Investment Idea – Grey Owl Capital Management, LLC

One Question for Messrs Buffett and Munger

Tomorrow, Saturday May 2nd, 2015, Warren Buffett and Charlie Munger will hold court over a crowd of 40k+. As they do every year, they will spend several hours answering questions about the current and future workings of Berkshire Hathaway. Three journalists and three investment analysts will ask the questions.

If we were given the opportunity to ask a question, we would focus on Berkshire Hathaway Energy -BHE – (formerly MidAmerican Energy) and the threat to traditional utility businesses from distributed generation (DG).

During 2014, BHE provided 9% of Berkshire’s revenue and 11% of pre-tax operating earnings. In the most recent annual letter, Mr. Buffett refers to BHE as one of the “Powerhouse Five” collection of Berkshire’s largest non-insurance businesses. He goes on to write, “a century hence, BNSF and Berkshire Hathaway Energy will still be playing vital roles in our economy.” Later, he adds that BHE has “recession-resistant earnings, which result from these companies offering an essential service on an exclusive basis.”

Their conviction is very high. We wonder if both Messrs Buffett and Munger are underestimating the potential threat from distributed generation (i.e. power generated at the individual household level using solar technology). Is it possible that the developments in Hawaii described in detail in a recent NYTimes article are just the beginning?

BHE has invested $15B in renewable energy generation capabilities and is the largest generator of renewable energy in the US. In addition BHE’s largest subsidiaries are in geographies with no immediate threat (the ratio of sunlight to traditional generation fuel cost is favorable). Yet, solar is not a typical fuel source. It is a technology that behaves according to Moore’s Law – every year it is twice as efficient and half the price as the previous year.

So, if we had the floor for a minute in Omaha tomorrow, here is what we would ask: “Messrs Buffet and Munger, what if technology made it so BHE was no longer the exclusive provider of power in its covered geographies? Doesn’t solar offer the possibility that the distribution component of the regulated utility industry shrinks significantly in size? BHE uses solar as a fuel source, but that alone can’t neutralize the threat. Solar has the potential to be much more than a substitute for coal or gas in the old utility regime. Centralized power generation isn’t necessarily ideal. In the past it was just the only practical option. Today, decentralized power generation is just as practical in a few locations (e.g. Hawaii), but it is becoming so in more and more geographies by the year. The efficiency of solar is increasing and the cost decreasing at a rate commensurate with Moore’s Law – and it should, as solar panels are similar in structure to computer chips. As this trend continues, individual solar power generation will become practical in more and more locations. And so, how can you be so confident in BHE’s ability to earn a “good” return long into the future? Is it possible that solar may be to the utility industry what the internet was to the newspaper business?”

We remain long $BRK, confident in the overall business mix, the broad diversification, and the “moat” that accrues from the structure Mr. Buffett has developed over the last 50 years. We are also optimistic that BHE managers can adjust the business to new realities over time. Still, we would like to hear some additional details on how they think about the distributed generation threat.

Long $BRK.

eBay: Secular Growth In a Low-Growth World

The overall economic environment has been and remains weak. Real GDP’s four-year CAGR from 2010-2013 is only 2.25%. Retail sales are weak too – growing 2.4% in Q1. Yet, ecommerce remains strong – growing 15% in Q1. Even in a stagnant economy there are secular growers. EBAY’s key metrics are growing even faster than ecommerce. Off-EBAY PayPal usage is accelerating. Merchant Services Total Payment Volume grew 33% y/y in Q2 2014. EBAY’s shares have been flat for six quarters, but intrinsic value continues to grow.

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While the overall economy’s slow growth presents an investment headwind, there are still opportunities. Of course, sales growth is not a prerequisite for investment success. Plenty of people have gotten rich buying depleting assets like oil wells. Price paid is always the determining factor. But, secular¹ growth has its merits, particularly in a world where growth is scarce. A growing company with a competitive business advantage can reinvest capital at a high rate. Owners can compound their return rather than continually look for the next place to put the proceeds of their royalty stream (to use the oil well analogy again).

Two of the most powerful secular growth trends today are the shift from offline retail to e-commerce and the shift from physical currency to cashless transactions. eBay (EBAY) is well positioned to take advantage of both of these trends.

