2017 Annual Report
In 2017, the portfolio returned 18.2% with a cumulative return of 63.1% since inception. The S&P 500 Index performed better in 2017 with a total return of 21.8%. This coming April will mark the 5 year anniversary of the fund. I would like to thank all of you for your continuous support and trust. I promise to work relentlessly to ensure our best years are ahead of us.
I hope you will enjoy my latest letter, topics include: thoughts on data science, investment framework, and our newest investment, Pandora Media.
Advances in data science & the information edge
The investment community is a noisy place. It’s riddled by an overload of information, speculative bloggers, ‘fake news’, sensationalist content, and the worst of it, participants with the patience and the attention span of toddlers. Technology has blessed us with an abundance of information, which happens to be a behavioral curse for most. Thanks to computing and the internet, the democratization of information has transformed information into data that computers can read. We are now in the middle of a renaissance in data analytics. An informational edge can be powered by computational power, machine learning, and data science.
Most of the great data and insights are contained within silos of a company and are non-public material information. The ‘unstructured’ data highlighted in blue are some of the data sets where the investor can play for an informational edge. Previously, this structured data required a substantial amount of resources and scale to benefit from it. The good news is, new low-cost tools and platforms have been developed and are available today.
The progress in data analytics and information technology benefits my investment practice tremendously. I can do much more in much less time. My schooling (Computer Information Systems major) and a passion for tech will aid me to build my new vision. This vision will utilize the advancements in data science to assist in my investment framework and decisionmaking.
It is important to note, with these advances, judgment is still the defining attribute of a successful investment. Interpreting this information properly (and without bias) can stack the odds in your favor but it provides no guarantee. To be a great investor, you need a complete toolset. I believe this practice will see long-term success and improvement because it is built on the foundation of an operational pedigree, a strong financial acumen, and sound judgment.
Discovering Undervalued Stocks & Picking Winning Investments
Today’s information moves at the speed of light, enterprises do not. The reason is, most substantive enterprises require time to execute whether the wind is going with it or against it. This timing differential is a damning proposition for the stock market. Investor psychology becomes thwarted by an abundance of externalities. The near-term bias of the market harshly punishes companies under temporary clouds, while the darlings of Wall St. with ‘rainbow and butterflies’ prospects get bid to the moon.
I have utilized a framework or checklist that has helped me identify potentially great investments and block out this noise. This framework is somewhat rudimentary yet powerful. The right answers will help identify whether the company has an enduring business worthy of further investigation. These enduring characteristics are competitive advantages and moats that help weather changes in the economic environment, temporary defeat/s, and other changes in business models (IE technological disruption).
Companies with such attributes could be selling at prices with a substantial margin-of-safety. Margin-of-Safety is a critical component for my ultimate decision to buy. Nintendo is a great example under this framework and became one of our best investments since the fund’s inception.
Investment Case Study: Nintendo
Nintendo had many challenges entering 2013:
Wii gaming console cycle was ending
Gaming on Smart Devices (Smart Phones & Tablets) was disrupting the traditional gaming businesses and were given out away for free essentially
Competition in the home-console business was still intense (PlayStation & Xbox)
Nintendo’s newest flagship console (the Wii U) received a lukewarm reception
Nintendo refused to participate or invest resources in the smart device gaming category.
A combination of negative sentiment, volatile market conditions, and poor near-term prospects sent Nintendo shares down to ~$12/share (its tangible book value) with an outstanding $8 to $9 dollars of that share price in cash. This is the quintessential example of buying a dollar for 50 cents. The market essentially wrote Nintendo off for dead. Nintendo ADRs (NTDOY) was bought for $12 – $13 per share.
Through this rudimentary checklist, it becomes clear there is something ‘special’ about Nintendo. The combination of their quantitative and qualitative strengths has provided the company an edge. This company is indeed worth a closer look.
Valuation based on Market Pricing of Similar Assets
It only required curiosity and diligence to recognize that Nintendo was money literally sitting on the floor. A close examination revealed billions of dollars of intellectual property and brand equity unaccounted for. To help support my valuation, I looked for public transaction data among the gaming industry. Activision’s merger with Vivendi Games provided a near perfect peer-to-peer comparison. My analysis utilized a market comparison of similar intellectual property and brand equity uncovered by the Activision merger. Before the merger, in 2007, Activision nearly had $7 billion hidden in book value. This is because intellectual property such as gaming franchises developed in-house do not show up on the balance sheet. If there is a merger or acquisition involving its IP, those assets get valued and show up as Goodwill & Intangible Assets. The value of their gaming franchises was revealed at $ 7 billion+ when the merger closed. My research indicated Nintendo’s IP was equivalent (if not better) to Activision. Based on these comps we based a conservative market value on Nintendo shares at least $24 per share. This provided upside of 100%+ with very little downside business risk. Nintendo was cash rich, no debt, and proved to be an excellent allocator of capital historically.
A No Brainer
Nintendo is a great example/lesson on how inefficient the stock market can become. In 2013, there were very few promoters of the stock when the company was roughly trading at $12/share (its book value) with $9 of it in cash. Yet after the stock moved into the $30s, Nintendo started getting bullish coverage and overreaching valuations. This year in Q4, I sold the last of our Nintendo shares at ~$49. It proved to be not only our best investment but also our most obvious one. My only regret is I didn’t buy more, much more! (everyone has at least one)
New Investment: Pandora Media [ticker:P]
To segue from Nintendo to our newest investment may look a bit risqué on the surface. It certainly doesn’t have the historical pedigree that Nintendo has but after a lot digging, I found plenty to like. Pandora Media is a broadcasting company which offers music streaming and automated music recommendation services. It is a relatively new issue, with an IPO in 2011. The stock has recently hit its all-time lows and we have become substantial buyers of the stock.
