absolute basis and more on a opportunistic basis and try and find attractive entry points for that.” See 3q19 earnings call.
  • “Given the volatility of the stock and the results, we remain cautious on the buyback. While the business is experiencing some headwinds now, we still note it generates strong free cash flow and we will prudently and opportunistically allocate it….As far as returning capital to shareholders, we remain cautious. There is volatility both in the business and in the marketplace, and we’ll wait for the year, as the year goes through on rather what we do with capital on — in that regard.” See 4q19 earnings call.

The following conclusions can be drawn from the quotes above:

  • Greg Maffei looks out for shareholder interests
  • Qurate had an uncertain year in 2019
  • The Qurate team is very transparent about what’s going on at the company
  • Greg Maffei liked the shares at ~$13. He isn’t a short term trader and was making an opportunistic purchase. Today’s shares trade at ~$10.50/sh.

In March of 2020 Mike George alluded to the current capital return strategy when he said:

“We chose to kind of…pause…share repurchases…I don’t want to tip our hand on any specific plans as I would say, we’re looking at lots of options, but you could envision a range of things from flavors of share buybacks…dividends…debt reduction…[or] green energy investments.” See: BAML Consumer and Retail Technology Conference. Note: The green energy investments are not random. They are a meaningful way for Qurate to manage its tax obligations.

Fast forward to August 2020 and Qurate Retail Group announced a transaction that will:

  • Pay $1.50/sh cash dividend;
  • Pay $3.00/sh preferred dividend, yielding 8% for 10 years; and
  • Result in a very levered common equity stub with a proforma market cap of ~$2.5Bn.

What In The World Is This?

With a stock price of ~$10.50/sh Qurate is giving investors the chance to redeem 45% of their capital currently invested in the business (assuming the preferred shares trade at par). Alternatively, investors can sell their common shares, almost certainly realize a tax loss, and purchase the preferred shares with the proceeds. More interestingly, investors could sell the preferred and buy more common shares, which now have even more leverage.

While some investors see as reduced confidence because of buybacks declining, others might look and see an opportunity to reward the true believers. To be clear, Qurate is shrinking the common equity to a proforma market cap of $2.5Bn by offering a preferred stock. This offers common stock investors, should they choose, an extremely huge effective buyback without introducing debt into the entity. It’s hard to fathom a more shareholder focused move.

In March 2020, Mike George talked about the share price performance. He said

“Well, I think when I look at the current share price and generally even the reaction to our Q4 results to me it just reflects this wall of worry that some investors have that we don’t share about whether we can sustain long-term growth in an environment where admittedly linear TV viewing has been declining. And so I think investors have looked at down 3% or so sales performance in 2019 at QxH and wondered if that’s about harbinger of the future.
We’ve also had some a little bit of margin pressure in 2019 but again I think investors have looked at that and said, I wonder if that’s the new normal, I wonder if Qurate but more specific QxH can continue to generate the kind of high free cash flow conversion that historically has had.
Our view is positive on all those questions.”

So, here’s what Qurate is really doing –

Qurate is giving investors the chance to express their views. Investors with doubts no longer have to watch Qurate buyback shares into a falling share price. Instead, they can get cash out today and even sell the preferred shares. Interestingly, the preferred shares are now trading for $106 per $100; implying a healthy appetite for the security.

Alternatively, investors can choose to believe in Qurate and exchange their shares for a highly levered common equity. In our view, the common equity is the best security to own.

Mike George and Greg Maffei have been very honest about Qurate’s issues. Fundamentally, the business is strong but does have transitory problems. Does it grow? No. Is that somewhat perplexing? Yes. But, not growing is also not shrinking. Most importantly, engagement continues to be strong (and growing).

Further, the Qurate team has given people the option to take some chips off the table. Many management teams, like Bed Bath and Beyond’s, would not do that. Instead, they would stubbornly buy in shares while destroying shareholder value. This is extremely positive for minority shareholders.

Why Wouldn’t John Malone Just Repurchase Shares Here

Investors seem to think Malone wants to take chips off the table here. After all, if he believed in the entity why wouldn’t he just keep buying back shares? Here is where some will call me naive: What if, just for a moment, we consider that John Malone is at a point where he doesn’t mind trying something creative to unlock value? What if he needs some cash for somewhere else and he’s concerned about taxes increasing next year? What if he is trying to leave an instrument in his estate that generates some additional cash flow? What if this gives him an even more accelerated path to a buyback if the market doesn’t respect his company?

Prerecap, this company would have taken anywhere between ~8-10 years to retire all the common equity. That’s just been cut in half. These guys play the long game and Dr. Malone just massively shrunk the duration of his equity base in a very predictable business. Moreover, not all that long ago he injected fresh capital into Discovery Communications, a business that claims to have similar dynamics (though we much prefer Qurate). So it’s not as if Dr. Malone believes the erosion of the bundle imminently ruins his companies ability to earn in the future.

Yet, people want more buybacks. Or more insider purchases. The problem isn’t Qurate. The problem is that complaint’s lack of creative thinking.

Here is a snapshot of insider activity since 2018:

Insiders were net buyers.

Yes, it would be nice to see insiders step up here. That said, find another public company has insider transactions that look like the ones above. Further, we will not be shocked to see Mike George rebase his options package shortly after this transaction. Then Malone and Maffei can buy some shares on the open market once the dust settles.

In conclusion, Mr. Maffei is delivering on his promise to increase shareholder choice AND massively shrinking his common equity base. What good would it be for his reputation if he put another $1.3Bn of “leverage” in front of the common equity right before it blows up? People see this move as weakness. They are wrong. It is a huge vote of confidence.

