I have managed this portfolio for six years now and thought I would share a few thoughts on my investment approach and how it has changed over the last few years, along with the global market environment and many lessons learned. Although it is common to evaluate a manager’s investment skill based on past returns alone, I think it is more appropriate to concentrate on the “how” – his investment decisions and the reasoning behind them considering the information available at the time. Was the manager just lucky, did he just ride a trend, and how repeatable is his success going forward?
When I started out in the midst of the financial crisis in 2008, it was very easy to pick big, stable businesses at low valuations (meaning: low risk, high return expectations). For example, eBay was trading at less than five times free cash flow – at this valuation, while the risk of permanent capital loss was very small, the chance to generate returns greater than 20% was very high (either supported by cash generation or multiple expansion). I ended up buying a basket of stocks with a similar profile, some of them well-known names (eBay, Carrefour, Munich Re, Kraft Foods, Starbucks, Walgreen, McDonald’s, Microsoft) but also smaller, lesser-known names (Orpak, Aspen Insurance Holdings, A.C. Moore, GFK, Paypoint).
By around 2011, markets were back to their pre-crisis levels and the rising tide had lifted most boats. The low-hanging fruit had been picked. As already mentioned in my last letter, many investors (Buffett disciples included) have since started paying up for companies. To justify higher prices, investors are increasingly talking about growth, hidden values (sum-of-the-parts valuations, restructuring potential) or financial gimmickry (refinancings, spin-offs, etc.). The more conservative folks talk about quality: quality of a business and quality of management. In their minds, high quality justifies a high price.
Having studied many portfolios from fellow value investors and having seen how many portfolios suffered severe losses of more than 50% in 2008, I’ve become very wary of paying a high price for anything. In my analysis, a substantial part of losses in value portfolios in 2008 was caused by holding on to stocks trading at high valuations – whether the underlying businesses were of high quality or not. Another question is what quality actually means. I noticed that people focusing on “quality” rather than intrinsic value often fail to account for the complexities of real life. As much as we all love wide moat businesses that keep growing with minimum capital requirements, it’s much easier to spot them in hindsight than to anticipate their success with foresight.
For example, while BMW – a darling in the European value community – is definitely a great brand with great products, it doesn’t come without risk. BMW’s top line is dependent on low interest rates and cyclical consumer demand, its ever-increasing leasing portfolio and leverage might bear risks (i.e. payment defaults, residual value-accounting), it is operating in an industry with global overcapacities, and its market valuation arguably looks rich if compared to its free cash flow generation over the last 10 years. A cynic might even say that BMW, rather than being a great car maker, has become a consumer bank with an attached auto assembly plant.
I could sum up several examples where a business’ perceived superior quality shows some weakness if thoroughly challenged. For instance, Tesco, considered almost an infrastructure-type of investment, is now unexpectedly struggling with competition from hard discounters such as Aldi. Coca Cola’s growth is exposed to the ongoing health debate and increasing competition from low-priced me-too competitors such as Soda Stream or no-name labels. Apple’s profits are heavily dependent on sales of a premium cell phone – a product subject to severe technological disruption and ever-changing consumer taste. In essence, even to the trained eye a company might look like a safe compounder – until it suddenly doesn’t anymore.
So, as global markets rose and the easy picks became rarer, I continued to invest in companies with low valuations – albeit of lesser prominence. My favorites became companies with high net cash levels and positive cash flows, those for which I assumed some safety net in the company’s assets or management’s quality at low valuations. This approach was essentially following the footsteps of investors I consider role models, who had made their most successful investments in option-type situations with asymmetric risk-reward characteristics. The idea was (and still is) that a portfolio of investments where the upside is significantly higher than the downside will do well over time, despite a few losers that are essentially built into the equation.
So far, the strategy has worked quite well. I also believe that the portfolio’s returns have been less correlated to the overall market development as the comparison with the MSCI World Index might suggest. Since I kept selling stocks when they became expensive, returns were driven by the underlying assets rather than market trends or sector rallies.
Still, I made a few costly mistakes that could have been avoided. In some cases, I attributed value where there was none, in others I just overpaid. Here are a few simple but important lessons learned:
- Negative working capital can be a structurally cheap and efficient way to fund a business as long as it is stable or growing. However, any conservative valuation should treat it for what it is: leverage (which will become obvious in a restructuring situation).
- Weak earnings quality can often be exposed by a rigorous analysis of capital expenditure and capital expenditure efficiency. For example, companies with long-life assets often show higher “EBIT” than the comparable (and arguably more relevant) cash flow measure “EBITDA less capex” – as can be explained by inflation, temporary maintenance underspending, costly technological upgrade or asset replacement requirements. In the media space, many companies report inflated earnings by overcapitalizing development, IT, R&D, or product licensing costs.
- Beware of businesses operating in weak momentum environments (e.g. due to regulatory changes, industry overcapacities, technological disruption or product substitution), as this might lead to accelerating earnings and asset price erosion.
Most of my mistakes were caused by overpaying due to lack of experience or rushing into investments where I didn’t want to miss profit opportunities. In the future, I shall be more patient in waiting for truly exceptional investment opportunities. This goes along with the affirming realization that, despite an increasingly expensive market, these last few years offered plenty of attractive opportunities.
All that said, an old quote found new resonance with me: “Nobody ever got fired for buying IBM.” In other words: it’s easier to justify losses or underperformance when purchasing shares everybody knows and loves. The flipside is that it is also more difficult to market a portfolio of undervalued nobodies, as clients might make the error to perceive such a portfolio to be of higher risk versus a portfolio of “blue-chips” or “story” stocks.
Despite these challenges, iolite will continue to pursue an investment strategy that focuses on asymmetric risk-reward situations, where the upside potential is significant and the downside is protected at the valuation levels seen at the time of capital allocation, as this seems a reasonable thing to do. I am in it for the long term, and you should be too.
The above commentary is excerpted from the iolite Partners quarterly letter for Q3 2014.
Disclosure: This document does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Past results are no guarantee of future results and no representation is made that an investor will or is likely to achieve results similar to those shown. All investments involve risk, including the loss of principal.
