Curated Insights 2019.01.25

Netflix flexes

Netflix has shows it owns completely, shows it own first-run rights to, hybrid shows like Hastings described, second-run shows — it runs the gamut. Critically, while some models are more profitable than others, all make the service more attractive to Netflix’s customers. This will be a particular challenge for a company like Disney: the company is staking a good portion of its future on its own streaming service driven by its own IP, but has not suggested a willingness to scale supply like Netflix has. That, by definition, will limit the company’s upside when it comes to consumer reach and also long-term pricing power.

T. Rowe Price’s Henry Ellenbogen on Gartner

Every company is trying to figure out how to use technology, internally and externally. One play on this is Gartner. Ninety percent of Gartner’s earnings before interest and taxes comes from its research business. It has two parts. Because of the demands that all companies have to use technology better and understand how their competitors are using it, the research product has transitioned from one that was nice to have to one you need to have. You can see it in Gartner’s numbers. Last year, it had over $2 billion of revenue and grew more than 13% organically. It’s a global business. We believe that it is going to continue to be a strong double-digit growth business.

The average customer spends $180,000 for Gartner research. They want to know what technology providers they should look at to answer their key questions. How are other people using technology and on-boarding it? How can they drive technology into a business line to get efficiency?

The other 20% of the research business is where the controversy has been. We have owned the stock since 2010. It has compounded at well over 20% since we’ve owned it. In the past two years, Gartner’s performance has been weaker, because it bought Corporate Executive Board, or CEB, a business best-practices consultant outside of technology that helps functional groups in a business understand issues in their areas.

Gartner instituted a turnaround at CEB. The product was fine, but it had to change the go-to market. They were selling by individual site license, as opposed to role-based pricing, and had to re-energize the sales force. A lot of costs have come into this division, with only modest improvement in growth; that’s where the controversy is. But Gartner now has an excellent franchise in an area that is becoming increasingly important globally.

In addition, Gartner has deleveraged. The leverage was about four times. It is now 2½ times, and the company is deleveraging at more than one time per year. They are back to buying back stock. We see low-$4 earnings per share in 2019. Free cash flow historically has been 130% or greater, because customers pay upfront. Next year, we see low-$5 EPS and close to $7 of free cash flow, and expect the company will return to trading at 20 to 25 times free cash flow, versus 18 times now.


T. Rowe Price’s Henry Ellenbogen on SS&C Technologies

When we think about compounders, the two key factors are ownership’s mentality and the durability of growth. My next pick, SS&C Technologies Holdings, came public for the second time in 2010, and we have been owners since the second IPO. Despite a mediocre 2018, the stock has compounded wealth at 24% since the IPO.

SS&C does fund accounting. It provides the pipes on the technology side and the service side for hedge funds. It’s the leading provider in the country; a lot of people in this room probably use them. And they are also the leader for private equity, and early last year, they bought DST Systems, which provides these services for mutual funds.

Bill Stone started the company in a classic American way, by getting a second mortgage on his house in 1986. He still owns 13% of it. Even in an industry where growth is neutral or negative, when you get into the plumbing, people can’t really take you out. You have a revenue stream, and you have pricing power. People worry about the health of their customers. But even under modest volume, Stone is going to have pricing power. If you change your back office and your accountants, you get all sorts of questions from your customers.

People are very concerned about the capital markets. But 10% of the company’s revenue is tied to market sensitivity; 90% isn’t. That’s about $50 million of Ebitda, if you assume a 30% correction, about 40% incremental margins. On the flip side, we believe that DST could yield an additional $50 million to $100 million of synergies beyond market expectations.

Another concern is that SS&C is 4.7 times leveraged, and the market doesn’t like leverage. This is the only highly levered name I am going to mention, and there are three reasons. First, Stone is investing his own money alongside other people’s, and he is very focused on paying down the debt. Second, the business is a very low capital-intensive one that is very sticky, and we think under normal operating situations, the leverage will be below four times by the end of this year. Third, when Stone bought DST, he got DST Health, which does $100 million of Ebitda and is a noncyclical business. If he wanted to, he could sell it at 12 to 15 times Ebitda, and that would instantly deleverage the company below three times. So he has another road out. We believe that SS&C Technologies will earn about $3.70 a share this year and $4 to $4.10 next year.


