Zuora: A Tax on Subscriptions

Subscription business models are the future. Or so we are told…

To be sure, subscription businesses have inherent advantages. They “know” how much they are going to sell next month. Therefore, they can plan their cost structures around fairly predictable anticipated sales. Further, they are more durable than many business models because inertia/switching costs tend to result in subscription renewals. Importantly, software subscription services should benefit from operating leverage at scale. Thus, they are potentially desirable investments. Hence the current research project: Zuora.

Zuora provides a software billing solution to companies that are launching subscription services. Scuttlebutt suggests the offering is quite good and customizable. Customers see value in Zuora’s offering because subscription services have billing nuances that most billing systems aren’t equipped to handle.

Think of the NY Times as an example. There are many different customers, all subscribing to a number of products, signing up at different times. Traditional billing solutions, designed for discrete transactions, cannot handle that load. Zuora built its business specifically to address these issues and remains focused on them. As a complimentary offering, Zuora also offers a revenue recognition software solution that helps customers accurately account for the revenues they earn (which isn’t always easy given length of terms, renewals, changes, etc).

The company’s sales strategy involves “landing and expanding.” That means they try to acquire a customer and then (a) sell that customer a more robust billing solution, (b) try to cross sell the revenue recognition solution to customers using Zuora’s billing solutions (or vice versa), or (c) a combination of the two. Importantly, this strategy requires large upfront investments. Sales cycles are lengthy, the product must be designed and tested for specific use cases, and good sales reps cost a lot of money. Therefore, sales efficiency and distribution are key to scaling quickly and obtaining a defensible position in the market. While there are less expensive billing solutions on the market, Zuora’s product has proven to be a good fit in the enterprise market.

Importantly, it seems as if Zuora’s product is sticky among the larger customers they serve. The company consistently increases the amount of customers billing over $100,000 in annual recurring revenue. That said, the company’s sales growth has slowed this year and there are questions around how quickly the product will scale.

Zuora seems to have a realistic, forward looking vision about future business models. Their theory of the case is businesses, enabled by IoT, will collect data on how their products are used. Those businesses will then offer users of their products subscription services as supplements to existing business lines. The theory is supported by a recent Barron’s article featuring Honeywell. See Footnote 1. Zuora will also benefit from increasing subscription businesses such as DAZN, FT.com, the Guardian, etc. See https://www.zuora.com/our-customers/ for a list of customers and case studies. But can Zuora serve these customers profitably?

Historical Financial Results

Zuora’s CEO, Tien Tzuo, recommends benchmarking SaaS businesses by subtracting cost of goods sold, general & administrative, and research and development costs from sales in order to determine “Recurring Profit.” Then, he suggests viewing sales and marketing expenses as “growth.” Using his own suggestion, Zuora’s historical financials don’t show recurring profit margin expansion:

Admittedly, there are timing differences between the costs Zuora incurs and the revenues it recognizes. For instance, the company has been growing revenues in excess of 30% per year until this year. Undoubtedly, they hired expecting more robust growth than they achieved. Therefore, their existing cost base is almost certainly too bloated relative to their revenue base.

Moreover, the company is highly likely to be erring on the side of over hiring so they don’t hinder growth. As of today, the perceived appropriate strategy is to acquire as many customers as fast as possible. Therefore, Zuora would be foolish to forego sales because of insufficient support. That said, it’s not certain that Zuora’s anticipated growth materializes and/or the cost base “right sizes.”

An Accounting Tangent

Accounting under GAAP penalizes enterprise SaaS businesses relative to traditional capital intensive businesses. Traditionally, a growing company in a capital intensive business would capitalize a portion of its growth spending. Only later would that company depreciate the spend on the income statement. Consequently, a traditional income statement did not capture “growth” capital spend.

Conversely, enterprise SaaS businesses have the opposite problem. These business are capital intensive, but they require human, not physical, capital. GAAP does not allow companies to capitalize human capital expenditures. Consequently, the current cost structure is fully captured but the revenue stream associated with these costs is not. SaaS income statements are further penalized because revenues are recognized as they are earned. This puts more pressure on the income statement relative to traditional businesses.

For illustrative purposes, let’s assume Zuora was selling a discrete product for $100 with 70% gross margins. The income statement in the quarter of sale would capture revenues of $100 and gross profit of $70. However, Zuora is actually selling that $100 product for $8.33/month. Thus, a quarterly income statement shows sales of $25 ($8.33 * 3) and gross profit of $17.50. Therefore, the entire cost to support and implement the product sale is in today’s income statement but only a fraction of the product sale is captured.

All that said, the income statement is not useless. At a minimum, it’s a relatively reliable picture of how Zuora’s costs have grown as the business grew. These dynamics have led to a cash flow negative company, despite $19.6mm of stock based compensation over the past 6 months.

The Future, Not The Past, Is What Matters

All of the above is interesting. Zuora’s vision of the world is interesting. It’s interesting to think of the potential business lines a connected world could create. It’s also interesting that a public company, with an allegedly incredible business model, continues to lose cash despite ~7% of its expense base being non cash share based compensation. Further, it’s interesting that the company has generated larger and larger losses as its business grows. But, what’s more interesting is Zuora still trades for $1.5Bn, or ~48.1x “recurring profit” before sales and marketing expense. Why?

The answer lies in the market’s expectation that this business is scaleable, has a long runway, and will generate predictable cash flows over time. If that happens, Zuora is going to be a cash machine in the future. Therefore, Mr. Market is assigning a high valuation because he believes Zuora is on the left side of the image below:

https://www.youtube.com/watch?v=bCBccKfG9U0&list=WL&index=6&t=0s @ 4:37

Mr. Market may be correct. That said, it’s difficult to handicap the odds because searching historical transcripts, presentations, and filings for “unit economics” and “contribution margin” returns no results. More importantly, the historical income statement doesn’t show evidence of R&D or G&A leverage. Therefore, Zuora’s ability to scale is more theoretical than tangible.

Further complicating the equation is every period showing “recurring profit” growth (though at a lower margin) corresponds with an even larger increase in sales and marketing costs. Bulls will argue the sales and marketing ramp is rational because this is race to get an installed base. Skeptics will argue it’s a structurally cash flow impaired business model. What is the truth?

Grow Now, Prosper Later

There is merit to the strategy of racing to acquire customers in an enterprise software business. Thus, the bull argument cannot be summarily dismissed. That said, the bear argument also cannot be summarily dismissed; Zuora not only hasn’t generated cash but also supports a healthy valuation. See Footnote 2.

As discussed, enterprise SaaS companies benefit from switching costs. What is the probability that a company is using Zuora to run its billing for a successful subscription business line? In order to make that decision a company like the Financial Times would need to:

  • (a) have enough pain with the current billing solution to consider switching,
  • (b) get comfortable with a competitor’s product,
  • (c) be willing to migrate billing systems and risk some sort of customer disruption (remember, the hypothetical company invested a lot to acquire those customers so disrupting the experience is a serious potential risk); and
  • (d) actually make the switch.