Wyndham Worldwide Corporation (WYN) is a global hospitality company. The Company offers consumers a collection of hospitality services and products through many lodging selections and price ranges from its vast collection of brands. WYN functions in three segments of the hospitality industry: lodging, vacation exchange and rentals, and vacation ownership.
I believe that WYN is a great investment for many reasons.First of all WYN is a compounding machine that uses the ample FCF that it generates yearly to further grow its business and improve its returns and earnings. The FCF is also sometimes used to buy back some of the company’s outstanding shares. WYN also has a high level of resiliency due to its largely fee-based business model in all three of its segments. WYN has a strong balance sheet, a lot of moats protecting its business, and is currently trading at a discount relative to its peers and based on a PMVsum-of-the-parts basis. WYN has a current estimated intrinsic value of$118, along with a32% margin of safety.
Threats, risks, and possible reasons for WYN’s low valuation
One of the main reasons why I believe WYN is undervalued is that most investors don’t understand timeshare, and therefore dismiss all together. In addition, WYN operates in a cyclical industry. The lodging, vacation rental, and time-share industries are all cyclical, and the key risk for potential shareholders in WYN is an economic declinewhich will then lead to a sharp reduction in business and personal travel needs and expenses. Additionally, WYN’s use of debt has the potential to intensify the damagingeffect of an economic downturn on its business operations. A risk for WYN’s time-share operations is the possibility for stricter credit conditions in the securitization market which will subsequently lead to areduction in growth andrevenue generation. Europe’s economic uncertainty, especially in the U.K., where austerity measures are stifling consumer confidence, may also be a cause for concern. WYN has about 100,000 vacation rental properties located in Europe. Given its significance presence in Europe, the current economic problems in Europe may restrict the growth of WYN’s vacation rental businesses.
High Switching Costs: When an owner decides to franchise one of WYN’s hotel brands, he/she ends up being locked in a 10-20 year contract. If an owner decided that he/she wants to exit WYN’s system and perhaps use another brand for his/her hotel, he/she will face hefty costs. These costs include but are not limited to costs associated with changing to another company’s system, and costs associated with rebranding their properties. Switching to another brand will also cause disruption to the hotel’s day to day business.
Brand recognition: WYN’s lodging business operates under 20 renowned hotel brands. WYN’s strong brand moat enables it to charge a premium rate and still grow its profits. It is also one of the reasons why its RevPAR was able to increase by 20% over the last 5 years.
Networking effect:WYN’s time-share exchange has a very effective competitive advantage that prevents potential entrants from stealing away its market share. This competitive advantage results from an integral network effect. In order to be successful in this sector, companies need to have a sizeable amount of time-share owners in an exchange. Attracting property owners and developers to an exchange is a very difficult task especially if they are already tied up with another company. Moreover, without having a sizeable amount of property owners and developers, it is hard for a potential entrant to draw in time-share owners to the exchange. WYN’s vacation rental business also possesses an integral network effect. It is hard for a vacation rental business to draw in property owners unless they already possesses a network of many prospective renters, and the opposite is true. The company’s hotel operations business also has a moat stemming from a network effect. With every additional number of properties and traveling customers in its network, more property owners that want to benefit from the large number of travelers in WYN’s network, get more drawn to WYN.
Customer captivity: WYN has an industry-leading customer loyalty program, Wyndham Rewards (among other programs including the RCI elite program) which attends to about 28 million members, over 7 million of whom are currently active worldwide. This program is lodging industry’s biggest loyalty program based on the number of participating hotels. Wyndham Rewards presents its members with numerous selections to accrue points. Members may accrue points by lodging in hotels franchised under any one of WYN’s brands or even by acquiring products and services from companies that are partnered with WYN in the program. Each member of the program has more than 400 choices to redeem his/her points (hotel stays, airline tickets, resort vacations, etc…). This program is currently accessible in the US, Canada, Mexico, Europe and China. Wyndham Rewards improves customer captivity and satisfaction, and ensures a high retention rate.
Economies of scale: WYN’s vacation ownership business has developed about 190 vacation ownership resorts in the US, Canada, Mexico, the Caribbean and the South Pacific. This embodies more than 23,400 individual vacation ownership units and over 915,000 owners of vacation ownership interests. WYN’s vacation exchange and rentals business services about 33.7 million members via its 4,000 vacation ownership resorts, and over 55,000 vacation properties. Moreover, WYN’s lodging business generates revenues from 20 different brands, with about 7,340 hotels and over 627,000 rooms around the world. All the aforementioned qualities enabled WYN to achieve economies of scale in its operations.
The graph to the right represents WYN’s long term (7 year) marginal cost (MC) and average total costs (ATC). Economies of scale are usually achieved when a company’s long term MC curve is below its ATC curve. As can be seen clearly in the graph this is the case for WYN.
WYN’s competitive advantage success is mainly attributed to its economies of scale and its customer captivity. When a company is able to attain economies of scale and customer captivity it usually possesses a very strong unbreakable moat. Additionally, WYN’s widespread lodging operation in all of its sectors and the synergy in its operations allow it to draw in more customers and it also allows it to strengthen its brand equity amongst its target group.
WYN on a Consolidated Basis
Below isWYN’s share price, market capitalization and enterprise value as of Sep10.
WYN’s trailing multiples are low relative to those of its peers.
WYN’s TTM operating and profit margins are both higher than the average of its peers. 19.13% of its revenues ends up as free cash. The company has been known for its strong cash generation which it compounds year after year and/or use to buy back shares.
Furthermore, WYN generates very strong returns on capital as can be seen below:
From a first look at the numbers below, we can deduct that WYN is in a good position with how it manages its leverage. Both its current and leverage ratios are situated between the industry and peers average. However, CHH alone has a leverage ratio of 145.35% when the rest of the peers excluding CHH have an average of 27.66%. When looking at it in this perspective we can deduct that WYN’s leverage position is not favorable compared to its peers (excluding CHH) and industry. Its leverage ratio is higher than both industry and peers (excluding CHH) which implies high levels of debt. Relatively speaking, this high level of debt adds to the company’s risk and should be reflected in a higher cost of equity relative to its peers.
When a company generates its earnings from more than one segment it is imperative to look at each segment individually to analyze its performance over a period of time and to see how it fared against the competition. WYN looks to be very cheap as a consolidated unit, but is it cheap when looking at each segment individually?