The Opportunity, and Potential Pitfall

It’s undeniable that Qurate Retail Group is in the middle of a massive transition. Long term, the business must pivot to non linear video. Medium term, the business has to integrate HSN into its operations. Short term, the business has to figure out why it has missed some trends and adapt to a faster product launch environment. All that said, the team at Qurate has always been forthcoming with the market.

They’ve pivoted their capital return strategy as the facts changed. Thus, if this entity really is a melting ice cube, as the market seems to think, Mr. Maffei will do everything he can for his shareholders. This is not some value trap where management stubbornly destroys value. This is a good business with an extremely adept capital allocator that is minimizing shareholder downside. The market just can’t see that yet.


Given the above, we are betting on an entity we believe can sustainably generate $500mm-$700mm of free cash flow available to common equity. Not all of that free cash flow will come to the common equity because some will reduce debt. However, there will be many options for that free cash flow given the debt market’s insatiable appetite and the quality of this business. If the debt markets substantially tighten up, then we will have a few lean years as shareholders. However, given the habits of the customer base and Qurate’s ability to pivot it’s offerings, we are prepared to hold this equity through a recession.

Hopefully the market continues to doubt Qurate and Mr. Maffei can work his magic on a doubted entity. When to sell will be a more difficult question. Given the lack of growth, we will almost certainly reduce some of the position if the price increases meaningfully. We hope to own this entity for a long long time. If we do this will be a very successful investment.

A Note on Capital Structure Complexity

Qurate is controlled by Dr. John Malone. It’s capital allocation is controlled by Greg Maffei, who was hired by John Malone as CEO of Liberty Media Corporation (“LMC”). LMC acquired Comcast’s stake in QVC in 2003 because it needed cash flow. Prior to 2003 LMC was basically a publicly traded entity that held a bunch of assets Malone had acquired at TCI (AT&T bought TCI then spun out LMC).

As a Malone owned entity, Qurate carries the requisite levered capital structure and typically employs a levered buyback strategy. In plain terms, Qurate has a bunch of debt and as it grows it uses more debt to purchase shares. This financial model is incredibly powerful when an entity is growing. It also spooks the market when an entity stops growing; even moreso when the entity shrinks. And Qurate temporarily shrunk in 2019. Hence the share performance.

Further complicating Qurate’s capital structure is a group of convertible exchangeable debentures (CEDs). These are debt instruments that can be converted into shares of an underlying company rather than settled in cash. The note holder has the option. In Qurate’s case, two CEDs are tied to stocks that are now in the money: Charter Communication and Motorola Solutions Incorported. The note holders currently have the option to “put” their notes to Qurate in exchange for shares.

The Charter exposure is covered by an indemnification agreement GCI Liberty agreed to when it was spun out of Liberty Ventures. The Motorola Solutions Incorporated exposure is being managed via a total return swap and some debt tender offers. Going forward, Mr. Maffei will aggressively manage these obligations.

Looking at this capital structure today it’s easy assume there is some questionable financial planning. However, many of these CEDs stem from a market call LMC made in 2000. That call was hugely successful but created an obligation in 2030. We are now approching 2030. Thus, previous smart actions are beginning to have negative consequences; albeit 30 years later. More importantly, the business quality can support the debt.

This is a high quality business with a highly engaged, recurring customer base. We look forward to watching Mr. Maffei’s next round of financial engineering masterstrokes.

Wells Fargo – More Pain; No Gain

Note: This is not intended to be a full investment thesis. This is an update. Feel free to contact me with any questions you may have.

We initiated a position on Wells Fargo in June and increased our position through July. To be fair, “initiated” is somewhat misleading because we owned a minority interest in the company as recently as 2/25/20. Thankfully, we sold as we believed we were early assessing the potential impact of COVID 19. We were right.

Unfortunately, we were wrong to purchase Wells Fargo in the first place. Your manager relied too much on the company’s reputation. In large part because he worships Buffett and Munger, both of whom historically praised Wells Fargo as an institution. Further, I competed against Wells Fargo while at BMO Harris Bank. While people often joked about enjoying competing against Wells, I realized Wells often won deals. Why? At that time much of the answer was the company’s ability to use its balance sheet to win deals.

As of this writing that ability is impaired. Wells Fargo now operates under an asset cap. That asset cap restricts the company’s ability to grow assets from its asset balance on 12/31/17. See https://www.federalreserve.gov/newsevents/pressreleases/files/enf20180202a1.pdf paragraph 5. The Fed imposed the asset cap as punishment for Wells’ flagrent disregard for regulator’s demands.

Unfortunately, our previous position in Wells Fargo was a pretty large one (~7% as of 1/10/20). The stock is down (a) ~65% YTD and (b) ~45% since we sold. If I were you, I’d want to know why I owned the stock now given (a) how poorly the entity performed, (b) how wrong we were previously, and (c) the interest rate environment. The reasons are as follows:

  • New Understanding of the Issues – In March the House of Representatives questioned Charlie Scharf, Wells’ new CEO. Concurrently, both the Republicans and Democrats released reports on Wells malfeasense. While the contents were shocking, a couple things became clear.
    • Wells Fargo’s previous management was not competent. They either lacked the willingness, knowledge, prioritization, or a combonation of the 3 (and then some) to fix the problem. The root of the issue stemmed from Wells’ culture of promoting from within. While this may be perceived as a positive, in Wells case it was a negative because no one in the organization had the necessary background to implment the needed changes.
    • Tim Sloan, the previous CEO, was told multiple times to hire a COO. He never did. Instead, he hired consultants to draft plans, submitted those plans to regulators, and never took any meaningful action to implement the plans. Charles Scharf, on the other hand, came in and hired Scott Powell as COO. Mr. Powell recently cleaned up Bank of Santander’s US consumer business, which suffered from similar issues to the ones Wells Fargo now faces.
  • Continued belief in credit competence – There were plenty of negative comments that surfaced in the documents released by The House. However, not one of those comments was aimed at Wells’ credit culture. Contrarily, it is evident that Wells promoted based on (and highly values) credit competence.
  • Rate uncertainty – While it appears as though rates may never increase, it’s important to acknowledge they may. Further, Wells (and most banks) have alternative ways to generate fee income. While it would be much better if Wells had an investment bank attached to it, determining the outcome of rates on the business is harder than it may appear. One example is mortgage underwriting. When rates decline, mortgage refinancing increases. That drives fee income to Wells, but also reduces current mortgage servicing rights’ value and reduces the rate that drives interest income. However, if home prices increase that interest rate may be applied to a higer asset basse. Thus, interest income may not be as impacted as it appears (though it would certainly get reduced as home price appreciation wont offset the rate decline). That is only one example, but there are many.
  • Price – Assuming $10Bn in losses this year, Wells would generate ~$15Bn/year in net income against a $100Bn market cap. The new management team thinks they can take $10Bn of cost out of the business. Let’s assume that’s aggressive. If they can take $5Bn out the equity offers a ~20% normalized net income yield.

Our success will be tied to Scharf and his team. Scharf, trained by Jamie Dimon, appears to have a good reputation. Some investors ask what he did at BNY Mellon. Two years is not a sufficient time period to make meanungful change in a large organization. Thus, this criticism is not weighted as highly as his tenure at Visa is. Our perception is that Mr. Scharf set Visa up for success today. However, Visa is one of the best assets on the planet; Wells is not. Regardless, Scharf pivoted a strong asset base in the correct direction at Visa. Wells has a lot to envy in it’s asset base. Hopefully, Mr. Scharf assess strategy as well at Wells as he did at Visa.

Time will tell whether the bet on Wells’ turnaround is smart. We will continue to own the business unless two years have passed and the asset cap isn’t lifted. If that happens, we may face a 20-30% permanent impairment of capital. At this position size, we believe we are risking 1.4-2.1% of the portfolio to potentially make at least 7.0%. That is an attractive reward/risk given that we believe the probability of success is greater than 30%.

More importantly, we believe the normalized dividend yield on cost will be quite enticing in a low interest rate world. That dividend yield is actual cash back into our pockets. Given that freedom occurs when cash flow exceeds expenses, this is a bet worth making. We will be rooting for Wells’ ability to generate relatively stable profit in order to support organizational changes.

A reasonable observer would push back on the 30% probability of success assesment. That would be a fair criticism and, to be honest, greater than 30% is fairly arbitrary. That said, it’s evident that Wells has an expense problem more than it has a revenue problem. The expense side of the business is completely out of whack because of all the spending Wells has to incur in order to modernize the bank. Compounding this problem is Wells cannot grow it’s assets until the asset cap is lifted. Unfortunately, “remedying” the problems that led to the asset cap are part of what is driving expenses up.

Importantly, we do not view this entity as a permanently melting ice cube. Rather, we view Wells as a scaled money center bank with very serious temporary problems. Hopefully those problems can get resolved and the entity can focus on growth again. Other banks have dealt with many similar issues already. Ironically, Wells didn’t need to address these issues because it performed so well through the 2007-2009 time period. It’s time for that to change.

Who knows, maybe one day Wells could even have a reasonably competent investment banking arm that would help diversify it away from net interest income. For now, let’s just worry about Mr. Powell getting the asset cap lifted.

Suggested Reading/Research





Pepsi: AB InBev Pt. 2?

Ramon Laguarta, Pepsi’s CEO discussed the company’s strategy going forward. Market share and efficient distribution are central to maintaining Pepsi’s competitive advantages. Discussing these factors, Mr. Laguarta said the following:

“…Whoever wins in e-commerce now and is able to capture those families that are trying this e-grocery service for the first time, I think, is going to win those families in the future. So we’re investing heavily in trying to be the first in that channel and trying to — and again, the investments that we made in the last few years, last year in particular, are helping us both from the data availability, the agility of our infrastructure to supply those channels, etc. So, e-commerce is a key area where we think we can gain market share.

Second is the strength of our DSD system and our ability to service the stores directly. I think it’s a capability that is quite unique, and it gives us the advantage to keep the supply chain going in spite of all the challenges we’re all facing. So that’s also an area where we plan to double down. That improves our execution in store and the inventory in store. And that is also a sustainable advantage.

The third one is brands. I know we have — we’re seeing consumers going back to brands that they trust, and we have quite a lot in many markets that consumers trust. There’s big brands that have been around for some time. We’ve modernized them. We’ve kept them relevant to the consumer.”

All of that sounds great. It’s all logical from Pepsi’s perspective. However, the underlying assumption is that Pepsi can win share of mind in an e-commerce world. While brands are objectively important, it will be interesting to see which brands are the winners. Will customers think of Pepsi or Amazon/Walmart when they think of grocery shopping on the internet?