It’s obviously possible for companies to switch, but it isn’t easy. Moreover, Zuora charges ~50bps on transaction volume. How much savings can a company capture by switching to a competitor? That competitor would need to be able to economically offer savings, guarantee a seamless transition, and close the sale. That is a tall order. So, grow now and harvest later!

Growing now and harvesting later is exactly what Zuora is trying to do. So it continues to aggressively pursue deals that look like:

https://www.youtube.com/watch?v=bCBccKfG9U0&list=WL&index=6&t=0s @ 3:20ish

A problem, however, is Zuora’s “recurring profit” margin, coupled with its sales cycle leads suggests the business economics are closer to the orange line below than the green line. And that matters. A lot.

https://www.youtube.com/watch?v=bCBccKfG9U0&list=WL&index=6&t=0s @ 13:13

For illustrative purposes, lets compare the Run Rate 7/31/19 financial results (above) to the year ended 1/31/19. Zuora discloses a net revenue retention rate of ~112%. Therefore, company’s 1/31/19 sales base of $168.8mm would result in $189.1mm of sales. The $100.8mm of sales and marketing exepenses deliver the “growth” of $13.6mm of new business. That $13.6mm generates ~$2.0mm of “recurring profit.” That is not an incredibly exciting return on sales spend. Please note that the actual run rate business at 1/31/20 should be substantially larger than the run rate business at 7/31/19 and this example is very imperfect. However, the example directionally demonstrates that Zuora’s business is not growing like a weed and realizing incredible unit economics. It must be noted the time period in this example also covers some sales execution issues. But, the example is useful to show this business, while priced like a Ferrari, may actually be a Honda.

Growth Persistence

Justifying Zuora’s current valuation requires a long time horizon and some creativity. In the words of Shomik Ghosh:

“In enterprise software, valuations are mostly quoted as revenue multiples. Companies are said to be valued at 15x NTM revenue or 10x NTM ARR. These again are proxies for eventual free cash flow generation. However, they’re necessary because building a discounted cash flow analysis early on in many of these company’s lives would have so many assumptions on it that the analysis would effectively be useless.

So what are the proxies commonly used for valuation? They include revenue growth, gross margins, LTV/CAC ratios, S&M efficiency, churn, upsell, runway, TAM, market share, etc. An exact same business with the exact same metrics will be valued more highly if it has 2 years of runway versus 1 year as the longer runway allows more time for growth and eventual higher free cash flow generation at steady state.” See Footnote 3.

Zuora is almost certain to continue growing sales given the business model and infancy of the product offering. As shown below, ~50% of firms with sales between $0-325mm can grow at or above 10% per year for 10 years (note there is some survivorship bias as some firms don’t last 10 years).

https://research-doc.credit-suisse.com/docView?language=ENG&format=PDF&source_id=csplusresearchcp&document_id=1065113751&serialid=f2q0vtKOQ202cwIOt6b1kRL6U91EC1rK7zBkPzU1tjI%3D&cspId=&toolbar=1 @ pg. 31

That said, other than faith, it’s hard to see how Zuora’s sales growth results in operating leverage. Further, the speed of growth over the long term and capital allocation is questionable. There’s something offensive about an organization spending $75.0mm of run rate R&D to support $202.7mm of run rate sales (regardless of how understated sales are). How does a company with only two real products need that kind of R&D investment? And, with $139.9mm of R&D investment over the past 4 years shouldn’t Zuora have more than 112% revenue retention if their end market is growing so much? While Zuora needs to iterate its product, this R&D spend (a) seems extreme and (b) could be better spent on an even bigger sales team to accelerate scaling.

Conclusion: Too Hard

Given concerns with Zuora’s capital allocation, it’s very difficult to determine the company’s steady state economics and the path to get there. There are so many intertwined variables that a model does more to serve as confirmation bias than an objective forecast of the future. Moreover, there’s nothing tangible that shows this business and/or management team is scaling.

There’s a strong desire to assume all this spending is rational. After all, very smart people (a) work at Zuora and (b) support the company as investors. Moreover, Zuora has a visionary concept of the future. Further, scuttlebutt suggests the product is good. All that said, investing isn’t rooting for a sports team. There is real money on the line. Given the lack of visibility into terminal economics, this business is better to let others wager on. Some bets are best observing from the sideline.

  1. https://www.barrons.com/articles/honeywell-is-a-growth-company-again-as-it-taps-the-power-of-big-data-51573227342
  2. According to Bloomberg there are 4,371 companies in the US and Canada that are classified as communications, consumer discretionary, consumer staples, and technology. Of those only 731 have a market cap in excess of $1.5Bn. Of that 731, 602 are free cash flow positive. Those sectors were chosen because they have reasonably good businesses in them (as opposed to energy and materials). Within the technology subset, there are 1,530 companies, of which 272 have market caps equal to or greater than Zuoras. Of those 272, 221 are cash flow positive. None of these numbers mean anything, per se. However, they do demonstrate that Zuora is among the most highly valued companies in the investable universe. That said, this is a pond worth fishing in because successful tech companies tend to produce the preponderance of value within the sector.
  3. https://www.linkedin.com/pulse/aligned-cost-structures-switching-costs-distribution-valuations/

Realized vs. Theoretical Gains

There’s a big difference between a company I am researching and one I have actual money on the line with. Perhaps I am flawed and need to intensify my emotional state when I research. But, I think the more likely explanation is real money intensifies the analysis/emotion. It’s one thing to see a historical operational hiccup, subsequent recovery, and determine “I can live through that.” It’s quite another to live through the hiccup and wonder whether the recovery will happen.

Similarly, it’s quite easy to say “This company is way too cheap!” I strongly believed Nordstom, Inc. was too cheap in August when the stock sold off in conjunction with Macy’s results. So I bought.

But here’s the problem: Nordstom faces structural headwinds, may or may not be innovative enough to grow its business long term, and has a lot of fixed costs embedded in the business. Therefore, if things unravel at Nordstrom they could unravel quickly.

So, why did I buy? I bought because I discussed the brand with a group of women who provided me with some comfort about Nordstrom’s brand equity. Moreover, I pay enough attention to retail to know the management team is attempting to transition the company to a modern retailer (unlike Macy’s). Further, I interviewed employees that told me the culture at Nordstrom is the best in the industry. Finally, the Nordstrom family (a) owns a large block of stock, (b) tried to take it private two years ago at near 2x my purchase price, and (c) committed to returning ~$5Bn to shareholders over the next 5 years (vs. a ~$3.9Bn mkt. cap at the time). Note – Family is italicized above because I think there’s a lot more pride on the line when the store bears the name of major shareholders than there is in most situations.