Rivulet Capital’s Oscar Schafer on Dollar Tree

Dollar Tree operates 15,000 stores under two distinct banners: Dollar Tree, a chain of variety stores selling a unique assortment of discount merchandise, all priced at a dollar, and Family Dollar, a chain of discount stores offering everyday goods and general merchandise. The Dollar Tree business is doing great, and it continues to execute on a growth model that has worked for three decades. The company acquired Family Dollar in 2015 and strove to really stabilize that business and turn it around. The reasons to be optimistic are that they have paid down debt and started ramping up investment in the Family Dollar stores. Most importantly, the stock price has declined to a point where I feel that I’m buying Dollar Tree for a fair price and getting Family Dollar for free. I like free options.

The Dollar Tree segment is a strong and stable business that will generate over 80% of consolidated operating income this year. A true “dollar” store, Dollar Tree employs a rapidly rotating assortment of merchandise to create a “treasure-hunt” experience. This format has proved to be largely insulated from e-commerce competition. The growth at Dollar Tree has been spectacular over the past 10 years, including during the financial crisis. Since 2006, the store count has more than doubled, from 3,200 to 6,900. Same-store sales growth has averaged 4.1%, and operating income is up by almost five times, with a compound annual growth rate of 15%.

Family Dollar’s business is different. A direct competitor is Dollar General. Family Dollar offers an assortment of everyday necessities in general merchandise, primarily to low-income consumers. Physical stores are much smaller; consumables make up almost 80% of the sales, and, over the past few years, the company has suffered from a litany of issues: food deflation, management turnover, and strategic operational business mishaps.

For many years, Dollar Tree was a stock-market darling, driving a 28% compound annual return from 2006 to 2014. Since acquiring Family Dollar in 2015, Dollar Tree shares have gone almost nowhere. This is due to dramatic multiple compression, not stagnating earnings. In fact, earnings were up by more than 60% in the past three years. On a combined basis, Dollar Tree is now trading at a relatively discounted valuation of less than 16 times forward earnings, and less than 10 times enterprise value to Ebitda.

We see multiple ways to win. First, we estimate that Dollar Tree can grow Ebitda at a mid-single-digit rate, even if we assume continued deterioration at Family Dollar. In this scenario, the company should still generate a billion dollars in excess free cash flow per year over the next few years. Having recently gained investment-grade status, the company can reallocate the cash flow from debt pay-down to share buybacks. This should drive double-digit earnings growth. Assuming a 16-times-earnings multiple on our estimate of 2021 earnings, I see 30% upside over the next two years.

Second, we see an opportunity for value-creating corporate action. In 2014, Dollar General attempted to buy Family Dollar for almost $10 billion. My research suggests that given the chance, Dollar General would again jump at the opportunity to consolidate its nearest rival. I estimate that the market is currently ascribing zero value to Family Dollar within Dollar Tree, so even if they sold Family Dollar at a discount to the 2015 purchase price, this would still unlock substantial value for Dollar Tree holders.

Serving the six-sided teeter totter: 2018 year in review — adventur.es

We often get asked by sellers, “What will adventur.es do for my company? What resources will you provide? What kind of growth can you promise?” Our answer is short and meant to be sweet — plan on adventur.es being a fair, long-term home for the business and its people, and nothing else. The response is almost always met with incredulity and usually leads to a great conversation.

What organizations do is overrated, while what organizations don’t do is highly underrated. It’s easy to make promises and we’ve certainly made plenty over the years that haven’t turned out well. What’s hard is following through — doing what you say you’ll do, when you said you’d do it, and under the terms agreed upon.

What’s even harder than doing what you say is intentionally not doing, and being transparent about it. Our first rule is “do no harm.” Humans are creatures of progress and crave shortcuts. We’ve learned that progress (almost) never comes by prescription, nor pill. Knowledge can light the path, but it can’t walk it for you. Often the right decision is to wait, gather more information, and reassess.

We ask that our sellers and company leadership have low expectations for us around everything except how we treat them. We’re not in the business of interventions, although we have paid for rehab a few times. If we intervene, we must see it through. It’s like a tree branch that is growing in the wrong direction. Merely pulling on it won’t solve the problem. The branch must be pulled and held, almost indefinitely. Sometimes we can help identify a poor direction, but leadership teams are the ones who pull and hold the branches.

The only other way to acquire a skill set is by hiring outside talent, a consultant, or a firm that can perform the difficult task. Again, there’s a nasty selection bias at play. If you’re excellent at a difficult-to-acquire and valuable skill, you typically don’t seek employment opportunities, or consulting gigs, or customers in small business, and especially in non-sexy industries.

Our goal is to find someone who has a range of experiences in successfully generating revenue through varied channels, building teams, and taking ownership of results. We know it’s humanly impossible for one individual to have deep experience in all the revenue disciplines. We expect this leader to build a team, both at the adventur.es level and within the portfolio companies, and draw on some stout resources already here.