The key issue will be whether Pepsi’s brands have the strength to pull consumers to those products going forward. The challenge Pepsi (and others) will continue to face is the internet is not the grocery store isle. There is unlimited “shelf space” and the distributor is the entity that owns the share of mind on the internet. To be fair, traditional distributors (grocery stores) also owned share of mind. However, the internet is different because the attention seems to trend toward natural monopolies.

Interestingly, barriers to entry to create a new e-commerce distributor are minimal. On the other hand, barriers to scale and mind share are immense. Thus, barriers to entry are minimal but barriers to success are huge. Therefore, successful, large scale e-commerce companies may be able to increase their bargaining power over Pepsi, Coke, and other CPG companies.

That said, the large CPG companies are going to have the ability to purchase the prime advertising slots on Facebook, Instagram, Google, Amazon, and Walmart. They will be able to release brands quickly and tailor ads to local consumers. Will the economics of these relationships be similar to traditional slotting fees? Maybe. Maybe not.

Regardless, it will be very interesting to watch. There’s always been a middle man between large CPG companies and the consumer. CPG has combatted that via advertising and owning shelf space. However, those company strategies were extremely effective in a world where attention aggregation was much easier (think TV and barriers to shopping outside a local area) than it is today.

It’s hard to argue Pepsi is thriving like it would have if the internet didn’t exist. These financial results, while acceptable, are far from stellar. That said, Pepsi has a heck of a business and returns on capital are improving.

It appears returns on capital have improved driven, at least in part, by improving the cash conversion cycle from 13.57 days in 2014 to -18.33 days in 2019. Straight out of the AB InBev playbook. Interestingly, Pepsi referenced zero based budgeting in the 2Q20 earnings call.

“As it relates to becoming stronger, we are putting an even greater emphasis on our businesses to have a zero-based spending mindset in which we must earn our budgets.”

This will be an interesting one to watch going forward.

Price Dictates Questions

It’s been an interesting couple months in the market. While the blog has been quiet, the market certainly hasn’t. Thankfully, the portfolio emerged unscathed. In fact, it’s arguably the best it’s ever been.

We added TransDigm as a core holding. Most of the position was added between 3/16/20 and 3/20/20. We initiated a position and quickly took it to 10% of the portfolio at cost. In retrospect, 10% may have been too small but it would take a truly exceptional opportunity to purchase more than 10% at cost.

TransDigm, at that time, was one of the easier additions to the portfolio I’ve ever made. Investors appeared worried TransDigm might have covenant problems, which brought the possibility of bankruptcy into play. Those fears were misplaced as TransDigm’s covenants only “sprung” when TransDigm drew more than 35% of it’s revolving credit facility. As of 3/16/20, it was pretty clear that TransDigm could survive for at least 1.5 years without tapping at least 35% of the credit facility.

Investor fear wasn’t completely unwarranted (though it did lack nuance) as TransDigm runs a highly leveraged strategy supplying parts to the aerospace industry. Aerospace was one of the hardest hit industries from COVID-19. While many were, and some remain, concerned that travel would be permanently altered by COVID-19 that concern is misplaced. At worst, a recession would potentially impair the long term growth rates in travel. But the desire to travel is highly unlikely to disappear. Just look at history.

At a ~$15.5Bn valuation the free cash flow yield to equity, on a normalized basis, appeared to be ~6-7%. Not screamingly cheap in absolute terms, but pretty solid considering:

  • near 0% interest rates,
  • potential upside from additional efficiencies from the Esterline acquisition
  • future acquisitions
  • the quality of the company.

People will push back on business quality. The most common criticism involves TransDigm’s “aggressive” pricing. That criticism has an element of truth to it but seems far closer to convenient criticism than reality. Yes, TransDigm increases the prices of some parts when they acquire companies. Yes, those parts generate absurd margins when viewed in isolation. However, people need parts and low volume parts need to cost a lot in order to justify production. That’s true in every industry. For instance, there are businesses that warehouse odd bolts, screws, and springs in order to sell them to refineries for thousands of dollars per bolt, screw, and/or spring.

While that may seem crazy to some, it’s also how business works. I’d rather partner with the people smart enough to find those opportunities than complain about them existing. After all, we live in the world that exists not the one we think “should” exist.

The most difficult question to answer was whether TransDigm would be able to refinance its debt maturities. A large portion of the company’s debt is due in 2026. The company’s ability to refinance that debt will be a function of whether (a) travel returns by 2023/2024 and (b) (1) the rate environment and (2) why rates are where they are.

It’s important for travel to return, or begin to trend in that direction, by 2023/2024 because lenders are going to want to see solid trends to refinance into. As stated, it’s highly likely that travel substantially returns. Thus, we are comfortable accepting the refinancing risk despite it introducing a potential total loss to the equation.

As of this writing, TransDigm’s stock increased ~70% from our cost basis. To be sure, today’s price might be insanity. In fact, we trimmed a bit of the exposure on 6/5/20 as Transdigm became 13% of the portfolio and the quoted price gives your manager indigestion. That said, TransDigm will remain in the portfolio regardless of quoted prices. It will leave the portfolio only if travel doesn’t return. Consequently, we look forward to a long partnership with TransDigm.

In conclusion, today’s buyers need to have much more nuanced views of when travel will return, how many acquisitions TransDigm can accomplish, and whether the company can increase pricing. Those are much tougher questions to answer. Thankfully the panic sellers helped us avoid those hard questions. Price dictates due diligence and the market rewards patience. Try to avoid the difficult questions by swinging big when you see the easy ones.