The “opportunity” presented itself because Nordstrom has not executed well over the last 3 quarters. I believe Blake Nordstrom’s death (Blake was a Nordstrom family member, co-President, and largely responsible for running Nordstrom Rack) was a very difficult event for the family/organization and sometimes life gets in the way of optimal business performance. Part of my belief stems from reading about Blake. Moreover, when I spoke to investor relations the woman I spoke to choked up a bit when I offered my condolences. Given everything above, I believe the market sees a potentially broken business with headwinds and I see a business that is facing headwinds but isn’t broken (though the business quality is clearly deteriorating from what it once was).

Despite the risks, I made the bet and was ready to collect dividends, watch share repurchases reduce the dividend obligation, and collect subsequent increased dividends (dividends per share would increase as shares outstanding decreased assuming the dividend payout remained the same). I “knew” the risks I took/am taking. I understand there is a path to failure in this investment. But, at the price I purchased the equity I thought the market was emphasizing the failure potential too much and missing a lot of the good the entity has going for it.

Shortly thereafter, the stock increased almost 40%. At that point, the decision to hold became a bit more difficult. The risk of failure also felt more acute because now Mr. Market was pricing in a more rosy scenario. Importantly, risks that lived on a spreadsheet or in a writeup now actually presented potential loss of real money and the odds had changed. At this valuation, the proposed share repurchases don’t accomplish as much. Moreover, the business risks haven’t changed. That said, if Nordstrom can accomplish their goals there is still quite a bit of value in the entity. Therefore, I decided to sell half my position to reduce some portfolio risk (Nordstrom was a ~5% portfolio weight at cost).

On the other hand, my second largest position (13% current portfolio weight) is in cable companies (Charter and Comcast). These have meaningfully appreciated. However, I haven’t even considered selling either because I fundamentally believe in owning broadband infrastructure for the long term. Thus, it would take a pretty egregious price to have me sell either position at this point. NOTE – I am not saying to buy cable company stocks right now! Nothing here is investment advice.

So, while a spreadsheet may produce similar IRRs for those two investments, the experience of owning the assets is quite different. The obvious response to what I am writing is “Retail investors should require a higher IRR to enter positions than cable company investors since there is less business risk in a cable company.” First, I agree. But more importantly, the right behavior/stomach is necessary to realize the theoretical IRR. And, that behavior can be difficult to handicap until the asset resides in an investor’s portfolio.

Generally speaking, I’ve found assets purchased because of valuation are much more difficult to hold because there is usually some element of business risk attached to them. Consequently, my focus has morphed to higher quality businesses trading at reasonable prices. However, I can’t help but look at my perception of mispriced assets. After all, I am trying to buy more value than I am paying for.

That said, the real gains are made from holding. And holding business risk is a lot tougher than it looks on a spreadsheet. Which is probably why the opportunity exists for those that are (a) right and (b) selective on price.

Recommended Reading

https://www.nytimes.com/2019/10/23/style/nordstrom-family-department-stores.html

Know What You Own

Andrew Rangeley recently wrote about sharing his investment ideas. The full post can be found at http://yetanothervalueblog.com/2019/07/some-things-and-ideas-july-2019.html. In the post, Andrew wrote “…the longer I invest, the more I think the most important part of this job / doing the work around this job is developing the conviction to hold an investment thesis.” I couldn’t agree more.

When I started investing I would look at what other people were doing and try to back into why they owned what they owned. I still think that’s a useful, and interesting, exercise. However, you must make sure you don’t rely on the conclusion of the person you are researching. Instead, research the idea in order to determine whether that particular asset is right for your portfolio.

The world has many potential outcomes. Unless you know why you own a position how will you know when to sell? Which path of outcomes bothers you and which paths are you OK with? I guess you can follow some famous investor’s SEC filings and sell when they sell. But, if you implement that strategy I would strongly advise against checking stock prices in between filings.

What happens if you follow your favorite blogger/Twitter account into a position? How will you know if they’ve changed their minds? You probably won’t. And they probably won’t think to tell you when they exit. You have to know what you own and why.

A recent example from this blog is Ryanair (RYAAY). I highlighted RYAAY as an interesting investment idea on May 22, 2019. As a quick aside, this is a good time to remind everyone reading this post that nothing here is investment advice. Anything SCG writes about is meant to highlight interesting things to research and/or look into for learning purposes only.

Anyway, the stock traded at ~$68/sh when we wrote about it. A mere 3 months later the stock traded at ~$57/sh. A 17% “loss” in 3 months (aka -68% annualized return). Impeccable market timing! Was I concerned? Not even a little. Would I have been concerned if I followed someone else into the position? Heck yes! SCG probably would have sold.

Furthermore, I worry that someone may have followed us into the position and sold at the wrong time. I implore anyone reading this not to buy anything I write about. If it interests you then please do your own research. Develop your own conviction so you know when to worry and when not to. Otherwise, you’re just donating money to people that did their work.

Unexpected Lessons

This site’s goal is to become a resource for people interested in investments. Therefore, almost all posts will be investment specific. However, there are exceptions to the rule. Arnold Van Den Berg’s life lessons are one of those exceptions.

Last week I attended an investment event organized by MOI Global. I enjoy those events because the community of investors is a truly amazing group of people. Therefore, I was intrigued when I saw a group of people gathered around a table at a cocktail hour. I figured some investing legend was waxing poetic about the merits of his/her investments. Naturally, I went to the table.

When I got to the table I saw Arnold Van Den Berg. I liked Mr. Van Den Berg’s talk at Google so I was excited to hear what he had to say. I was mesmorized the minute I sat down.

Mr. Van Den Berg was telling stories about his parents surviving Auschwitz. The most memorable story described his father surviving death marches. A death march was a 24 hour hike through deep snow. The participants had “normal” clothes on. If someone’s knee touched the snow, the Nazis beat them. If the person didn’t get up, the Nazis killed them.

Mr. Van Den Berg said his dad survived by focusing on locking his knee the second his foot touched the ground. Why? Because that was the only way to:

  • keep his knee high enough out of the snow, and
  • support his body weight given how depleted his body was.

His father attributed his survival on his ability to singularly focus on that task. His ability to focus was driven by his will to survive. And, his will to survive existed because of his family. Regardless of his circumstances, he focused on his wife and children.

Throughout his time at Auschwitz Mr. Van Den Berg’s father would see young, able bodied men come into the camp. Almost all of them withered away within 6 months. Arnold’s father said many of them lost the will to live because they didn’t have a larger purpose. Once they lost the will to live, death was inevitable.

I tried to absorb everything I could from Mr. Van Den Berg. Some lessons include:

  • When your life is more important than your principles, you sacrifice your principles. When your principles are more important than your life, you sacrifice your life. Mr. Van Den Berg is alive today because a young woman valued her principles enough to risk her life in order to smuggle him out of Amsterdam.
  • Never underestimate the power of the subconscious mind.
  • Focus is key to success.
  • Never give up. Whatever failure brought you to the point where you’re considering giving up also took you closer to success.
  • In order to be successful you must:
    • (a) be totally honest with yourself,
    • (b) repeat the actions necessary to become who you want to be,
    • (c) do good (the universe rewards those that legitimately add value),
    • (d) believe in yourself and your life direction.

