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





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.

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.

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/

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. 


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
  • 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

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


See also the Airline Weekly podcast: found at
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.