No Answers

Dear Stakeholders,

Your manager doesn’t have the answers to the questions today’s world poses. Nor does anyone else. In three weeks, I have gone from (a) contemplating what all the “fuss” was about to (b) realizing the human species is at war against a virus. War forces people to contemplate things they never thought they would have to.

As for your portfolio, we are positioned more defensively than normal. To be sure, the time to position defensively is when times are great. Times are not great. However, the possibility of going much lower exists today. It’s also very possible, though unlikely in my view, that I am writing this at the exact bottom. Humility is why we remain allocated to equities.

Our current bond/stock allocation is ~34/66%, respectively. We will deploy half the bond allocation if things get “stupid cheap.” Moreover, our stock holdings have substantially moved into the “quality” realm; perhaps at the exact wrong time.

People will criticize me for style drift. I could care less. My job is to make sure this family’s wealth escapes this period in tact. As a reminder, wealth is not a number; it is relative purchasing power. Will people accumulate more wealth than we will by seeking distressed assets and being right? Yes. But, we will survive. Survival is our most pressing concern.

If I were you, I would ask why our holdings have changed so much despite my claims of being a “long term investor.” I will discuss a couple major changes below.


It’s no secret I pounded the table about airlines “being different this time.” In fact, on March 4th (only 12 days ago), I said we would hold airlines through this draw down. What changed?

On March 7th, I received a transcript of a discussion that opened my eyes to what was about to happen. If that transcript was even remotely accurate I determined airlines were about to have a liquidity crisis. Yes, the balance sheets are strong, but, in the short term, so is the cash burn. The potential duration of the cash burn is “what’s different this time.” Compounding the problem was the US policy response as of a week ago.

Fast forward to March 14th and The White House mentioned governmental assistance for the airlines, cruises, and hospitality industry. Therefore, I feel somewhat validated in my conclusion. The terms of any bailouts are not being discussed so it’s too hard to handicap how impaired the equity will be (if at all). Therefore, it’s simply too difficult to hold that risk when there are alternative ways to express our view that travel is a staple.

I humbly ask forgiveness for taking a loss on the position. A black swan occurred and I bailed. Whether the risk/reward was dumb at the time of the bet is something we can discuss. Whether bailing was the correct decision in the long term is also debatable. In hindsight it will all look obvious. In real time these have been very difficult decisions.

AB InBev and Phillip Morris

We sold these positions for correlated reasons. Both positions were taken because I viewed emerging market growth as a positive. While AB InBev executed sub optimally, Phillip Morris has done a fine job. That said, both of these companies sell vices into large emerging market populations. Many of those populations are South of The Equator. It is about to get cold there. COVID-19 thrives in the cold.

On or around March 7th, JP Morgan stated (on a call) that emerging market health systems are woefully unprepared to deal with the coming crisis. Further complicating the outlook, COVID-19 is killing people with preexisting conditions. Heavy alcohol consumption has been a contributing factor to COVID-19 mortality rates. Data suggests the majority of alcohol is consumed by the top decile of drinkers. Smokers’ lung health is unquestionably poor.

Accordingly, I have a high degree of certainty that smokers and heavy drinkers in emerging markets will prove among the more vulnerable (unless we eradicate the virus). Thus, I painfully report that I expect deaths to result in a negative decline in the demand curve for these products. Moreover, this instance forced me to consider the impacts of a virus like this occurring again. Accordingly, these entities hold risks we are unwilling to bear.

To be sure, there is a very reasonable possibility we sold “too cheap.” However, Bill Miller’s firm wrote a letter last year that made a lasting impression on me. In the letter they commented that their biggest mistakes came from holding stocks whose fundamentals deteriorated below their expectations at underwriting. In those situations, they held because they thought intrinsic value declined less than price. The results were poor.

Warren Buffett summarized his thoughts on the issue slightly differently when he said “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” AB InBev has been leaking for a while and I suspect Phillip Morris will prove leakier than I originally underwrote. Thus, we are sidestepping the current risks given the facts as I understand them today.

Again, these may have been poor risks to take in the first place. There is no way to replay the hand dealt. Regardless, after seeing more cards, I’ve decided to fold our hand.

The Current Portfolio

I will not discuss our current holdings here as it makes my job tougher at the moment. That said, I am very happy to be partnered with Berkshire, Dr. Malone and Mr. Maffei, Mr. Roberts, and the team at Markel. I have very limited concerns about whether we will be wealthier in 5 years than we are now. Unless the entire system collapses. This update won’t matter much if that’s the outcome.

The Correct Investment Question, As I Perceive It

As discussed, we are at war with COVID-19. The world economy has ground to a halt in an effort to contain and fight the virus. A time may come where we have to make a collective choice to sacrifice the old and unhealthy to save the economy. Thankfully we are not there yet.

Consequently, I am contemplating three scenarios:

  1. Success – Humans band together, stay inside/socially distanced, and bend the curve of COVID-19. We could come out of this current state in 2-3 months. The mood would likely be celebratory and it’s possible pent up demand results in a spending spree. However, supply chains have ground to a halt so there’s minimal chance of a “V shaped” recovery in the manufacturing sector. This is because there will be a lag between when supply can ramp up to meet demand.
  2. Malaise – The news trickles and trickles out and we stay in this state for longer than 3 months. It’s hard to see how this state of the world could possibly be good for equities over the medium term. Layoffs would almost certainly begin en masse and a deep recession is in the cards.
  3. Failure – We lose the fight against the virus and decide to go on with our lives, albeit with immense pain of human loss. From an investment perspective, that may be OK as the wealth the older generation accumulated and is saving would be passed to people in peak spending years. From a human perspective, it would be devastating and we would probably lose some of the older members of this family.