Wyndham Hotel Group (WHG), is the world’s largest hotel company based on the number of properties. Wyndham Hotel Group makes up about 21% of WYN’s reported revenues. The segment witnessed about a 9% revenue and EBITDA CAGR over the last 5 years.
Wyndham Hotel Group is a one of WYN’s top performers. In addition to its revenue and EBITDA growths, WHG also witnessed a 16.67% RevPAR growth. This shows that the company’s additional rooms generated additional income instead of being obsolete.
WHG will be compared with Marriott (MAR), Hyatt (H), and Choice Hotels (CHH). These are some of the best performing businesses in the lodging industry.
As can be seen above, WHG recorded the highest operating margins compared to Marriot and Hyatt, and high returns on capital. CHH recorded the overall highest margins and astonishingly high returns compared to the rest. However, as we saw before CHH had very high leverage. Its leverage ratio was 3 times higher than WYN’s leverage. The opportunity cost of CHH’s high returns and margins was incurring extremely high levels of debt. When looking at it in that perspective I believe that WYN has the more favorable situation.
The reason for WYN’s success is in its business model. WHG generate more than 90% of its revenue through a franchising model rather than a direct ownership one. Franchised hotels have considerably less fixed costs than owned hotels and have historically operated better in the good and bad economic times. The franchising model is flexible and adaptable to change as a result of its low operating cost structure. When this low structure is combined with recurring fee streams, the result, as can be seen above, is high margins, returns, and free cash flows.
Vacation Exchange and Rentals
Wyndham Exchange & Rentals (WER) is the largest member-based vacation exchange network in the world based on the number of vacation exchange members and related vacation ownership resorts. WER is also the largest marketer of professionally managed vacation rental properties in the world based on the number of vacation rental properties marketed. WER makes up about 30% of WYN’s reported revenues. The segment witnessed a 5.78% revenue CAGR and 4.4% EBITDA CAGR over the last 5 years.
WER’s members fell by about 2% over the last five years, not a large drop considering that IILG’s (WYN’s main competitor) members dropped by almost the same amount. Its revenue per member grew from $176.73 to $181.02, its rental transactions increased by almost 54%, and its average net price per vacation rental grew by about 11.5%. WYN is one of the strongest operating companies in this area of the hospitality industry.
WER and Interval Leisure Group (IILG) control more than 95% of the market share in the timeshare exchange business (WER: 60%, IILG: 35%). As a result I will be using IILG as its main competitor when comparing its operating margin and ROC.
Although WER generated strong returns and operating margins over the last five years, it was not able to generate higher returns and operating margins than IILG. For WER, the key drivers of future growth will be, growth in its operating statistics (number of members, revenue per member, rental transactions, and price per vacation rental), and operating margin. Given that over the last 5 years, WER has been able to grow its operating statistics, and maintain a stable operating margin, it can be safely deduced that WER will be able to grow in the coming years.
Wyndham Vacation Ownership (WVO), is the world’s largest vacation ownership business based on the number of resorts, units, owners and revenues. WVO makes up about 50% of WYN’s reported revenues. The segment witnessed a 5.27% revenue CAGR and 2.5% EBITDA CAGR over the last 5 years.
WVO’s gross VOI sales grew by about 44% over the last five years. Its tours and VPG both grew by 28%, and 16% respectively. WVO is WYN’s largest segment based on revenues. The fact that it has been growing steadily over the last 5 years is a strong indicator of WYN’s strength and growth and high growth prospects.
WVO will be compared with Marriott Vacation & Rental properties (VAC), Hyatt Vacation Ownership (H), and Starwood Hotels & Resorts (HOT).
As can be seen above, WVO incurred the highest operating margins and came in second to H in returns (not by a lot though).
In 2010, management started to focus on increasing its margins and returns by growing its Wyndham Asset Affiliation Model program (WAAM). WAAM was designed to capitalize upon the large quantities of inventory in the real estate market without undertaking the sizeable costs that complements property acquisition and/or new construction.
WAAM has two components, WAAM Fee-for-Service, and WAAM Just-in-Time. The former offers turn-key solutions for entities that own or control recently developed inventory, which WVO then sells for a fee via its widespread pipelines. WAAM Fee-for-Service allows WVO to expand its portfolio without undertaking massive capital expenditures (maintenance capex was only $107 million last year), while supplying additional channels for new owner acquisition and growth through its fee-for-service property management business. In 2012, WVO introduced WAAM Just-in-Time, an inventory acquisition model. This model enables WVO to obtain and possess finished units that are close to their time of sale. As a result, this model drastically reduces the time between the acquisition of the inventories and the subsequent return on investment which occurs when the units are sold.
WVO’s focus on increasing revenue from its WAAM will drive high returns and margins in the future. In 3-5 years majority of WYN’s timeshare business will be in “asset-light form” (i.e. through its WAAM). This should result in higher returns and margins. WYN is attempting to reach WAAM target of 15% to 20% of gross VOI sales over the next five years. Following the application of its WAAM model, WYN will attempt to transform its timeshare business into an asset-light structure.
Share Buybacks: Over the last 6 years, WYN’s board authorized share buyback programs worth $3 billion. Currently, it has $476 million shares remaining as of Apr 23, 2014. Since 2007, management has also raised its share repurchase programs five times, most recently on July 23, 2013. I believe that this strong affiliation to always increase shareholder value serves as a strong catalyst for WYN in the coming years given its successful history in doing so. WYN is constantly attempting to improve its shareholders’ returns, even during bad economic periods.
Asset-light structure: As I mentioned earlier, WYN is steadily redeploying its vacation ownership business away from the actual ownership of the asset and towards more of an asset-light structure via its WAAM program. This transition is going to serve as a very important catalyst for WYN as it will enable it to grow its FCF even more in the coming years and reduce its capital expenditures tremendously.
Yield management: WYN’s exchange business has recently implemented a yield management system, which has shown a lot of success. As a result, WYN is working to apply this system to its rental business as well. WYN’s successful yield management system has also been applied to its vacation ownership business. WYN has introduced it in the UK and Holland, with other European markets expected to adopt its system in the coming periods.