What went wrong?
Pandora has suffered from poor executive management and board stewardship. While it has grown to generate over $1.3 billion in revenue, the company is unprofitable. Previous management lacked focus and vision on its core product: online media streaming which is monetized through advertisements and subscriptions. Instead of layering an innovative ad-platform on top of their innovative music-platform, they chose to build their advertising business through radio’s traditional channels.
Purchase of TicketFly for $450 million in 2015. A non-core business specializing in music events (sold for $200 million in 2017)
A failed international expansion which Pandora shut down in 2017
Late entry into on-Demand music streaming (released in 2017)
In 2017, Pandora was in search of cash or a buyer after squandering most of its capital. Pandora’s search for capital was successful at the cost of the common stakeholders with a 20% dilution of common shares. Pandora issued $480 million of Convertible Preferred Equity to Sirius XM (Ticker: SIRI) which is convertible at $10.50/share. Sirius XM was also granted board seats (Liberty Media CEO, Greg Maffei is now Chairman) and hand-picked new executive management.
Pandora doesn’t pass our checklist at first glance, however, Liberty’s interest in Pandora Media motivated us to take a closer look. If Pandora was interesting to them at $11 to $15 per share, the stock could be interesting to me at $7 a share. In the 3rd and 4th quarter we started ‘getting in the weeds’ and studied the industry in depth.
In Liberty We Trust
The Liberty empire has a reputation I am very confident about investing in. Their magic formula starts with good businesses within their core competencies, then putting the right management teams in place and leveraging those companies appropriately. Liberty controls Sirius XM with a 65% ownership stake, which now owns a 20% stake in Pandora Media.
I believe many of Pandora’s problems have been self-inflicted. Their core business stands on firm ground with a lot of untapped potential. Liberty’s investment in Sirius (in 2009) proves their ability to turn-around a poorly ran broadcasting company. Before Liberty, Sirius XM was over-levered and on the verge of bankruptcy. After Liberty, it’s value quintupled and the business prints $500+ million of FCF annually. This is not a one-off, Liberty has a long history of value-creation and their shareholders have been rewarded exceptionally well.
After studying Liberty’s 2009 investment in Sirius XM, I was happy to see similarities in the deal for Pandora:
Stakes were initiated at approximately 1.9x EV-to-Sales
Convertible preferred equity was the capital infusion of choice
Poor capital allocation decision-making riddled both companies
Very little interest by strategic buyers or private buyers
Strong brand strength, large user-base, strategic car partnerships/install base
Core Underpinnings of Pandora Investment Thesis
[Advertising Monetization Improvements] Digital ad-spending has grown over 25-30% annually since 2014 and forecasted to grow at this rate until 2020. Pandora’s advertising unit is only expected to grow by single digits this 2017. This is a very large opportunity that Pandora’s last management squandered. I believe Liberty/Sirius recognize this and believe larger ad growth is obtainable. I expect the new leadership’s laser focus on radio advertising to return growth in ad dollars per active user by double digits. Their investments in ad-tech platforms will support this growth in addition to building out programmatic ad partners and self-serve ads.
[Subscriber Monetization Growth] Pandora has a large subscription opportunity with the addition of its premium on-demand access. Their subscriber base is significantly underpenetrated, accounting for only 7% of the 74 million users. Pandora is currently negotiating subscription tiers to help grow their paid-subscriber base. This includes tiered rates for family plans and student plans. Lastly, Pandora’s new CEO has a subscription business pedigree by leading Dish Network’s Sling TV division as CEO.
[Spotify IPO] Spotify is expected to IPO by Q2 of 2018 at a valuation of $18-$20 billion dollars. Pandora’s $1.3 billion valuation will look like a bargain especially if they succeed in boosting revenues at a double-digit pace in 2018. A positive change in Pandora sentiment could provide 100% upside from today’s share price.
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[Smart Speakers] The Amazon Echo smart speaker has an estimated install base of 30 million devices. Along with Google Home and Apple’s HomePod, smart speakers are estimated to grow to 150 million by 2020. This smart speaker solved a major pain point for home listening. Pandora should benefit from this new technology. In November, Pandora reported monthly active users on “voice-activated devices” has grown 282% and the average person listens to 65% more music after purchasing the device. This is an enormous growth opportunity because more time listening means more ad slots.
[Connected Cars] there will be an estimated 50 million connected cars on the road by 2020. Car radio listenership benefits from a captive audience. Captive audience’s sell at higher ad premiums. Pandora’s new team is investing heavily in ad-tech and I suspect geo-local targeting will be a key feature.
[Buyout Candidate] Pandora is a natural fit and strategic asset for the Sirius XM/Liberty portfolio. Liberty covets Pandora’s business and has stated multiple times what they were willing to pay for it. The buyout premium starts at approximately $8/share. That is a 50%+ premium to today’s share price of $5/share. The bull case would value Pandora at $15/share as Greg Maffei of Liberty floated in July of 2016. The offer valued the company at over $3.4 billion.
M&A Arbitrage Investments, Time Warner [TWX]
We are stockholders of Time Warner once again. After selling our shares at $103 in Q3, the DOJ is attempting to block the merger and bringing ATT to court. TWX shares dropped as low as $88/share on the news. My position on this merger hasn’t changed. I believe there is a very small probability of this merger being blocked since the businesses do not intersect. The DOJ vs ATT trial is set for Q2 for this year and I anticipate a successful merger by 2018 to conclude.
Chief Investment Officer