The situations contemplated above clearly under represent the total spectrum of outcomes. That said, those are the mental buckets I have. It’s noteworthy that the combination of situations 1 and 3 exceed the probability of situation 2 in my mind.


In closing, these are unprecedented times. It’s possible, though unlikely, a drug is developed to kill this virus. Let’s hope so.

I apologize for any imprudent risks I may have taken. I can assure you that I care deeply about not repeating the same mistakes; if they actually were mistakes.

If life were a golf game then COVID-19 is a huge “duck hook” that put everyone behind the trees. Given the circumstances, I think it’s best to chip the ball back into the fairway rather than try to blast it through the trees to hit the green.

There will undoubtedly be a time to second guess these decisions. As stated above, my goal is to make sure we financially survive.

Until the next update, stay home and stay safe.


The Gut to Win

Running a concentrated portfolio is one of the surest ways to win. It’s also the surest way to lose. Moreover, the difference between winning and losing may not be much.

It’s been an interesting two weeks at SCG. Your manager has been public about liking the risk/reward offered on many airline equity investments. It’s only right to acknowledge those public declarations created additional emotional pressure when inevitable uncertainty materialized.

Owning an asset is far different from researching an asset. It’s easy to contemplate a recession, terrorist attack, or outbreak while researching an investment opportunity. For airlines and travel, a researcher would find that even after 9/11 and The Great Recession air travel proved resilient. As shown below, travel demand bounces back pretty quickly.

Source: https://www.transtats.bts.gov/TRAFFIC/
Source: https://www.transtats.bts.gov/TRAFFIC/

It’s hard to imagine scenarios worse for passenger demand than 9/11 and/or 2008-2009. That’s easy to wrap one’s head around. Right? Sure, until you own the position and see this:

Source: https://www.wsj.com/articles/smart-travel-planning-in-the-time-of-coronavirus-11582726776

And what happens when you see headlines about stories about L.A. declaring a state of emergency? See https://www.cnbc.com/2020/03/04/los-angeles-area-officials-declare-local-emergency-confirm-new-coronavirus-cases.html. What then? How does your data feel when a stock chart looks like this:

Or, God forbid you decided to own one of the riskier stocks in the sector and stare at a 40% drawdown in under a month?

How does that historical data feel now that IATA projects $27.8Bn of revenues lost in 2020 just in Asia? See https://www.iata.org/en/pressroom/pr/2020-02-20-01/ . How does it feel to watch conferences get canceled? How does it feel to have anyone with a shorter term time horizon say you’re an idiot for remaining long?

Thinking Long

None of that feels like the underwriting felt. It feels scary. It is scary. It’s also not rational. Making matters worse, an investor is able to cut the current pain, and avoid further pain, with just one click of a button. All he/she has to do is sell. That feels so much safer. It’s also a great way to donate profits to Mr. Market.

Fundamentally, an investor is entitled to earn the returns of the business he/she chooses to purchase only when that investor is willing to own the crappy times for the business. An investor is not entitled to return while avoiding risk. Instead, that investor is only entitled to donate return to those willing to suffer.

As Tom Russo has summed up, both the investor and the business must have the capacity to suffer. Running a concentrated portfolio substantially increases the need for an investor to have the capacity to suffer. As a quick aside, Joel Greenblatt mentioned he found letting his winners run to be as, or more, difficult than watching his positions go against him. SCG would have benefited from letting certain winners run longer. That said, we’ve also been fortunate to make some timely exits so the jury is still out on our long term selling record.

If not now, when is this thesis wrong?

One major reason to own airline stocks is a bet that consolidation enables relatively fast responses to demand shocks. COVID-19 has certainly created a demand shock; or at least the perception of one in the US. It’s undeniable that the current quantity of seats demanded will be lower than projected, and will almost certainly see year over year declines. But have the demand and supply curves actually moved to create an industry doomed for failure? Doubtful.

As of today, a bad case scenario would result in 2% of the population dying. That is a lot of people. It’s also approximately less than one year of anticipated seat mile growth. Recently, airlines have managed to keep load factors reasonably stable, which is evidence of rational growth.

It’s not a stretch to think 4 major players could manage a 2% decline in capacity. Moreover, the reduction is unlikely to be permanent given people’s desire to travel. Heck, even now 90% of people are proceeding as planned for Spring Break. See https://skift.com/2020/03/02/nearly-90-percent-of-u-s-travelers-have-yet-to-cancel-plans-due-to-virus-skift-research/?utm_campaign=Daily%20Newsletter&utm_source=hs_email&utm_medium=email&utm_content=84159193&_hsenc=p2ANqtz-85tAqLAorvJy3UYCXoTZpScFaLaC8xeSlOtuSkv7bkvKT0m-XK73LjiiIfQVutz3O_FfDNhhU5EYt-ttBxH7s5JFOFKPcg464bzHsbSDu8bOS6H_Q&_hsmi=84159193 .

But What If They Are Go Bankrupt?

Equity owners of the entities controlling the planes could see a permanent impairment without the industry stopping. All you need to do is look at the time period between 2000-2012 to see the potential devastation. That said, airlines, specifically US airlines, are in a much healthier position going into this potential crisis.

An incredibly bearish argument would say the airlines have 2 months of liquidity before things get really scary.

Source: Company 10-Ks

However, that assumes there are zero revenues, the costs stay almost totally constant, and the airlines cannot mitigate any of the damage. That scenario is highly unlikely. Moreover, if demand falls to zero there are going to be way bigger things to worry about than the health of airlines.