International expansion: WYN is constantly trying to expand internationally. WYN anticipates that it will be able to double the number of rooms in the Asia-Pacific region in the next 2 years. WYN also anticipates that it will be able to grow the number of rooms in South America at a rate of 15% per year, and 8% in Europe, The Middle East, and Africa. WYN also plans to open a Wyndham Hotels & Resorts-branded property in Colombia and Nicaragua this year. Over the next 10 years, the company also plans on opening 20 Super 8 hotels in Turkey. WYN has recently announced that it opened its first Super 8 hotel in Saudi Arabia, with 20 more planned to be built in the next 5 years. In addition, WYN has also announced plans to open the Middle East’s first Wyndham Garden hotel in Qatar. The hotel is expected to open in 2017. All these new developments will help the company gain more market share in the hospitality industry, and increasing their returns and profitability in the coming years.
I have estimated an intrinsic value for WYN using a sum-of-the-parts valuation. Rather than seeking pinpoint precision, the aim of the valuation is to demonstrate that the stock is undervalued even using conservative assumptions.
All of the multiple assigned were based on each sector’s PMV (private market value), the value that a potential buyer would assign to an entire company, sector, etc… The PMV was computed based on an average of multiple deals that have occurred in the past. Given each sector’s strength, I think that the multiples assigned were extremely conservative given their upside potential. However, it is better to be more conservative than aggressive.
The foregoing valuation is conservative not only due to the multiples employed, but also because of WYN’s earnings and returns potential as well. I believe that WYN is a compounding machine. It generates plenty of FCF every year which it then reinvests to grow its business. This can be evidenced by the company’s continued strong generation of free cash and the subsequent increase in its earnings and returns (WYN had a 15% CAGR in its reported EPS over the last 5 years). It is because of that reason, in addition to its share buybacks and WAAM program, that I am reasonably confident that the value of the company in the future will be greater than or equal my estimated intrinsic value.
Stephen P. Holmes is WYN’s Chairman and CEO. Holmes has worked for the company or one of its predecessors for about 20 years. Based on WYN’s successful track record, it is safe to say that Holmes has done an outstanding job as manager of the company. The fact that WYN has had high ROC and has returned free cash flow to its shareholders through buybacks and dividends attests to that.
Before becoming the Chairman and CEO of WYN in 2006, Holmes served as vice chairman and a member of the board of Cendant Corporation, and Chairman and CEO of Cendant’s Travel Content Division. Under his leadership there, some of his significant accomplishments included the formation of the TripRewards loyalty program, the formation of the successful RCI Points program for the timeshare industry, and successfully growing the timeshare development business to becoming the largest seller of VOIs.
From 1990 to 1996, Holmes served as the EVP and CFO of HFS Inc. HFS provided fee-based consumer services primarily to the travel and real estate industries. He was credited for successfully bringing the company public. Throughout his time as CFO, HFS acquired more than 20 companies, grew its market cap by 20 times (from $1 billion to $20 billion), and was one of the fastest growing stocks on the NYSE. Holmes was also a managing director of The Blackstone Group. He was engaged with the strategy, negotiation, and integration of acquisitions for the Blackstone investment partnership.
Holmes’ success at WYN is credited to his experience in investing and private equity (The Blackstone Group), his experience in providing fee-based services (HFS), and his experience at Cendant where he was able to understand and successfully implement a flourishing timeshare business.
Wyndham Worldwide is a leader in the hospitality industry. It is the world’s largest hotel company based on the number of properties, the largest member-based vacation exchange network in the world based on the amount of vacation exchange members and related vacation ownership resorts, and the world’s largest vacation ownership business based on the number of resorts, units, owners and revenues. WYN is currently selling at a discount relative to its peers and based on a PMV sum-of-the-parts basis. WYN is a strong compounding machine that generates a lot of FCF which it uses to grow and expand its business, and to buy back its shares to increase shareholder value. WYN also has a lot of moats protecting its business, and fending off any potential entrant from entering the market. I estimate an intrinsic value for WYN of $118, and a margin of safety of 32%. I recommend a long position for this company.
The stock markets rose during most of the quarter. Only in mid-August did a correction occur, when the Ukranian crisis threatened to escalate both militarily and through economic sanctions while bad economic data from Europe and China also weighed on the markets. But the dip lasted for only two weeks, as the situation in Eastern Europe calmed down, the US economy registered strong growth, takeovers especially in the pharmaceuticals and technology industries fed speculation and the European Central Bank loosened monetary policy further.
Roughly as many winners as losers
There were roughly as many winners as losers. No single stock contributed more then one percentage point to performance, whether positively or negatively. As a group, our large cap technology stocks, Microsoft, Hewlett-Packard and Cisco, did especially well with a contribution of 2.0%-points to performance, as did our two cruise ship lines, Norwegian Cruise Lines und Carnival, with 1.3%-points. All of these shares are listed in US dollars, which rose strongly during the quarter to add 2.7%-points to performance. The impact of the other currencies was small (0.2%-points). Losers included our three oil service companies, Akastor, Aker Solutions and Petrofac (together -1.1%-points), as well as those firms that are particularly sensitive to the slowdown in European economic growth, such as our temporary employment agencies Randstad and Adecco, the automotive supplier Leoni and French broadcaster TF1. It was striking how hard the market punished companies that missed quarterly earnings estimates (Software AG, Kingfisher). Put options on the indices S&P 500, Stoxx 50, FTSE and SPI cost 0.6%-points. We bought these derivatives in August to hedge against a collapse in the markets in case the Ukrainian crisis spun out of control (see our blog article from July about our handling of political risks).
Another two new ideas in the portfolio
After we found three new ideas in each of the previous two quarters, we came across another two in the reporting period, Petrofac and Norwegian Cruise Lines. Moreover, we were able to add to our positions in Kelly Services, Rent-A-Center and Carnival at attractive prices. We sold Temenos and Newell Rubbermaid, because they had reached their intrinsic values. We trimmed our stakes in Hewlett-Packard and Teleperformance as good performance had made them too big.