Curated Insights 2018.08.03

Once in a lifetime, if you’re lucky

Apple did it the old fashioned and the new fashioned way – great products, great marketing, incredible innovation, brilliant people, global supply chain, incessant improvements and updates, buybacks and dividends, R&D and M&A, domestic hiring and international outsourcing, wild creativity and diligent bean-counting. They had it all and used it all. It’s an amazing story. Many of us were able to be along for the ride.


Business lessons from Rob Hayes (First Round Capital)

It is a red flag for me if the founders have 20 slides in their deck on their product and are not getting into issues like distribution, team or other parts of the business. There have been very few products that cause people to beat a path to the door of the business on their own [like Google or Facebook]. Successful companies almost always have operators running them who know how to market, sell, manage an income statement and hire.


Why do the biggest companies keep getting bigger? It’s how they spend on tech

The result is our modern economy, and the problem with such an economy is that income inequality between firms is similar to income inequality between individuals: A select few monopolize the gains, while many fall increasingly behind.

The measure of how firms spend, which Mr. Bessen calls “IT intensity,” is relevant not just in the U.S. but across 25 other countries as well, says Sara Calligaris, an economist at the Organization for Economic Cooperation and Development. When you compare the top-performing firms in any sector to their lesser competition, there’s a gap in productivity growth that continues to widen, she says. The result is, if not quite a “winner take all” economy, then at least a “winner take most” one.

What we see now is “a slowdown in what we call the ‘diffusion machine,’” says Dr. Calligaris. One explanation for how this came to be is that things have just gotten too complicated. The technologies we rely on now are massive and inextricably linked to the engineers, workers, systems and business models built around them, says Mr. Bessen. While in the past it might have been possible to license, steal or copy someone else’s technology, these days that technology can’t be separated from the systems of which it’s a part.

This seemingly insurmountable competitive advantage that comes with big companies’ IT intensity may explain the present-day mania for mergers and acquisitions, says Mr. Bessen. It may be difficult or impossible to obtain critical technologies any other way.

Everything bad about Facebook is bad for the same reason

Facebook didn’t intend for any of this to happen. It just wanted to connect people. But there is a thread running from Perkins’ death to religious violence in Myanmar and the company’s half-assed attempts at combating fake news. Facebook really is evil. Not on purpose. In the banal kind of way.

Underlying all of Facebook’s screw-ups is a bumbling obliviousness to real humans. The company’s singular focus on “connecting people” has allowed it to conquer the world, making possible the creation of a vast network of human relationships, a source of insights and eyeballs that makes advertisers and investors drool.

But the imperative to “connect people” lacks the one ingredient essential for being a good citizen: Treating individual human beings as sacrosanct. To Facebook, the world is not made up of individuals, but of connections between them.

The solution is not for Facebook to become the morality police of the internet, deciding whether each and every individual post, video, and photo should be allowed. Yet it cannot fall back on its line of being a neutral platform, equally suited to both love and hate. Arendt said that reality is always demanding the attention of our thoughts. We are always becoming aware of new facts about the world; these need to be considered and incorporated into our worldview. But she acknowledged that constantly giving into this demand would be exhausting. The difference with Eichmann was that he never gave in, because his thinking was entirely separated from reality.

The solution, then, is for Facebook to change its mindset. Until now, even Facebook’s positive steps—like taking down posts inciting violence, or temporarily banning the conspiracy theorist Alex Jones—have come not as the result of soul-searching, but of intense public pressure and PR fallout. Facebook only does the right thing when it’s forced to. Instead, it needs to be willing to sacrifice the goal of total connectedness and growth when this goal has a human cost; to create a decision-making process that requires Facebook leaders to check their instinctive technological optimism against the realities of human life.

Thinking about Facebook

If you accept that assumption, 35% EBIT margins on $97 billion in sales would equal $34 billion in operating income. Inversely, that implies more than $60 billion in expenses (COGS + OpEx). This suggests that Facebook’s run rate expenses will more than triple from 2017 to 2022. Over that same period, these assumptions would result in cumulative revenue growth of around 140%.

Let me give you one example to show just how much money we’re talking about here (over $40 billion in annual expenses). It’s assumed that Facebook will need to hire many people for its safety and security efforts. If it adds an additional 20,000 employees and pays them $200,000 each (not a bad salary!), that would cost them $4 billion a year. For some context, Facebook announced back in October that it planned on hiring an additional 10,000 safety and security personnel by the end of 2018. I’ve tried to give them plenty of room, and this still only covers roughly 10% of the incremental costs we need to account for to push operating margins to the mid-30s.