The Most Likely Outcome

SCG is positioning itself to take advantage of further pain. Please note, we hope none happens and pray the human toll is minimal. However, thinking rationally about the current situation, it’s hard to see permanent long term consequences.

Yes, the short term could be painful. Yes, things are scary right now. Yes, it sucks to have a drawdown in a big position. All that said, our view is this virus is here to stay. Accordingly, sheltering in place won’t do anything for most of us. Moreover, most of us will not have our lives impaired. Thus, the probability that Americans decide to incur pain for a meaningful amount of time is low to quite low.

Therefore, we will continue to hold our airline positions and earn the reward liquidity tempts us to sell out of. As stated, the pain is likely to get worse. Potentially much worse. Buckle your seatbelts and put your seatback in the upright position.

Bargain Bin or Dumpster Fire?

Ollie’s Bargain Outlet Holdings is setting up to be an interesting situation. The company buys “end of run” goods and sells them at deeply discounted prices. Grant’s Interest Rate Observer described Ollie’s business as follows:

“The closeout business is off-price retailing without the frills. Like the cigar-butt investor, the closeout merchant finds stock where it’s cheapest: in discontinued merchandise, canceled orders, modified orders, liquidations. He buys low, sells a little higher.”

Interestingly, Ollie’s has no online presence. Despite that, or perhaps partly because of that, the company has been thriving. https://www.forbes.com/sites/abrambrown/2019/04/01/the-outlandish-story-of-ollies-a-5-billion-retail-empire-that-sells-nothing-online-but-is-beating-amazon/#71c235e850d5 . The question before investors is whether Ollie’s future looks like its past. If so, Ollie’s equity appears reasonably priced.

The average Ollie’s store produces roughly $475k of unlevered earnings. Those stores grow earnings at roughly 2% per year IF you look at 2 year comps. Given where assets trade, it’s not unreasonable to assume a required return of 8% for owning the unlevered equity of the stabilized store base. Therefore, each existing store could be worth ~$8.1mm.

Today, there are 332 existing stores. Thus, the value of the equity of the business as it exists today could be ~$2.7Bn IF the assumptions above are valid. The current offered price of Ollie’s equity is $3.5Bn. Why might that be a reasonable price to pay?

Ollie’s believes they can grow the store count to 950 stores. Their strategy involves entering adjacent markets. They are expanding West as they started on the East Coast. The current store footprint appears to be as far West as Indiana down to just West of Jackson, Mississippi. Importantly, the company has a history of successful store openings.

Each store costs approximately $1.0mm to open. Assuming the $8.1mm value cited above is correct, each store opening creates ~$7.1mm of value. They believe they can open 45-50 stores per year. Therefore, the present value of the growth could be anywhere up to $2.0Bn (assuming a 12% discount rate).

Accordingly, the offered price of the Ollie’s equity is ~75% of the present value of the equity. Not a screaming bargain, but also reasonably cheap given the environment today. Why? First, Ollie’s had a bad quarter. Second, key man risk materialized.

Missed Execution

Note: Technical analysis isn’t part of this discussion but that is a scary chart.

Missed earnings (and a demanding valuation) caused the sell off during the week of August 26, 2019. As the company tells it, accelerating store openings and odd box sizes caused some disruption to the company’s growth formula.

Source: Mark Butler’s opening remarks on the 2q20 earnings call.
Source: Q&A portion of 2q20 earnings call.

The pace of store openings allegedly stressed the entire system and resulted in SG&A deleveraging (meaning SG&A as a percentage of sales increased). This is a plausible explanation because Ollie’s took advantage of the Toys ‘R Us (“TRU”) bankruptcy and acquired some good real estate. On one hand this was an opportunistic way to open stores in good locations. On the other, the store acquisitions complicated Ollie’s growth formula.

First, Ollie’s accelerated its store opening cadence because they wanted to get the TRU stores open. Second, the TRU real estate introduced a different store footprint/layout. Mr. Butler attributed some of the operating hiccups to those factors. Mr. Butler’s track record warrants some deference. Therefore, this appears to be one of those situations where the reality of operating a growth company comes in direct conflict with Wall Street’s Excel models.

Further hurting Ollie’s quarterly results was Ollie’s inventory consisted of lower margin products. This is meaningless to a long term investor. What matters, long term, is whether Ollie’s is satisfying its customers. A skeptic would argue Ollie’s margins came down due to inventory quality. Again, Mark Butler’s record warrants deference.

The Potential Opportunity

To summarize, Ollie’s had a pretty poor quarter and the stock was priced for perfection; not a good combination. Below is a screenshot illustrating Ollie’s multiple compression as market participants realize (a) growth isn’t painless and (b) margins occasionally compress.

At the time Mark Butler tried to settle investors by saying:

Thinking long term, the case for buying Ollie’s shares rests on the power of the business model, increased scale resulting in more inbound calls from companies looking to liquidate end of run goods (and excess inventory), and store openings driving efficiencies through the business (by absorbing the recent distribution center costs, for instance). Scale resulting in better buying opportunities is a particularly compelling thesis. As the barriers to new product discovery continue to erode CPG companies, set up for longer production runs and pushing demand, may have more frequent forecasting misses. Accordingly they could need to sell through a channel that is (a) discrete and (b) can actually move the excess product quickly. Ollie’s appears to have a high probability of solving that need.