Petrofac is an engineering company in the oil and gas industry headquartered in London. Outside the United Kingdom it operates mainly in the Middle East, North Africa and the Caspian region, where it handles projects primarily for the local national oil companies. Historically, Petrofac has grown a great deal organically and has the highest margins in the industry. The company has never lost money on a project. Moreover, it has partnered with oil producers in the production business. Two of these ventures reported delays and weak oil production, which led to a profit warning and drop in the stock price. The founder and CEO remains the largest shareholder and is very involved in operations. His achievements and the record-high order backlog make us optimistic about the future. We estimate the stock’s intrinsic value to be GBP 18.50.
Norwegian Cruise Lines is an American cruise line. We already made our first investments in this sector in the second quarter with Carnival, among other things because we find the industry’s structure attractive, given its high growth rate, high margins, industry concentration and an attractive product. Norwegian came under new ownership in 2008 and since then has become the big challenger in the industry with the youngest fleet and fresh, innovative ideas. This is the Carnival brand’s formula for success from the 1990s, and by following it Norwegian has managed to nearly double its revenues and increase its operating earnings tenfold. As the company will bring more new and thus highly profitable ships to market in the next years, we believe that it will continue to develop well.We estimate the shares are worth USD 54.
Potential of the fund has increased
We are of course not pleased that we have been unable to beat the market in the last five months. But it is also not realistic to expect that we do so all the time, because we are unable to identify the winners of the near future. So we don’t try. Instead, we look for undervalued companies that should deliver above average performance sometime in the medium term – when exactly is impossible to say. Thus, patience is required. What makes us optimistic for the future is that we have once again found undervalued companies, thanks to which the earnings potential of the funds, as measured by the intrinsic values of our stocks, has risen since the start of the year, though the NAV has essentially not moved. We should therefore be able to deliver satisfactory returns in the medium term.
The above commentary is excerpted from the Classic Global Equity Fund quarterly letter for Q3 2014.
Discovery Communications, Inc. is a global media company that provides content across multiple distribution platforms, including digital distribution arrangements, throughout the world. The company’s content spans many non-fiction genres.Its main network (the Discovery Channel) is the most widely distributed television brand in the world, reaching more than 224 countries. Discovery’s three main networks, Discovery, TLC, and Animal Planet, reach nearly 100 million households. The company has more than 2.2 billion subscribers worldwide.
As of October 4th 2014, Discovery was selling at a market price of $37/share. The company had 464 option-adjusted shares outstanding (see exhibit 9). This yields a market cap of $17,168 million, and when adding Net Debt of $6,702 million we get an Enterprise Value of $23,870 million. Given Discovery’smost recent EBITDA of $2,431 millionthe company is being valued at ~9.82x EBITDA ‘14. I estimate that Discovery’s FCF will grow by about 11-13% in the next few years. Discovery currently trades at 14.5-15.0x FCF. I estimate that Discovery will generate about $1,303 million in FCF next year. This indicates a day-one cash-on-cash return of ~6.8% with a strong possibility/likelihood of that FCF growing in the low to mid-teens range over the next 5 – 7 years as the company’s international network expands and grows in the upcoming years. The company is currently being run by a great management team that has a lot of stake in the business as 43% is owned by them. Discovery is also backed by one of the best capital allocators, John Malone, and has incurred very high returns and margins over the last seven years.
Discovery’s U.S. Networks represent about 50% of the company’s total revenues. U.S. Networks operates and wholly owns nine networks including Discovery Channel, TLC and Animal Planet (all three generate about 70% of revenues). This segment also holds a 50% investment in The Oprah Winfrey Network(OWN), and has recently announced that it is acquiring a majority interest in The Hub (the company previously had a minority interest in it). Revenues are generated from fees charged to distributors in addition to advertisement sold on its networks.
The company’s top three channels, Discovery channel, TLC and Animal Planet,aresome of the top channels in the U.S.They are also the top cable networks in many key demographics, with ratings witnessing continuous growth year after year. After acquiring full interest in The Hub, the company repositioned the channel from a strictly children’s network to a family network. The network witnessed continuous double digit growth in its viewership from children aged 2-11 over the last eight consecutive quarters. Advertising revenue is rising in this network as toy companies are increasingly using it to promote their products to children. There aren’t many channels aimed at children and parents, this really places The Hub in a good competitive position.Although OWN witnessed a slow start upon its launching in 2011, the network is improving steadily. The channel recently saw a 50% surge in viewers during prime time. The recent deal signed with Tyler Perry helped increase viewership, and should keep doing so in the future, which will follow in an increase in advertising dollars.
U.S. Networks’ sales have increased by 43% (6.2% CAGR) since 2008. In that same period, the segment reported high gross margins (75% on average), operating margins (58% on average), and FCF margins (55% on average). The segment’s gross margins remained stable during that period; its operating margins increased by 13% at a CAGR of 2.02%; and its FCF margins increased by 9% at a CAGR of 1.52%. All these numbers are great indicators of the segment’s effectiveness and efficiency at operating, and generating profits and cash. However, looking forward, growth in this segment is not going to be substantial. 2016 revenues are projected to be $3336, a 13% increase from this year’s revenues. (See exhibit 1)
Discovery’s International Networks segment is the company’s key growth driver. The segment makes up about 48% of the company’s total revenues, and is one of the key differentiators between the company and its competitors. The segment generates its revenues from operations in virtually every pay television market in the world through an infrastructure that includes operational centers in London, Singapore and Miami. Discovery has significant negotiating power with distributors internationally since it has an average of 8 channels available in each country it operates in. Discovery has a strong presence in Latin America as it has many top networks and channels there. For example, Discovery Kids is the number one cable network in Brazil. Pay-TV is growing at a fast pace internationally, and Discovery is well positioned to reap the benefits of this growth.
Discovery’s well established position in the international scene has provided with a strong edge over its competition. For example, Netflix has recently started to look for opportunities in Latin America. Discovery owns the content and the channels there and so it wouldn’t make sense for them to allow Netflix to stream their content. Additionally, competitors like Scripps have been trying to break into the international market but have struggled to do so. Discovery had already an established position internationally as it has established its position 20 years ago.