Some of this advice may sound like self help BS. But, it’s coming from a man that grew up with a father and mother that survived the Holocaust. Moreover, he survived being in an orphanage while his parents were in Auschwitz. He lost 39 family members over that period. Therefore, I think his perspective on life is one worth taking seriously.

This post isn’t going to help anyone outperform the market. It won’t bring anyone back from sizing a position too big or making some analytical mistake. But, hopefully it keeps the world in perspective and helps someone realize how lucky they are. There’s a lot to be grateful for. Take a moment, remember that, call your loved ones, then get back to trying to outperform.

Recommended Reading/Viewing:

Mr. Van Den Berg at Google

https://www.barnesandnoble.com/w/think-and-grow-rich-napoleon-hill/1116671906#/

https://www.barnesandnoble.com/w/mans-search-for-meaning-with-new-foreward-viktor-e-frankl/1028813627#/ – Haven’t read this but @jerrycap recommended it and his book choices are pretty solid.

Beta is Risk

Yes, you read the headline correctly. The academics got it right. Sort of…

Public market investing rewards those who can identify assets trading at discounts to what they will be worth in the future. But what about the time in between initial purchase and the future? That’s where Beta comes in.

Beta, for those that don’t know, is the measure of a stock’s movement compared to the market. So, if a stock has a Beta of 1.25 a stock holder should expect to see 1.25x the volatility (good or bad) of the market. That volatility can cause some pretty costly errors.

Many, if not most, people have the capability to pick businesses that make sensible investments. Many, if not most, people have the ability to decide a sensible price to pay for an asset. Few people, however, have the ability to consistently see how assets are trading and remain rational. Moreover, the faster the prices move, the less rational people are. Why?

Upside volatility in stocks people don’t own causes FOMO (fear of missing out). This can lead to investors chasing stocks that run at exactly the wrong time. Downside volatility in stocks people own cases the flight response nature ingrained in our psyches. This can lead to people bailing on stocks they own at exactly the wrong time. Joel Greenblatt summarized public investing well when he said he gets paid more to have a strong stomach than for his analytical ability. See http://cfany.gallery.video/fullconference/detail/video/6053271135001/joel-greenblatt—keynote-presentation:-ben-graham-vi at 17:20 and 21:00ish.

So yes, Beta is risk. To the investor’s behavior. Beta, however, is not investment risk. Nor is it business risk. Thus, the academics got it right. Sort of…

Buybacks: An Inside View

Delta bought $1Bn+ of their own shares in February 2019. In doing so, Delta accelerated management’s planned capital return to shareholders. My first thought was “Delta thinks its stock is cheap.” Today, I view the move as smart capital allocation with potential upside.

Delta funded the transaction with a seasonal working capital debt facility. Usually a company has to pay an upfront fee to obtain a new debt facility. Let’s assume the upfront fee was ~37.5bps given Delta’s credit profile and ongoing bank relationships. Like all debt facilities, there’s an associated interest expense with the facility. These facilities are usually priced in relation to LIBOR. For this discussion, I assumed Delta has to pay LIBOR + 150bps. That said, I suspect the cost is closer to LIBOR + 75bps or LIBOR + 100bps. Either way, the example yields the same conclusion.

Assuming Delta obtained the facility in January, the cost of the facility looks something like this:

Note – the repayment assumptions accelerate during the summer because that is peak travel season.
Note also – Delta’s 2020 bonds yield slightly more than 2.60% to maturity. The facility above assumes a 4.15% interest rate. Thus, I suspect these calculations prove overly punitive to Delta’s ultimate interest expense.

As shown above, Delta incurred an incremental interest expense of roughly $13.8mm. What did Delta gain?

Delta’s dividend savings during the period almost exceeded the cost of the facility. On an annualized basis, the dividend savings exceed the assumed facility cost by 138%. Obviously, this math can get taken to an extreme because the company can retire more shares as it borrows more money. That said, this is a great example of how an investment grade balance sheet enables a company to play offense when opportunities present themselves.

Delta’s decision carries some risk. If the summer travel season is poor then Delta may not be able to pay the facility off as quickly as I assume. In that case, the facility costs will exceed my projections. Nevertheless, the company could manage an additional billion dollars of debt, if necessary (it had $1.9Bn of cash as of 3/31/19).

Importantly, despite any temptations, management didn’t get too carried away on the facility size. Accordingly, Delta made a low risk, potentially high reward bet. Those are exactly the kinds of bets I want my management teams making.

NOTE: Delta increased their dividend from $1.24/sh/yr to $1.40/sh/yr following the repurchase. This reduced the annualized savings from retiring the February shares from $24.3mm to $2.2mm. Personally, I would prefer for them to retire the shares and pay special dividends rather than raising the promised dividend. That said, I understand management’s decision and remain pleased with the corporate finance decisions.

European ULCCs – Time Arb Available

Ryanair (“the Company” or “RYAAY”) is Europe’s largest low cost airline (“LCC”).  The Company’s operations are extremely strong and it’s balance sheet is pristine.  Historically, the Company consistently produced the best margins in the industry.  RYAAY’s income statement is under pressure because Europe has way too much flying capacity and competitors are acting irrationally.  Moreover, Brexit fears and a recently adopted union contract (Ryanair wasn’t “union” until last year) have investors very nervous about the future.  So nervous that Ryanair’s ADRs are selling at $70.19/ADR (as of 5/22/2019) vs a high of ~$127.20/ADR (set 11/27/17).

Consequently, Ryan Air’s EV has meaningfully declined:

Note, the current EV is $13.3Bn (excluding leases, which account for 6% of the fleet) on a $12.8Bn market cap.  The company thinks its stock is cheap and just announced a $700mm buyback.  Therefore, roughly 5.5% of shares outstanding will be bought in at arguably attractive prices. 

Importantly, Michael O’Leary, the CEO, is not known to overpay for anything.  Further, he’s demonstrated particularly adept capital allocation. For instance, he made an incredible aircraft purchase following 9/11 and opts to pay a special dividend in order to maintain cash flow optionality.  Given his record, it’s unlikely he is going to meaningfully overpay for stock. Further, he has 112 million reasons to double profits over the next 5 years. See https://skift.com/2019/02/11/ryanair-ceo-michael-oleary-could-get-a-giant-payday-despite-airlines-current-woes/. Thus, I don’t foresee him using cash for anything unproductive at this time. Accordingly, I give this share buyback more weight than others.  

Nevertheless, it’s important to see whether anything fundamentally changed within the company to warrant the downward enterprise value rerating?