The Short Story

In March of 2019 Grant’s Interest Rate Observer wrote negatively of Ollie’s shares. A prescient call, Grant’s rested some of it’s thesis on valuation. But, valuation wasn’t all:

“As no proper bear case rests on valuation alone, our bill of particulars goes well beyond that FAANG-like multiple. Among its highlights: rising competition, operational shortcomings, low inventory turnover, high exposure to financially vulnerable consumers and accounting problems.”

The first accounting claim Grant’s alleges is Ollie’s free cash flow and net income diverge substantially. While this is true, it’s also somewhat explainable by store growth. Ollie’s inventory is growing at ~14-16% per year, which is in line with store count growth. Comparing Ollie’s to another high growth retailer, Five Below, its unclear the free cash flow conversion is a concern.

The second, and more compelling, accounting claim Grant’s discusses relates to Ollie’s irregularities pertaining to inventory and pre-opening expenses (oddly these include store closure costs). Grant’s discussion is concerning given the outdated inventory systems Ollie’s allegedly uses. To summarize the concern, if it is true that Ollies has terrible inventory systems, its possible that reported gross margin overstates actual gross margins. That said, it’s tough to overstate cash generation. And Ollie’s generates cash. Enough cash to retire $200mm+ of borrowings since 1/30/16 while investing in growth.

Grant’s concludes by mentioning the internet may increase competition for closeout sellers. While that may be true, Mark Butler contended that Ollie’s offers a preferred liquidation channel because there are no prices found on the internet. Therefore, a company like P&G can sell Tide through Ollie’s without upsetting the brand’s image in most consumer’s minds. Both thesis have merit but again, Mark Butler’s argument seems more likely.

More Fodder For Short Sellers

On December 1, 2019, Mark Butler, Ollie’s CEO and founder, died. Turn on an earnings call and listen to his enthusiasm. The man is irreplaceable.

One example of Mr. Butler’s genius was buying wedding dresses on closeout. No one sells wedding dresses at a closeout store. Consequently, Ollie’s got a fair amount of publicity from selling deeply discounted dresses. It’s unclear whether the remaining buying (and management) team will be willing to take those types of risks.

Mr. Butler’s replacement, John Swygert, has been with Ollie’s for a long time but is untested as a CEO. So, this would be an opportune time for a short seller to test him and/or shareholders. It appears as though that is going on as the side by side shown below is making the rounds.

The implication of that side by side seems to be that Mark Butler talked about toy sales when they were good and John Swygert is not talking about toy sales when they are bad. That conclusion appears tenuous given Swygert’s comments that “we are pleased with what we’re seeing right now.” Further, Mr. Butler and Mr. Swygert have different styles. Some of the language change may be attributable to who delivers the message. Long term investors should be way more concerned with the accuracy of these statements:

The Shorts May Have a Real Argument

Mark Butler’s death is a potentially derailing event. He had a reputation as an extremely sharp buyer and a one-of-a-kind charisma. It’s quite plausible that Ollie’s dependent on one man; that story isn’t uncommon in retail. That said, Ollie’s team has been there for a while. They’ve thought about succession planning as evidenced by elevating John Swygert’s position in the company a few years ago.

Importantly, based on a conversation with a very trusted source, we find it likely that there is institutional knowledge within these types of organizations. Coordinating purchases, store openings, inventory management, and logistics is probably more than one man can handle. JP Morgan has this to say about Ollie’s bench strength:

Source: JP Morgan Ollie’s note released 02 December 2019

Going forward, it’s almost inhuman to expect Ollie’s to hit their short term plan. Those people lost a leader. But, if the team can focus on execution, maintain buying relationships, and continue to open stores then Ollie’s should have a very good future. Parsing short term issues from fundamental long term business erosion probably won’t be easy.

The Balance Sheet: A Potential Asset

Ollie’s doesn’t own its real estate. Therefore, the business doesn’t need to carry the leverage it would need to if it owned it’s real estate. Instead, they have ~330mm of lease assets on the balance sheet. Accordingly, Ollie’s cost of real estate flows through the income statement (and operating cash flows) as rent rather than through interest expense, changes in PP&E, and net financing cash flows. The average lease term is 7.2 years so there could be some liability if certain store results erode quickly.

Other than leases, there is no debt at the company. Many retailers would fund at least a part of their inventory carrying costs with a revolving credit line. While Ollie’s has a $100.0mm revolving credit line, that line is undrawn. If the share price sells off too much, Ollie’s could use it’s $10.1mm of cash and some of its credit line to retire shares. They opportunistically bought in shares at ~$58.02/sh last quarter. We expect some more repurchases in the upcoming quarter considering they should be generating seasonal cash and the shares are currently trading at $53.34/sh.


Today’s investor gets paid for taking execution risk and betting on the business model. Whether the odds offered are enticing enough is another matter. There’s currently uncertainty around whether the new team can execute the growth plan.

An under discussed risk is how the new CEO interacts with the Board. Will he be able to take over after a charismatic founder passed away? Will he feel comfortable implementing “risky” and/or unconventional (like the wedding dress sale) promotions/actions? Mark Butler’s shoes are not easy to fill…

This is one to watch. Assuming the discussion above is accurate, the upside offered in the stock is probably not much more than 40% (assuming no share repurchases). The downside could easily be ~30%. Accordingly, an investor needs to be ~43% or more certain that a Mark Butler-less team is up to the task. Therefore, this may be one to watch from the sidelines.

PS. What will Chuck Akre’s firm do? Is Mark Butler’s death sufficient reason to sell or did they bet on the business and team? That will be interesting to see given The Art of (Not) Selling.