Discover is also is continuously expanding internationally. It has recently acquired Dutch cable operator Ziggo, Pan-European platform Eurosport, SBS Nordic Operations, and Channel 5 UK, home of many hit shows like Big Brother, The Dome, CSI and Person of Interest. The acquisition of Eurosport is an important factor for the company’s future growth. The channel reaches more subscribers across Europe than ESPN in the U.S. Eurosport has one feed that is sold on a Pan-European basis. The channel has a strong local presence and Discovery is planning to take advantage of that and expand on it. With ESPN’s recent focus on Latin America, Eurosport has a chance of taking control of some of the market in Europe. Moreover, Discovery recently announced that it had entered into a content partnership with China’s WASUDigital TV Media Group, for its 24/7 Pay-TV channel Qiu Suo. Given that Pay-Tv’s demand is growing rapidly in the Asia Pacific region, Discovery is bound to reap strong benefits. Asia Pacific accounts for more than 55% of global Pay-TV subscriptions. The low level of Pay-TV penetration in Asia Pacific is expected to create a huge opportunity to expand the company’s subscriber base there.
Discovery’s InternationalNetworks’ sales have increased by 146% (16.2% CAGR) since 2008. In that same period, the segment reported high gross margins (66% on average), operating margins (31.7% on average), and FCF margins (42.3% on average). The segment’s gross margins decreased moderately from 66% to 62%, during that period; its operating margins remained relatively stable; and its FCF margins increased by 15% at a CAGR of 2.39%. These numbers are good indicators of the company’s effectiveness oversees. The numbers aren’t as high as the US networks’ numbers and have somewhat remained stable as a result of the company’s continued expansion. More spending, implies lower high margin expansion. Looking forward, growth in this segment is going to be substantial. 2016 revenues are projected to be $3,850, a 35% increase from this year’s revenues. International revenues have always lagged the US revenues. This year they reached their highest level. They represented 48% of revenues. In 2016, they are projected to surpass the US Networks’ number and represent 54% of revenues. (See exhibit 2)
Discovery’s Education network generated $118 million in revenues last year.The segment’s revenue represents 2% of Discovery’s total revenue. Education is comprised of curriculum-based product and service offerings. Discovery seeks to expand this business by acquiring other related companies in the U.S. and internationally.
Discovery Communications on a Consolidated Basis
Discovery Communications proved over the years that it is one of the best companies in the world. It was able to achieve that as a result of its successful business model. Discovery is a vertically integrated content company that owns many channels, networks, and the content therein. Discovery owns almost all the digital rights to its content. As a result the company has a strong advantage over its competition in that it’s getting revenues from distributors for current content, in addition to also getting incremental cash flow from its dated content. Lately, Netflix started investing its own original content production as it started to realize where the real power lies in this industry. Content is the key to continued growth and sustained advantages over competition in this industry. Technology and distribution platforms will come and go, the only thing that will remain intact is the original content that drives demand in this industry. As a result, I believe that Discovery is going to be able to endure any impending disruption to its business model over the next 10-15 years, if not more.
Over the last seven years,the company’s total revenues grew by 72% at a CAGR of 9.5%. During that period, gross margin averaged 70.4%, operating margin averaged 36.8%, net profit margin averaged 18.4%, and FCF margin averaged 19.1%. Discovery’s gross margins decreased moderately from 70% to 68%; its operating margin increased by 16% (from 30% to 35%); its net profit margin increased by 111% (from 9.2% to 19.4%); and its FCF margin increased by 6.42% (from 13.6% to 19.7%). (See exhibit 3)
Discovery’s returns were very high too during the same period. The company’s TTM ROC was 26.4% and its ROE was 19%. ROC and ROE averaged 28.47% and 13.53% respectively over the last seven years. Both ROC and ROE show the superior advantage that Discovery has in this business.(See exhibit 4)
All the above results are great indicators that this is a great business to invest in. To make sure that the company is indeed a great investment I am going to compare its performance with its peers, Time Warner, AMC, Sripps, and 21st Century Fox. I am going to use averages of the last seven years for both the peers as one group versus Discovery (for more details please refer to exhibit 5).Average operating margins over the last seven years was 37% for Discovery vs. 20% peer average; net profit margin was 18% for Discovery vs. 10% peers; FCF margin was 19% for Discovery vs. 16% peers; ROC was 28% Discovery vs. 16% peers; and Financial Leverage was 2.0 for Discovery vs. 2.3 peers. These results might not be a perfectly fair representation of performance since they are averaged; however, they do give a good idea of how well Discovery fares against its peers.
Discovery’s superior returns and margins are clear indicators that the company is operating with moats. Discovery Communications is branded as the world’s leader in the production of non-fiction content. The company has a strong portfolio of brands satisfying consumers’ multi-varied interests. TLC is the number one female lifestyle brand in the world, Animal Planet, and the Discovery Channel are also leaders in their respective segments; and according to industry estimates, the Discovery Channel is actually the number one brand in overall quality in America. Discovery’s brands are so strong that the channels themselves have become commonly known as ‘the nature channel,’ ‘the health channel’ and ‘the animal channel’. Discovery has strong brand names and few competitors, this resulted in their strong brand moat.
Throughout its many years of operating successfully and expanding, Discovery was able to garner a very high and extensive customer reach. This high customer reach enabled the company to have a strong competitive advantage. The company’s content, is produced once, and is then distributed across its many subscribers at no additional cost. The company’s extensive customer reach which resulted in a wide subscriber base enabled Discovery to attain operating leverage. Moreover, the high customer reach means that Discovery can be in a better bargaining position with regards to advertisement pricing.
International expansion is one of the keys to the company’s long term success. However, some countries might not have the best or the latest infrastructures and might be lagging in technology. This could hinder the company’s international growth prospects and poses as a risk for its international expansion plans.
Another looming threat that could negatively affect the company is the risk of consolidation among cable and satellite providers. The consolidation among the cable and satellite providers has the potential to diminish the number of distributors available, hence raising the distributors’ bargaining power. In the US, about 90% of Discovery’s revenues come from the top 10 distributors. If that number diminishes, the company could lose some bargaining power in the future. In addition, many of the countries and territories in which the company operates has a small number of dominant distributors. If they consolidated the company would face the risk of losing revenues as a result of the distributors’ strong bargaining power.
Discovery is more reliant on advertising revenue than its competitors, with 50% of revenues coming from advertisements alone. Hence, an economic slowdown, or a downturn will inevitably hit Discovery harder than it would its competitors, as most companies usually cut on advertisement expenses first in a bad economy.