Here’s my point: I have a tough time understanding how Facebook can possibly need to spend this much money. It seems to me that this is largely a choice, not a necessity.


Apple’s stock buybacks continue to break records

No company has bought back more shares since 2012 than Apple. It has repurchased almost $220 billion of its own stock since it announced in March 2012 that it would start to buy back shares. That is roughly equivalent to the market value of Verizon Communications. Over that period, the number of Apple’s shares outstanding has dropped by just over a quarter.

Waymo’s self-driving cars are near: Meet the teen who rides one every day

Tasha Keeney, an analyst at ARK Invest, says that Waymo could choose to offer an autonomous ride-hailing service today at around 70 cents a mile—a quarter of the cost for Uber passengers in San Francisco. Over time, she says, robotaxis should get even cheaper—down to 35 cents a mile by 2020, especially if Waymo’s technology proves sturdy enough to need few human safety monitors overseeing the autonomous vehicles remotely. “You could see software-like margins,” Keeney says.

Bill Nygren market commentary | 2Q18

A closer look reveals that Gartner stock fell when management opted to substantially increase selling and marketing expenses to pursue accelerated organic growth, which in turn decreased the company’s reported earnings. The way GAAP (generally accepted accounting principles) works, because the future benefit of a marketing expense is uncertain, the cost is immediately expensed. But at a company like Gartner, these marketing expenses could easily be seen as long-term investments in company growth. That’s because a Gartner customer tends to remain with the company for a long time—a little more than six years, on average. So we adjusted the sales and marketing expenses to reflect a six-year life, just like GAAP would treat the purchase of a machine that was expected to last six years. With that one adjustment, Gartner’s expected EPS increased by almost $3. Using our adjusted earnings, which we believe reflect a more realistic view of those intangible assets, Gartner appears to be priced as just an ordinary company.

Ferrari slumps after CEO says Marchionne target is ‘aspirational’

Ferrari is banking on Camilleri getting up to speed quickly to press ahead with Marchionne’s plan. While Marchionne was planning to retire from Fiat Chrysler in 2019, he was meant to stay on at Ferrari for another five years. His succession plan was not as advanced at the Maranello-based company as it was at FCA.


WeWork is just one facet of SoftBank’s bet on real estate

If the market opportunity is big, SoftBank will typically make investments in regionally dominant companies operating in that sector. After all, if worldwide dominance is difficult to obtain for any one company, SoftBank is so big that it can take positions in the regional leaders, creating an index of companies that collectively hold a majority of market share in an emerging industry.

Heineken inks $3.1 billion deal to grow in hot China market

The deal will help Heineken gain a tighter foothold in a crowded field by leveraging China Resources Beer’s extensive distribution network, while also sharing in the returns of China’s beer market leader. China is now the second-largest premium beer market globally, and is forecast to be the biggest contributor to premium volume growth in the next five years.

Under the deal, Heineken’s operations in the country will be combined with those of China Resources Beer, and the Dutch brewer will license its brand to the Chinese partner on a long-term basis, according to company statements Friday. China Resources Beer’s parent company will acquire Heineken shares worth about 464 million euros ($538 million). Heineken will also make its global distribution channels available to China Resources’ brands including Snow, according to the statement.

Branded Worlds: how technology recentralized entertainment

There are two answers to the first question: cost and time. Maybe it’s a lot easier to shoot and edit movies/TV than it used to be, but sets, locations, actors, scripts — those are all expensive and difficult. Better amateur work is still far from professional. And while it’s true we’re seeing interesting new visual modes of storytelling, e.g. on Twitch and YouTube, it’s very rarely narrative fiction, and it’s still distributed and monetized via Twitch and YouTube, gatekeepers who implicitly (and sometimes explicitly) shape what’s popular.

More importantly, though, democratizing the means of production does not increase demand. A 10x increase in the number of TV shows, however accessible they may be, does not 10x the time any person spends watching television. For a time the “long tail” theory, that you could make a lot of money from niche audiences as long as your total accessible market grew large enough, was in vogue. This was essentially a mathematical claim, that audience demand was “fat-tailed” rather than “thin-tailed.”

China is building a very 21st century empire—one where trade and debt lead the way, not armadas and boots on the ground. If President Xi Jinping’s ambitions become a reality, Beijing will cement its position at the center of a new world economic order spanning more than half the globe. Already, China has extended its influence far beyond that of the Tang Dynasty’s golden age more than a millennium ago.
It used to be the case that active portfolio management was the default investment style. Over time, and with the help of academic finance, we have come to realize that there are other factors at work. The most obvious of which is the market factor or beta. It is this insight that underlies the rise in index investing. A trend which by all accounts is still in place.