The first half of this year was full of noise and distractions for EBAY: publicly-hostile correspondence with activist investor Carl Icahn (who did make some good points), a security breach that forced a system-wide password reset, and a new algorithm from Google that had a detrimental impact on search results for eBay listings. Despite these challenges, EBAY grew Enabled Commerce Volume (ECV) 26% year-over-year in the second quarter. This is up from 20% in the first quarter of 2013. And, it is significantly better than the already strong growth in ecommerce. The US Census Bureau estimates ecommerce grew 15% in the first quarter compared to 2.4% for all retail sales.²

While EBAY’s company-wide trends are strong, PayPal’s trends are even stronger. Every single metric is solid, but we are particularly excited to see Merchant Services Total Payment Volume growing at an accelerated rate – from 26% year-over-year in the first quarter of 2013 to 33% in the second quarter of 2014. This tells us that PayPal is NOT just being used within eBay’s Marketplaces. More and more, it is being used across ecommerce (and even offline) to facilitate payments.

Figure 2 – EBAY’s payment metrics slide from the Q2 2014 earnings call shows strong growth in merchant services TPV.

We first discussed our eBay position in our third quarter 2013 letter. At the time of that letter, EBAY shares traded just above $50. We wrote, “We initially purchased eBay shares in December 2011. At the time, eBay was unloved trading at 18x 2011 earnings per share and just 12x 2012’s prospective earnings. Since then, eBay’s shares have returned over 75%, but that return was all in 2012. Shares have been flat throughout 2013.” It is now nine months later and we can say shares were flat for all of 2013, as well as the first two quarters of 2014. In other words, our EBAY investment has not produced results for six quarters. However, intrinsic value has grown significantly. This is the more important metric for the long-term investor.

While the economy is growing at low-single digit rates, EBAY’s industry (ecommerce) is growing in the mid-teens, and EBAY’s participation in this industry (its ECV) is growing in the mid-20s. Yet, EBAY trades at the same multiple as the S&P 500. With the S&P 500 at all-time highs and growth scarce, there are few bargains. We think EBAY is one.

This article is an excerpt from our Q2 2014 quarterly letter.

1 A trend that is neither cyclical nor seasonal but long-term in nature.

2 Click here

Disclosure: At the time of publication, GOCM was long EBAY. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Any information prepared by any unaffiliated third party, whether linked to this newsletter or incorporated herein, is included for informational purposes only, and no representation is made as to the accuracy, timeliness, suitability, completeness, or relevance of that information. The stocks we elect to highlight will not always be the highest performing stocks in the portfolio, but rather will have had some reported news or event of significance or are either new purchases or significant holdings (relative to position size) for which we choose to discuss our investment tactics. They do not necessarily represent all of the securities purchased, sold or recommended by the adviser, and the reader should not assume that investments in the securities identified and discussed were or will be profitable. A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.

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Will World Wrestling Entertainment Pin NBC?

(This was originally published on Seeking Alpha on Jan 13, 2014.)

At this week’s Consumer Electronics Show, World Wrestling Entertainment (WWE) announced the launch of WWE Network. Covering the event, The Wall Street Journal wrote, “World Wrestling Entertainment Inc. is sidestepping the cable world that long has been its bread and butter to launch the WWE Network, a subscription-only, online video channel that will air round-the-clock programming.”

While a terrific opportunity for significant value creation, it is unlikely this is a complete “sidestep” of cable. Rather, WWE is flexing its collective muscle as it continues to renegotiate its two largest broadcast rights agreements with NBC Universal. The contracts for “Raw” and “Smackdown” expire this year and NBC Universal’s exclusive negotiation period concludes at the end of this month. The timing of the network announcement seems aimed at pushing NBC Universal toward action. It was as if they said, in the words of the late Randy “Macho Man” Savage, “Hey NBC, snap into a Slim Jim!”

We typically invest in high-return businesses, with strong competitive advantages, and executives with a record of excellent capital allocation and balance sheet management. We aim to hold these types of investments for at least 3-5 years and in the best case, forever. We discussed our five largest positions, all of which meet these criteria, in our third quarter 2013 letter.

WWE does not exactly fit these parameters. Yet, we are owners of WWE equity. It is our belief that the current “Raw” and “Smackdown” distribution agreements are so far below market that there is a high probability they will renew at 2, 3, or even 4x the current rate. The majority of this new revenue should flow to the bottom line. Thus, we were willing to overlook their shareholder-unfriendly dual share class structure, an operating history that includes questionable capital allocation decisions, and a dividend that is not covered by current cash flow. The immediacy and magnitude of the event present an incredible risk reward dynamic.

We have followed the evolution of the media business for some time, compelled by the increasing value of content in general and “DVR-proof” content (typically live sports) specifically. Additionally, we find the ongoing shift in media consumption patterns brought on by the proliferation of broadband Internet access intriguing. We watched from the sidelines for several years. Then, we came across a Forbes video and story highlighting the pending WWE broadcasting deal negotiations. We immediately recognized the investment opportunity.