Online technologies are challenging business models throughout the media sector and could diminish Discovery’s profitability. Viewership of its programs could fall below expectations, and advertisers could pull back on their spending, both of which could drag on Discovery’s ad revenue growth. The recent emergence of online multimedia from companies like Hulu, Amazon, and Netflix have been increasing the consumption of TV content over the internet. However, the company acted fast and entered the online industry by introducing Discovery Digital Networks (DDN). Moreover, the company also started partnering with online content providers and showcasing its contents there. The company signed deals to show its contents through Time Warner, Netflix, and Amazon. The risk here would be if the company wasn’t able to emerge a winner after these attempts.
As of October 4th, 2014, Discovery was selling for 14.7x FCF as opposed to a peer average of 20.7x FCF (29% discount); 11.1x earnings vs. 19.1x earnings of its peers (42% discount); and 9.8x EBITDA vs. 11.11x EBITDA peer average (12% discount). These multiples show that the company is selling at a slight discount. To get a better idea of how much the company is worth I am going to value it using EV/EBITDA sum-of-the-parts valuation with three scenarios, stress case, base case, and an upside case. (See exhibit 6)
The company’s segments’ EBITDA as of the latest filing date were as follows, U.S: $1,708 million, Int’l: $976 million, Education: $27 million, and Corporate Expenses: $ -$286 million. Starting off with the base case, I am going to assign the U.S segment a 9x EBITDA multiple as a result of its stagnant future outlook, the Int’l segment a 15x EBITDA multiple as a result of its outstanding past performance, and positive future outlook, the education segment and corporate expenses I will keep as market (9.82x EBITDA). Putting these numbers all together yields an intrinsic value of $46/share, along with a 20% discount. Using stress case multiples, I decided to give a bottom multiple for the U.S segment of 8x EBITDA, and a 12x EBITDA multiple for the international segment keeping the rest constant. This gives us a worst case scenario of a 3% downside, which is not that bad. In an upside scenario, I gave the U.S. segment a 10x EBITDA multiple and the international segment a 17x EBITDA multiple, keeping the rest constant. This yielded a $54/share intrinsic value along with a 31% discount.The range of intrinsic values ($36-$54) that Discovery has is not the best in terms of a discount;however, given the company’s positive outlook in the international market, and since management will probably compound capital at a high rate of return, this range is good that warrants an investment.(See exhibit 7)
Discovery is currently being headed by CEO David Zaslav. Zaslav has done a great job of growing the company’s revenues and profits ever since he took control. Zaslav gets an annual compensation of $33 million, 68% of which is in equity. Compared to his peers, he is overpaid in terms of total compensation as the average salary of his peers is $19.6 million; however, his equity-based compensation is highest amongst his peers (23%). The excess in total compensation is mostly in equity.Having more equity is better than cash since it will ensure that his interests are aligned with those of the shareholders. All of the other senior managers get paid adequately with a very strong equity-based component (See exhibit 8 for more details).
Management has a very good business attitude and knows how to get the best out of its products. When OWN first aired, it wasn’t a big success. However, management believed that the company was producing a good unique product and instead of losing hope after a couple of years they stood by it. Now the network is starting to grow especially with the addition of new top programs and shows. Management is also very good at reforming, updating, and enhancing old channels, and overhauling under performing ones to produce successful ones instead. Examples include, the transformation of Discovery Health to OWN, HD Theater to Velocity, Planet Green to Destination America etc… Management is also successful at creating new shows by building off of prior or existing shows’ success. A good example is Gold Rush and Jungle Gold. Discovery’s management team also likes to always lead a trend instead of following it (the company’s three main networks are perfect examples). The launch of curiosity.com, a platform that aggregates cool learning experiences from across the web, and the recent investment in Lumosity.com, a brain fitness application are also good examples of how management likes to lead a trend.
Discovery Communications is a very good and solid compounding machine. The future looks bright for the company especially in the international scene. The company has very high and strong margins, returns on capital, and a growing stream of FCF. The company is not selling for a huge bargain but given its qualities, opportunities, and the fact that it is run by great management that knows how to compound capital at very high rates of return, I recommend investing in it today.
The following article is extracted from the Bamboo Innovator Insight weekly column about the process of generating investment ideas among wide-moat businesses in Asia. Each month, an in-depth presentation on one such business is featured in The Moat Report Asia.
The following is the draft course outline and announcement to Accounting Fraud in Asia, an official course in the Singapore Management University (SMU) degree curriculum that will be launched in January 2015. Taught by KB Kee, managing editor of The Moat Report Asia and faculty (accounting) in SMU, the course is the first of its kind to be taught in universities in Singapore/Asia and worldwide and is open to all university students worldwide on global exchange programs with SMU.
A dedicated new website platform (Asian Extractor: Unearthing Accounting Fraud in the Asian Capital Jungle) has been created to feature news, analysis and unique content about Asian accounting fraud for the course participants (students, instructor, guest speakers and thought leaders). Please drop us an email at firstname.lastname@example.org to tell us what you wish to see in the course Accounting Fraud in Asia and the website Asian Extractor and we will incorporate your valuable suggestions and feedback. We look forward to extending our thought leadership about Asian wide- moat compounders with more value-added content about Asia’s accounting fraud risks and governance pitfalls for our Members as we journey together in the miasmic Asian capital jungles.
“So Eddy, about half of your one thousand childcare centers are cashflow-positive because of the government subsidies?”, I asked Eddy Groves, the billionaire founder of Australia’s ABC Learning, then the world’s largest-listed childcare company, in an “innocuous” manner in October 2007.
I had deliberately praised Eddy effusively before asking the question so that his ego is inflated and his guard is down. ABC was at the peak of its success then with a market value of over A$4 billion and a sophisticated institutional investor had plunked in S$500 million in May 2007, followed by another S$30 million in February 2008.
“No, no, no, it’s only about a third!” Eddy let loose a Freudian slip.
My question to Eddy had employed some psychological teasing: “So you smoke five packs of cigarettes a day?” “No, no, no, it’s only about one pack!” – OK, he smokes cigarettes after all.