Operating Performance

Going back to 2006, Ryanair’s operating performance has been fairly volatile.  That said, the company’s trends are strong driven by increasingly efficient asset utilization.  A chart may help show this:

As shown in the chart above, over time, Ryanair generates more sales per dollar of assets employed.  This indicates the Company consistently improves it’s ROE potential.  However, margins are volatile.  Today, margins are within the “normal” historical range.  That’s a pretty impressive feat considering the state of European air travel.  Most importantly, RYAAY’s margins have a reasonably high probability of increasing as the competitive landscape rationalizes.

Competitive Landscape

European air travel demand is remarkably resilient.  Since 2005, passenger kilometers traveled have increased at 4.9% per annum (vs. 2.1% in the US).  JP Morgan attributes that growth to (1) the stimulus of low fares (the low cost carrier (“LCC”) model is younger in Europe than the US); (2) Western European trips/capita well below the US; and (3) under penetrated growth opportunities in Eastern Europe.  Moreover, LCCs grew their share of air travel from 17% in 2008 to 25% in 2018.  This happened because LCCs (1) stimulated air travel with low fares (remember, trains are very viable competitors in Europe); (2) took market share from legacy airlines; and (3) opened new bases at secondary airports.

Here are a couple interesting charts illustrating potential European travel per capita and LCC market share:

Unfortunately, the European airline sector made a classic mistake.  They expanded capacity way too quickly; growing capacity by 8-9% in calendar 4q18.  Estimates suggest 1q19 capacity growth will also be close to 8-9%.  Compare those rates to the 4.9% growth in passenger kilometers traveled and it’s easy to see why there are short term capacity problems.  Michael O’Leary discussed Europe’s airline industry on Ryanair’s May 2019 conference call:

I’ll bet O’Leary’s comments prove reasonably accurate.  Especially as they pertain to Ryanair’s ability to weather the storm.  Yes, he is outspoken, brash, and sometimes contradicts himself, but his track record at Ryanair is impeccable.  Further, his relentless focus on cost cutting is where I want to bet in a commodity game.  That said, avoiding commodity games could be a smarter way to invest.  Regardless, I have a sickness that pulls me toward my perception of value wherever I find it.

See below for some additional context on potential consolidation and the European airline industry’s recent economics:

Ryan Air Business Strategy

Ryanair is an amalgamation of Walmart, Amazon, and the airline industry.  The company is hyper focused on efficiency.  According to a friend (@Maluna_Cap on Twitter), Ryanair’s IR department said the entire airline has a call every morning.  After the first wave of flights takes off, the head of each airport dials into a conference call.  On the call they all give status updates.  Managers are expected to explain the reasons behind any and all delays.  Imagine the pressure of having to explain to ~80 peers why your airport performance was poor that day. Needless to say, that culture results in an efficient airline.

Note: Overall on time performance is declining in Europe due airport congestion and inadequate air traffic control infrastructure.

Ryanair’s strategy is to price seats extremely low in order to drive yield factors.  Beginning in 2014, Ryanair adopted its own version of “scale benefits, shared.” The airline has consistently dropped price in order to drive yield. Since 2014, prices per passenger declined from €46/passenger to €39/passenger. On average, Ryanair’s fares are 15-20% lower than its nearest competitor (Wizz), 30-40% lower than EasyJet, and 70-80% less expensive than Lufthansa, IAG, and Air France/KLM.  The result speaks for itself:

Note: Ryan Air pursued the strategy of using fares to stimulate growth

Ryanair’s low fares stimulate air travel.  Many of RYAAY’s destination airports are secondary airports (think Midway in Chicago rather than O’Hare).  Therefore, they are less expensive to fly into (Wizz benefits from using secondary airports as well).  Moreover, they are looking to increase passenger traffic. This gives Ryanair negotiating leverage over the airports. Consequently, Ryanair’s network has structural cost benefits embedded in it; especially against anyone not named Wizz.  Importantly, those cost advantages are hard to replicate because Ryanair’s scale results in increased discounts.  See below for Ryanair’s scale advantage:

Next, Ryan Air sells consumers ancillary products.  Similar to a grocery store’s use of milk, Ryanair prices seats at razor thin margins in order to sell additional upgrades (seat choices, preferred boarding, snacks, etc).  Thus, high load factors help (1) improve (a) revenue (additional people to buy ancillary products), (b) margin (ancillary revenues are almost completely accretive to margins), and (2) reduce costs as Ryan Air can negotiate better rates with airports, as discussed above.

Finally, Ryanair operates a very young fleet, which it owns.  The young fleet requires less maintenance and downtime.  Therefore, Ryanair’s maintenance costs are low and fleet utilization is high.  Moreover, Ryanair carries very modest leverage so the entity avoids a lot of the fixed costs embedded in financing a capital heavy business.

Putting it all together, below is a chart that shows Ryanair’s costs (CASK), revenues (RASK), and operating profit (EBIT per ASK) vs. Easy Jet and Wizz (note: all units per kilometer, which is the appropriate metric to use; generally longer trips generate more profit):

Business Conclusion

Fundamentally, its hard to see why Ryanair’s enterprise multiple warrants a long term multiple contraction.  Yes, there are short term issues.  And yes, the decision to recognize unions could hurt the underlying economics of the business in the short term.  However, based on Ryanair’s history, I suspect they will manage their unions as well as anyone.  Moreover, there is room to raise ticket prices to cover additional costs and still offer incredible value to customers.

Brexit is a major short term concern.  In the event of a hard Brexit, Ryanair is going to have to work with the EU to structure their shareholders in a way that 50% or more are EU domiciled (due to EU regulations).  Further, there will likely be some travel disruptions as 23% of Ryanair’s sales come from the UK.

However, it’s hard to see Brexit being a permanent overhang on the LCC travel industry.  Travel existed before Brexit.  One would think rational minds can prevail in order to keep travel occurring after Brexit.  That statement may be debatable.  Regardless, it appears as though extremely poor short term industry dynamics and Brexit concerns resulted in a potential opportunity. 

Valuation

Ryanair’s relative valuation is pretty low compared to it’s history. While the growth potential may have slowed, it still exists. Slower growth, combined with potentially higher labor costs, would warrant some multiple compression. However, the current rerating seems overdone.

Source: Bloomberg; 5 year Equity Relative Valuation vs. Self
Source: Bloomberg; 2 year Equity Relative Valuation vs. Self

Moreover, the company is guiding to between €700-€950 of profit this fiscal year. That means the offered unlevered earnings yield on the enterprise is 6-8% on depressed earnings. Furthermore, an entering shareholder’s return will benefit from the 5% share buy back authorization.

As of today, I believe Ryanair is approximately 25%-30% undervalued. I’m basing that on a number of scenarios. The downside risk to my terminal value estimate is approximately 33%, my base case expects terminal value to increase by 58%, and my blue sky scenario expects terminal value to increase 86%. The investment’s realized return will depend on the accuracy of those estimates, the time it takes for the market to realize Ryanair’s value, and whatever cash flows Ryanair generates.