The analysis is relatively straightforward:

WWE content is approximately as valuable as “live sports” content. While WWE events are not “live sports” they have attributes that make them equally “DVR-proof.” Nielson estimates that 95% of the TV audience for sports watches live. Live viewership for WWE events is in the low 90%s.
Given current market rates, WWE should be able to increase their rights fees by 2-4x. WWE’s current deals are both several years old and were below market from the beginning. If WWE is able to renegotiate their cost per viewer hour to match the low-end of current sports rights deals (Fox’s NASCAR deal) their rights fees would more than double. At the high-end (NBC’s NHL deal), their rights fees would increase more than 13x. 2-4x is a conservative estimate.
A market-rate rights deal for “RAW” and “Smackdown” would translate to significantly higher EBITDA and a much more valuable business franchise. A doubling of the rights fees would add close to $85mm to EBITDA. A quadrupling would add close to $255mm. At three times the current contract, we get a back-of-the-envelope fair value around $25 / share. This is almost 50% upside from today’s price of $17.
The catalyst is imminent. With NBC Universal’s exclusive period about to expire, we believe a new deal could be announced in the next few months.

Oh, by the way, the WWE Network could have some value too.

Long WWE.

The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this blog will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.

We’ll Buy a “Poor” Capital Allocator Like Microsoft Anytime

Microsoft (MSFT) is as out of favor as out of favor can get. Apple adds “i” to the word “Cloud,” talks about it at a developer conference, and Steve Jobs is on the front page of the Financial Times. Microsoft releases the fastest selling operating system of all time (Windows 7) and then the fastest selling consumer device in history (the Kinect) and newspaper editors and investors alike just yawn. Microsoft can’t innovate, Steve Ballmer inherited a great company but hasn’t really done anything to move it forward, and he allocates capital poorly with dumb acquisitions (Skype) and silly R&D projects (Kin One and Kin Two).

Despite this, or perhaps because of it, we think Microsoft is a spectacular investment opportunity. We have owned Microsoft for several years, trading around the position multiple times. Today it is one of our largest positions. We articulated our thesis at length in a recent quarterly letter. In this brief post, we want to take a look at the claim that Mr. Ballmer has been a poor allocator of capital.

Last week, David Einhorn presented his investment thesis for Microsoft at the Ira Sohn Conference. He was bullish on the stock. He said it is very cheap on both an absolute basis and relative to the market and yet the business is outperforming the average S&P 500 company by a wide margin. Mr. Einhorn believes Microsoft is cheap for a reason. He argued that the number of poor capital allocation decisions on the part of Steve Ballmer has overwhelmed the superior operating performance and good decisions that have been made.

It seems clear that Steve Ballmer IS an “overhang” on the stock as Mr. Einhorn phrased it. The stock would likely appreciate if he was to move on. However, the question of whether Mr. Ballmer truly is a poor capital allocator seems less obvious to us. Remember, it isn’t his fault that the market irrationally bid the stock up to a PE of 70 right when he took over as CEO. So, you can’t judge him on stock performance alone. In addition, we think that the sheer size of Microsoft can cause confusion. Skype may or may not turn out to be a good acquisition. If it is a mistake, the $8.5B price would seem to make it a big one. But, it is only 4.5 months of free cash flow to Microsoft. What has Mr. Ballmer done with the rest of Microsoft’s cash?

From a base of $10.5B in 2000, Microsoft grew free cash flow (i.e. operating cash flow less capital expenses) to $22B in 2010. This is a CAGR (compound annual growth rate) of 7.7%. The total free cash flow generated over this ten year period was $155B. During that same period, Microsoft returned to shareholders $142B in cash via dividends and stock buybacks. In other words, Microsoft returned 92% of all the cash they generated to shareholders!

Let’s now use this information to perform a brief thought exercise. Today, you can purchase Microsoft stock for $24/share or you can buy the entire company for $203B. Imagine you were to buy the entire company today. Next, imagine that Microsoft were to grow free cash flow at the same rate for the next ten years that it did for the previous ten years. This means the firm would generate $360B in free cash flow over the next ten years. Given the firm’s historical need to retain very little capital, further imagine that 92% of all cash generated was returned to shareholders. Let’s assume it is all in the form of share buybacks so we don’t need to worry about taxes. At this point you would have received 1.6x your money back AND you would still own the entire business that is Microsoft: whatever it is that becomes of a cloud development platform (Azure), software as a service (Office 365 and Dynamic CRM), home entertainment (XBox, Kinect, XBox Live), etc., etc. Hmm… maybe Mr. Ballmer has presided over some innovation.

If those are the available investment dynamics, one could certainly do much worse. Perhaps that is exactly Mr. Einhorn’s point. If you buy Microsoft today, you likely get the above investment dynamics. You also get a free call option on Mr. Ballmer’s departure.

A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.