When ABC went bust, the liquidators found out that as many as 430 out of its 1,075 Australian centers are found to be operating below the breakeven level and they were inflating the number of kids enrolled to collect the government subsidies as revenue booked. The reason for my probe was because I noticed discrepancies in the accounts when a change in accounting standard in 2007 impacted the way it reports and discloses its revenue that year. “Capex fraud” with artful related-party accounting transactions was committed.
The accounting fraud of ABC Learning illustrate the interdisciplinary connections to psychology, government-business nexus, business model analysis, and the type of accounting transactions and risks prevalent in the Asian business context. ABC is one of the many real-world Asia-focused case studies used in the course Accounting Fraud in Asia to inject practical realism, sharpen the students’ critical thinking skills, and hone their skill-set in applying what is learnt into the messy world of reality.
One might think that this type of probing “technique” to detect accounting frauds and avoid millions in losses is “clever”.
Such “technique” couldn’t be more foolish. Why?
Because each time we touch Darkness, Darkness also touches us back; each time we touch Accounting Fraud, Accounting Fraud also touches us back. It is easy to be devoured by Darkness, to descend into Darkness when one is overconfident and succumbs to temptations. You lose your Authenticity as a person.
The instructor’s motivation in launching this course has been driven by disappointment from observing up close and personal the hard-earned assets of many investors, including friends and their families, burnt badly by the popular mantra: “Ride the Asian Growth Story!” He witnessed firsthand the emotional upheavals that they go through when they invest their hard-earned money – and their family’s – in these “Ride The Asian Growth Story” stocks either by themselves or through money managers, and these stocks turned out to be the subject of some exciting “theme” but which are inherently sick and prey to economic vicissitudes. They may seem to grow faster initially but the sustainable harvest of their returns is far too uncertain to be the focus of a wise program in investment. Worse still, the companies turned out to be involved in accounting frauds. Their financial numbers were “propped up” artificially to lure in funds from investors and the studiously-assessed asset value has already been “tunnelled out” or expropriated. And western-based fraud detection tools and techniques have not been adapted to the Asian context to avoid these traps. After a decade-plus journey in the Asian capital jungles, it has been somewhat disheartening as the instructor observed many fraud perpetrators go away scot-free and live a life of super luxury on minority investors’ hard-earned money. And these perpetrators, the Darkness, make tempting offers to various parties in the financial community to go along with their schemes. When we have knowledge in our hands, we have a choice to stay away from these people and away from temptations and do the things that we think are right.
Also, one may get overconfident in the use of “tools” and “techniques” which can be dangerous without a framework adapted to the context of the Asian capital jungle. Like in warfare, we try to scrutinize the enemy, the fraud perpetuator, for outward signs of what was going on within. A strategist might count the cooking fires in the enemy camp and the changes in that number over time, adapted into what we call “financial analysis”. Yet, the contextually-intelligent strategist also knew that just as he was watching the other side, the other side was doing the same with him. Why not deliberately distort the signs that you are looking at? Why not mislead by playing with appearances? If they are counting our cooking fires, why not light more fires to create a false impression of our strength?
Thus, information may be used to inform or deceive.
Thus, this elective course is designed for students to understand and feel the importance of bias in accounting and financial information through the interdisciplinary lenses: the ways that conflicts of interest affect the financial reporting process, the institutional mechanisms that limit or exacerbate this behavior, the power held by the preparers and reporters of information in the political, social and economic context of the countries and companies that do not permit a transparent flow of information. This is particularly true in Asia which is not a monolithic homogenous bloc and can be a heterogeneous mess for users of accounting information without a practical and resilient framework adapted to the Asian capital jungle.
Relevant real-world Asian case studies will be incorporated throughout the course for discussion so as to sharpen your critical thinking skills and to hone your skill-set in applying what is learnt into the messy world of reality. A dedicated new website platform (Asian Extractor: Unearthing Accounting Fraud in the Asian Capital Jungle) has been created to feature news and analysis about Asian accounting fraud for the course participants (students, instructor, guest speakers and thought leaders), thus providing a unique opportunity for the student to pursue intrinsic excellence beyond the GPA by interfacing and interacting with the world with his or her thoughts and analysis.
We need Icy Discernment to detect the accounting fraud in the Asian context; and we need a Warm Heart, an inner compass and framework, to help us not lose our way in difficult and uncertain times as we journey together in the dangerous Asian capital jungles.
Your output from the Accounting Fraud in Asia course:
Cold Eyes and Warm Heart.
|Feedback on the Course Content
Drawing upon his decade-plus experience of interacting with the diverse players and “Extractors” in the Asian capital jungles, including the true-north focus on the positive “Compounders” who create sustainable long-term value, the instructor KB Kee shares an authentic perspective on using the pragmatic framework to dissect and detect cases of Asian accounting fraud and to illuminate the evergreen lessons for lifelong learners to discover contextually-relevant forms for themselves.
Sharing this framework and its inter-disciplinary content has won the appreciation of a selected global group of professional institutional investors, secretive hedge fund giants, billionaires, family business owners, entrepreneurs, executives and savvy private investors who are paid-subscribers and clients of the instructor’s practice-based research work (The Moat Report Asia) and teachings in a series of executive workshops and seminars. We are humbled that our thought leadership in this area is on the first page ranking of Google (without any SEO) when one types in the words Accounting Fraud in Asia.
SMU Course Elective under GRS for All Students: No Prerequisites, No Tests/Exams
This course has been done in successive runs for professional investors, business management executives and lifelong learners by the instructor and is adapted to be suitable for all SMU students as well as exchange students who are intellectually curious and motivated learners. No prerequisites are needed for this course. The course qualifies for one credit unit under the Global and Regional Studies (GRS) elective. There will be no tests and examinations for this course.
This course also serves as the general foundation – and also sequel – to the multitude of other SMU courses, from Study Mission, Corporate Finance, Financial Accounting, Management Accounting, Corporate Reporting & Financial Statement Analysis, Audit & Assurance to Strategy and Ethics & Social Responsibility. It aims to cultivate a critical mind for facts and descriptive information to now hang together on a latticework of analytical framework in a usable form to illuminate the unique perspective of doing business and investing in the Asian capital jungle.
Learn more about The Moat Report Asia.