In short, I firmly believe the expected value of this bet is positive. My bet is Ryanair’s current valuation reflects short term (12-18 month) concerns rather than a permanent degradation in operating potential. Accordingly, Ryanair warrants consideration at these levels.   Disclosure: Purchased a starter position on 5/21/2019 (yesterday); concerned about portfolio construction considering my Delta and Alaska investments.

———————————————————————————————-

Wizz is also interesting around these levels because almost all of the same analysis applies.  Wizz, however, is smaller, younger (still non union), and leases its planes.  Generally speaking, my view is the offered price on Wizz is much closer to intrinsic value.  That said, Wizz will likely reward its shareholders through growth.  In my view, Ryanair’s current EV and balance sheet provide a reasonable source of margin of safety.  Therefore, I am more comfortable buying the proven asset at a discount to what I think it is currently worth.  Moreover, Ryanair’s growth isn’t done even if it is going to be slower. 

Airlines – Grounded or Taking Off?

It doesn’t make any sense that Warren Buffett, arguably the greatest quality investor ever, retreated to his “value” roots to invest in airlines. This is the same guy that didn’t let Nike get through his investment filter. And now he invested in airlines? Airlines! The…worst…business…ever. Or is it?

Note: This is not investment advice! An airline investment is extremely risky and should only be undertaken after deep due diligence. If you believe what is written here and buy the shares of any company mentioned you should expect to lose your capital to someone more informed than you. Furthermore, the volatility in airline stocks is not for the faint of heart. Do not let yourself get interested in this idea if you consider Beta to be a meaningful metric.

Airlines: A Brief History

First, some facts must be stated:

  • Airlines will never be a capital light business. They require reinvestment to remain relevant. They may not need to purchase all new airplanes (ahem, American), but they do have to consistently reinvest in the cabin and airport experience.
  • No matter what, people will complain about flying. Very rarely do you hear someone say “Let me tell you how much I enjoy flying commercial airlines.” Usually people say they are being treated like cattle and getting gouged. The gouging claim is particularly interesting considering its never been less expensive to fly, but I digress. See
    https://www.travelandleisure.com/airlines-airports/history-of-flight-costs
  • The history of the airline industry is littered with wasted stakeholder capital. Note, I did not say shareholder. Everyone has had to compromise; shareholders, debt holders, employees, and sometimes customers. Here’s a quick look at a truly horrendous industry history:
Source: BAML

Historically, financially weak competitors wreaked havoc on financially responsible airlines. Usually, the weak competitor had poor cost structures and too much leverage. Combine that with high exit barriers and high fixed costs and you have a recipe for disaster.

Why? Airline seats are commodities. Always have been and probably always will be. Thus, airlines can’t do much when competitors react to financial trouble by pricing seats to cover variable (rather than all in) costs. Once an airline prices seats in that manner, all competing airlines are faced with two bad choices:

  • Don’t match price, lose yield, and pray to cover costs.
  • Match price, lose margin, and pray to cover costs.

Neither of those choices are great. The problem gets exacerbated when the financially distressed competitor files for bankruptcy. Bankruptcy usually enables poorly run/capitalized airlines to restructure their liabilities (such as union contracts, debt arrangements, etc.). Following the bankruptcy proceedings, a new, lean airline emerges to compete against the well run and responsible airline. Thus, responsible airlines have had to compete with poorly run airlines while they were in decline followed by cost advantaged competitors post restructuring. That’s a tough equation.

The Enigma

If all that is true why did Buffett choose to invest in this space? Doesn’t he understand history? Doesn’t he understand that buying a one of a kind brand like Disney at a market multiple is a great bet? Isn’t he the one that said a capitalist should have shot the Wright brothers? Isn’t this the man that said:

“Businesses in industries with both substantial overcapacity and a ‘commodity’ product are prime candidates for profit troubles. Over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over capacity and a new profitless environment.

The Pari-Mutuel System

Buffett understands compounders, capital light compounders, pricing power, quality, and any other phrase you throw at him. But, what I believe he understands better than most is the odds at which each bet stacks up against each other. As Charlie put it:

“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet…The prices [are such]…that it’s very hard to beat the system.” – Charles T. Munger

While the odds offered are important, any damn fool can also tell you a three legged horse isn’t going to win the race. A lame horse is a lame horse. Good odds aren’t going to change that. So, what does Warren see that makes this horse worth betting on?

Industry Facts

Today, 4 major airlines control 80+% of all US seats.

Source: BAML

More importantly, at least 3 of the 4 are financially stable. The one that concerns me the most is American. Doug Parker, American’s CEO, would respond by saying the company’s loan to asset value (“LTV”) is reasonable. I don’t necessary disagree with that thought process. However, I worry about the interest expense (an added fixed cost in a downturn) causing irrational behavior. Given the industry’s history, I’d far prefer American to have a better balance sheet this late in a cycle.

Nevertheless, here is Scott Kirby, President of United, discussing what is “different this time:”

American remains my “canary in the coal mine.” That said, American is acting rational and the Big 4 have been rational since they consolidated. Whether they remain rational in a downturn remains TBD. But, as my friend Jake Taylor mentioned in his book The Rebel Allocator, industries can usually remain rational when they have under 5 major participants…

In the meantime, airlines benefit from:

  • structural tailwinds (people valuing travel and bragging via Instagram; the trend towards urbanization also helps because consumer spending on travel to see family has proven to be resilient),
  • technological advancements (far better scheduling and pricing ability),
  • more efficient, rolling hubs (3 large legacy carriers can run much more efficient hubs than 6 carriers could ever hope to),
  • decoupling of booking fees and ancillary revenues (ancillary revenues are harder to price shop and therefore more inelastic),
  • airport infrastructure that is difficult to expand (gates are somewhat constrained), and
  • the often overlooked credit card agreements.

A Quick Note on Game Theory

Airlines seem to face a prisoner’s dilemma with pricing decisions. A description of the prisoner’s dilemma can be found at
https://en.wikipedia.org/wiki/Prisoner%27s_dilemma. There’s validity to the argument that in any given pricing situation Airline A is incentivized to “cheat” on price in order to gain market share. Since Airline B is afraid of that incentive, Airline B is incentivized to do the same. Thus, they will both end up cheating and aggregate returns will be suboptimal.

However, the prisoner’s dilemma applies to a game played only once. In the airline industry the game is played thousands of times every day. If Airline A cheats on one route, Airline B can respond on a different route. The 4 major participants signal to each other over and over again. They all also respond to these signals. When the game is repeated with such frequency it’s more likely to lead to prices that generate acceptable (though not great) returns.

Therefore, the repetition of the game reduces the potentially destructive incentives to cheat. Borrowing/bending a term from physics, the industry remains in quasi stable equilibrium. See
https://web.ma.utexas.edu/users/davis/375/popecol/lec9/equilib.html.

Competitive Position Assessment

SCG likes the competitive positions of the ultra low cost carriers (Allegiant, Spirit, Frontier), Delta (generates a revenue premium), and Alaska (benefits from a cost advantaged union contract that is unlikely to go away). As I see it, costs are the only way to win consistently in commodity industries. That said, Delta is an incredibly well run airline and has proven revenue premiums are sustainable in this industry. It’s only right to credit Phil Ordway of Anabatic Investment Partners as the original source for that line of thought. His thought process is compelling and I haven’t been able to debunk the reasoning. Disclaimer: Long Delta and Alaska.

Credit Card Agreements: The Gem No One Cares About

The industry’s credit card agreements are immensely profitable for the airlines. Further, the cash flows are growing at reasonable rates and generate free cash flow “float.” Alaska Air Group discussed their credit card agreement at a JP Morgan event. Here’s what they said:

Note: ALK’s enterprise value is $11.4Bn (inclusive of pension obligations and operating leases). So, cash flow from credit card/loyalty agreements totals 8.7% of a fully baked enterprise value.

It’s certainly interesting that Buffett, who’s core competence is financials, just happens to be interested in airline stocks at the same time the industry’s credit card economics improved. Maybe it’s a coincidence. Maybe not.

Interestingly, Delta recently announced that they renegotiated their deal with American Express. See
https://ir.delta.com/news/news-details/2019/American-Express-and-Delta-Renew-Industry-Leading-Partnership-Lay-Foundation-to-Continue-Innovating-Customer-Benefits/default.aspx. That new deal extends the relationship to 2029. Delta expects to generate $7.0Bn of free cash flow from this agreement by 2023 (vs. $3.5Bn in 2018). Of that $7.0Bn, $3.0-4.0Bn will be a “marketing fee.” Marketing fees are pure margin and don’t require Delta to fulfill any obligations. The remaining $3.0-4.0Bn of cash flow has a murkier margin because the benefits usually reduce revenues per flight. That said, if the benefits are used to fill an otherwise empty seat they are virtually all margin since the variable cost of that seat is negligible.

At a minimum these credit card agreements are a very efficient way to finance the business. A bull would argue this portion of the business is a high margin sales organization growing at ~14% per year. What’s that worth? Joe DiNardi, an analyst for Stifel, Nicohaus & Co is asking that same question:

Most importantly, why have the credit card economics changed so much and are these changes sustainable? That was a difficult question to answer. Scott Kirby believes it’s because of the airlines’ improved financial positions. See below:

Mr. Kirby’s explanation is rational. Distressed loans require banks to hold more capital against the loans. That additional capital requires a return. Therefore, the notion that banks historically hit their “hurdle rate” by keeping all the credit card economics makes sense. With the industry in better shape, banks now hold less capital against the loans and probably generate more cash management (and other ancillary) revenues. Thus, they are more willing to give up some of the credit card economics.

Importantly, Delta’s recent announcement seems to suggest the good times will continue for the airlines and credit card commissions. That’s good for all stakeholders.

Why Delta

Now that we’ve established that airlines might be reasonably healthy horses, it’s time to look at the odds offered on the bet. This post will analyze Delta because SCG believes it’s far and away the best run hub and spoke airline in the world. Further, Atlanta is a sustainable competitive advantage for Delta’s network. Atlanta is so valuable because it’s incredibly efficient. Some estimates say Atlanta is up to 200bps more profitable than other hubs. This advantage stems from Delta dominating the hub and Atlanta’s traffic volume.

Perhaps most importantly, Delta can survive turbulent periods. In the event of a downturn, Delta has $1.9Bn of cash, $3.0Bn of revolver availability, and generated free cash flow in 2009. Therefore, Delta can probably handle the left tail of potential outcomes. Delta has $1.7Bn of debt maturities coming due in 2020 and $1.4Bn due in 2022. It would be nice to see them refinance and meaningfully extend the term of that debt. Now is a good time to refinance because debt markets are seemingly starved for yield.

Delta’s Offered Odds

With that in mind, let’s take a look at Delta’s free cash flows available to equity since 2009. This analysis of free cash flow available to equity adds back a proforma adjustment assuming 40% of capex was financed with debt. As of today, Delta’s debt to Net PP&E totals 37%. Delta’s management is pleased with the balance sheet today. Thus, analyzing average free cash flows using a proforma adjustment assuming 40% of capex will be financed going forward is reasonable assumption.

Since 2013, Delta’s average pro forma free cash flow available to equity totaled $4.1Bn per year. As stated, this number rests on the proforma adjustment assuming that 40% of capex was/will be financed. Again, I am comfortable with that assumption because (a) it’s unreasonable to expect Delta to not finance any equipment purchases, (b) the balance sheet is in a reasonable financial position (debt and debt like obligations account for 41% of asset value; those obligations consist of $9.0Bn of pension obligations, $10.7Bn of debt, and $5.8Bn of operating leases), and (c) it’s more important to figure out how the business is going to look going forward rather than what it looked like in the past.

2013 is a valid starting point for the analysis because it is the year the DOJ approved the last of the Big 4 mergers. A reasonable argument can be made that requires the analysis to look back to 2009 (which is why I showed those years as well in the chart above). That said, I base this analysis on the competitive period that is most similar to today.

Going forward, Delta should return most of the free cash flow available to equity to shareholders. Let’s say they use 20% of cash flow to build cash reserves and 20% to voluntarily reduce pension obligations. That leaves about $2.5Bn for dividends and share repurchases. As of 3/31/2019 there were 655mm shares outstanding with a promised dividend of $1.40/share/year. Therefore, Delta will be paying roughly $920mm in dividends annually. Thus, approximately $1.5Bn, or 4% of the current market cap is available for share repurchases. Note, this assumption doesn’t take into account the impending growth in credit card cash flows.

I’d be remiss not to mention that Delta’s market cap includes $2.0Bn of equity investments in other airlines, a refinery that does about $4.0Bn of sales every year (total assets were $1.5Bn at 3/31/19), and a maintenance repair organization (“MRO”). The MRO has run rate revenues of ~$800mm annually with “mid teens” margins. Further, Delta expects the MRO to achieve $2Bn of revenues over the next 5 years. All together lets say the assets mentioned in this paragraph are worth $4.0Bn.

Accepting the assumptions above, Delta currently trades at an 11+% free cash flow available to equity yield. Moreover, they have the opportunity to “buy in” 4% of their shares every year. IF the competition remains rational shareholders have a reasonable chance to earn 13-15% on their capital in the foreseeable future. Those kinds of returns will generate a lot of wealth when rates are below 3%.

The Bet

Returning to Munger for a moment…the airline “horse” may not be the best. But the odds offered are intriguing. Importantly, the horse is reasonably healthy. One question remains: is the future actually different this time? Who knows? Buffett put his chips in. I did too. But, I may be some schmuck that convinced himself an elegant theory was correct because I wanted to believe it so badly. Time will tell. I’ll still be in the position when the story is told.

The beauty of this game is Buffett’s “fat pitch” doesn’t have to be anyone else’s. Regardless of people’s conclusions, it’s important to look at why the greats do what they do. The thesis above isn’t dispositive, but it does hit many of the key points. See also
https://twitter.com/BillBrewsterSCG/status/1010219620131893250 for a bit more industry information.

As always, please feel free to contact me with any questions and/or corrections.

PS. I asked Charlie about the airline investment. He said this:

Recommended Reading/Viewing/Listening

https://www.sec.gov/Archives/edgar/data/1670076/000119312517106522/d366312ds1.htm

See also the Airline Weekly podcast: found at
https://airlineweekly.com/
And really any of the speeches at The Wings Club found on YouTube

The Rebel Allocator is a fantastic and fun book with many pearls of investment wisdom.

PPS. If you liked any of the above commentary look into subscribing to Airline Weekly. Also, follow Phil Ordway @pcordway on Twitter. Phil is the Portfolio Manager at Anabatic Investment Partners LLC. He gave a fantastic presentation to Manual of Ideas that started my research journey. Finally, try to participate in any Manual of Ideas events you can. John Mihaljevic puts on great events and strikes me as a person doing it for the right reasons.

FIZZled Out

The world can change. Fast. Or at least perception can.

At hand is a confession. Or rather, a reflection.

The game of investing is hard. Very hard. A mere 18 months ago I was fairly convinced LaCroix was a true brand. The kind that could stand the test of time. The kind that a young Buffett and Munger would dream of. At the time I saw (and to some extent still see) a low wallet share, frequently purchased, habit forming product that didn’t suffer from taste attrition. The taste attrition attribute was absolutely key to my thesis because it’s the quality that makes Coke so desirable. And, more importantly, keeps customers returning. See the clip below (starting at ~44:28 for why I thought that was so key).

Below are screenshots of when I made my meaningful purchase and sell decisions on National Beverage Corporation (“National Beverage” or “FIZZ”), the owner of LaCroix. I am sharing because I think it’s important to be transparent. In that same spirit I have to admit I bet too little at the time. I wasn’t fully comfortable running a portfolio back then so my strategy was to bet small and ensure survival.

Below is a chart of what happened during my “investment.” I put investment in quotes because it is never my intention to hold a position for under a year. In my view, holding a security under a year is closer to speculation than investing.

Ultimately, I got nervous about how quickly the position increased. I just couldn’t get myself to hold on to an entity priced at ~2.5% current cash flow yield (~$100mm of trailing 12 month free cash flow and a $4.0Bn enterprise value at time of sale). So I sold. The hardest part of selling is I was certain the business would continue to grow. So, I felt pretty horrible as I watched the stock increase another 20% within 10 weeks.

Fast forward to today…I tweeted at @alderlaneeggs (hereafter “Mr. Cohodes”) asking why he was short the company. I was poking around because the stock has fallen substantially since I exited.

Mr. Cohodes is known for shorting frauds. It was odd to see him short this company because, while I agree there are substantial corporate governance issues, I don’t believe fraud is a major risk. While he didn’t give me a direct answer, he did mention competition and his Twitter feed has pictures showing Costco discounting LaCroix Curate (an extension of the LaCroix brand). Therefore, I believe Mr. Cohodes is short because of capital cycle theory (more assets/competition chasing the market) resulting in LaCroix discounting to drive sales. Discounting is not only a sign of organic demand declining, but also results in lower margins.

I didn’t realize I’d find out whether he was right so quickly. Tonight FIZZ released its 10-Q. It contained the following:

Source: http://ir.nationalbeverage.com/static-files/6b551c4f-17d8-40e9-82c9-a7faf2302bec

In layman’s terms the 10-Q said “We’re selling less LaCroix because of a lawsuit ( https://www.usatoday.com/story/money/nation-now/2018/10/05/lacroix-lawsuit-claims-sparkling-water-ingredients-cockroach-insecticide/1532241002/ ). Consequently, our manufacturing margins declined because we processed fewer units and costs stayed fairly constant.” I’m skeptical the lawsuit is the real driver of the volume decline. Therefore, as of today, it looks like Mr. Cohodes is right.

Alternatively, it is possible the lawsuit against LaCroix really has hurt volumes and customers are waiting for the outcome. I suspect the headline of the lawsuit reads worse than the facts ultimately prove. If that is truly the case, I’d bet LaCroix will recover (see Chipotle for an example of a food company rebounding from negative health publicity).

Nevertheless, look at the reaction to the 10-Q:

Which brings me to my takeaways from this post:

  • Beware that facts can change pretty quickly- Just last quarter FIZZ disclosed 16% growth in the Power+ (mostly LaCroix) brands. What a difference a quarter makes.
  • Don’t be afraid to sell when you think you are getting above fair value- I exited when the cash flow yield felt egregious. The short term pain of exiting and watching the stock run up is worth not being in the stock today.
  • Be mindful that things you know may not be so- I was certain LaCroix would grow and grow. This is now two consecutive quarters of free cash flow erosion. Pay attention to facts as they develop and don’t get anchored to an opinion/conclusion.
  • Seek out smart people with divergent opinions- I wasn’t prepared to purchase the stock today. I didn’t have enough data. But, tweeting at Mr. Cohodes (and his response) reframed how I view the situation.
  • The only thing worse than a value trap is a busted growth story.
  • Remain humble.
  • Never anchor to a narrative.

ROIC And Returns

Warren Buffett discussed his Kraft Heinz mistake with Becky Quick. While he still views Kraft Heinz as a wonderful business, he paid too much. Here is a screenshot of the transcript:

Source: https://www.cnbc.com/2019/02/25/full-transcript-billionaire-investor-warren-buffett-speaks-with-cnbcs-becky-quick-on-squawk-box-today.html

Investors often say that overtime your returns will converge with the business’ returns. As Buffett mentions above, that is simply not true. What is true, however, is your returns converge with the underlying business when you purchase a business and it grows substantially following your purchase. The higher the entry price, the more the business has to grow in order to provide the owner with the business’ underlying economics.

The reason is simple. As an owner/partner, you earn your proportionate economics on the earnings a business generates. However, each partner has a different entry price based on a different earnings base (depending on when they purchased shares and/or LP interests). Therefore, each owner/partner is entitled only to his/her purchase yield on the base he/she acquired. Following the purchase, however, an owner’s economics on the incremental earnings base mirrors the underlying economics of the business.

Kraft cannot grow the earnings base Buffett paid for. Thus, he is stuck (for now) earning $6Bn on his $100Bn purchase price. His economics will only improve if KHC (1) repurchases shares when they yield more than 6% on the enterprise (he is effectively averaging down in that transaction), (2) grows again and is able to earn more than $6Bn pretax without needing to raise additional equity, or (3) successfully executes an accretive acquisition.

As the greatest of all time shows, price is extremely important on slow growing businesses. More importantly, he provides some clarity on an often misunderstood investing idea.

Note: This discussion assumes Buffett purchased Kraft with 100% equity. That’s not factually accurate. Financing decisions can change the specifics of the discussion above, but the points made above are accurate for teaching purposes.