Found via www.valueinvestingworld.com, a great video coming out of Bridgewater covering everything 99.9% of people will ever need to know about macro economics. The production quality is superb, we should all thank Mr. Dalio for sharing this.
A very worthwhile watch, John Malone gives us a glimpse into the mind of a great capital allocator.
On November 14th, Gotham City Research published a report alleging that the Tile Shop (TTS) was using an undisclosed related party to fraudulently inflate its earnings. Later that day the company responded with a statement denying every allegation except that they do business with an export trading company owned by one of their own employees. The next day a number of banks put out research notes recommending the stock, stating that they believe the company’s financials are accurate and the core business sound. After all this, the company is trading at an enterprise value of about ~ 920 million, a generous valuation that for me begs the question, is this a fraud or not?
TTS V.S. Topps Tiles U.K.
I’m not going to cover 90% of what Gotham did in its report, so you should go read it if you want the whole story. What I’m going briefly discuss is, after know everything Gotham has said, what does a “normal” tile retailer look like, and what can that help is infer about TTS? Gotham used the long bankrupt Color Tile Inc. as an example of what tile economics should look like. I think that’s a decent comparison, but using a now bankrupt company seems a touch rocky to me. So instead I went and looked at Topps Tiles; a specialty tile retailer in the U.K., that I think makes for an equal or better comparison. Topps Tiles has 320 store locations in the U.K., $275 (USD) of revenue in 2012, is publicly traded and has a market capitalization of approximately 175 million GBP or 262 million USD.
First up, what are gross and EBITDA margin? TTS sports some of the badest (best) in the business, at 70% gross and ~27.5% EBITDA. The more mature Topps Tiles has a gross of 59% and an EBITDA of around 11% between 2010 and 2012. Many people, myself included, have doubted whether TTS can maintain such outstanding margins as it becomes a national retailer, and Gotham wen’t so far as to deny that the gross margin is even real. The reality is that no one but the company knows the truth about gross margin. For now, all that we can say is that a gross margin of 70% doesn’t seem to be the norm for large flooring retailers.
Margins are very important but the inventory levels are what I find really interesting. This was a major focus of Gotham’s report, and something I missed completely when I looked at the company earlier this year (shame on me). In its report Gotham cited a metric called Days Sales Inventory, which is calculated as ((Inventory / COGS) *365). And indeed, TTS has some very high days sales inventory. Since 2007 DSI has been at or above 250, and currently stands at a striking 411 on a trailing twelve-month basis.
However, I feel i must mention that when looking at both companies one thing I noticed though is that because of how DSI is calculated, a company with a higher gross margin will tend to exhibit a higher DSI. This puts TTS at a comparative disadvantage for no reason other than it supposedly buys cheaper. (See exhibit above) Therefore I took the step of adjusting Topps Tiles gross DSI for the difference in margin between the companies. The result, even with this adjustment TTS exhibits much higher DSI than Topps Tiles in every period.
Forgetting DSI for a moment, comparing the two companies in more absolute terms provides an even better sense of the profound amount of inventory that TTS is carrying on its books. Topps Tiles has 320 stores and $275 million in sales in 2012. It carries $41 million (USD) of inventory to support its operations. TTS has 80 stores and $ 218 million of sales in the TTM period, and carries $71.8 million of inventory as of Q3 2013 or 75% more than Topps Tiles.
Why and how can a company that is supposed to have better gross and EBITDA margins be carrying so much inventory?
I ended the last section with a question because that’s all I have. As far as I can see there is no direct proof that TTS has done anything illegal – only circumstantial evidence (the exception being not disclosing a related party.) This brings me to what short sellers sometimes call cockroach theory. The analogy is that just as if you’ve seen one cockroach the likelihood is that there are others, if you see one instance of misconduct, the likelihood is that there is more. TTS has already showed us at least one cockroach by admitting to the non-disclosure of the related party. Taken together with the massive inventory levels and the other issues brought up by multiple reports, I’ve come conclude it is more likely than not that something rotten at The Tile Shop.
As Mr. Munger would do lets leave off by examining the counterfactual; what if TTS is not a fraud? In that case what we’re left with is an incompetent management team, an unproven business model, a highly leveraged capital structure, plenty of shareholder lawsuits, material weakness in financial reporting, and a shit-load of tile.
Disclosure: Short TTS
Found via Gavyn Davies always excellent blog the below video of a recent speech by Larry Summers is mucho interestante.
Memo Attention Apple: A Map to Pandora’s Jugular
I am disgusted with myself for not seeing what was right in front of me, and I am disgusted with iTunes Radio for the same thing. Since September, I have been short Pandora (P), believing that iTunes Radio would be a powerful competitor, powerful enough to knock the luster off P’s Tech-bubble 2.0 valuation. Essentially, I was betting that Apple would continue its legacy of creating products that offer a superior user experience. Instead, what they released was a half-baked add-on whose only purpose seems to be demonstrating that Apple (AAPL) has forgotten its roots. Unlike other Apple products, iTunes Radio seems to be based on the thesis that people will value features over depth of experience. This is a shocking and disturbing outcome for Apple shareholders, since the entire Apple Empire has been built on delivering products that are the antitheses of such geeky reasoning. The good news is that iTunes radio is highly fixable. Here’s how to do it.
Forget the Features! (Know Your Customer)
Apple has put a lot of emphasis on the breadth of its catalogue, and the higher sound quality on offer. This is a mistake. While both of these things are worthwhile, they are only marginally additive to the average user experience, which is the only thing that really counts.
First the catalogue, lets face it; most people listen to the hits. Yes you will find one in a hundred people who want to hear 1950’s French pop music but most of us don’t want to hear much more than we would on traditional radio. Ask any musician, the Pareto Principal in full effect when it comes to the average persons musical tastes. That is to say, 80% of the people only care about 20% of the music, and the real numbers are probably much more like 95% to 5%. This is simply not a differentiating factor for the average streaming radio user, end of story.
Sound quality is the other oft-touted feature that offers only the most marginal improvement to the average users experience. Think about yourself in the car, how bad does the sound quality have to get before you change the station? For me, if it’s a song I like, things have to get pretty awful before I touch the dial. The idea that users are going to flock to iTunes for higher sound quality is ludicrous. Look at how many people use the crappy ear-bud headphones Apple gives out. If quality was really a motivating factor, everyone would be walking around with Sennheiser headphones – they’re not.
Fix the Algorithm! (Quality of Selections)
This is a difficult claim to make. But I’m gonna do it anyway. The iTunes radio song selection algorithm is broken, and needs to be fixed. Reasonable minds will enquire; do you have any data to support that conclusion? And the answer is no. I have only my own experience. Nevertheless, I feel confident in asserting that the iTunes algorithm is at present, far inferior to the one Pandora employs. I’ve reached this conclusion after trying ten of my favorite artists on both stations and comparing the musical selections each platform played. The result; I was blown away at how bad iTunes radio performed at selecting relevant songs. That said, I encourage readers to run a similar experiment for themselves, and come to their own conclusions. Don’t take my word for it – go try it out.
The bright side of this, (if you can all it that) is that the affect of the inferior algorithm on the user experience is so obvious, I honestly cannot imagine that it’s not being worked on as we speak. In addition to the tweaking of the broader algorithm, we can reasonably expect improvements in iTunes performance as data from user input is incorporated into the system. Pandora for instance benefits from years of people plugging away at their thumbs up / down icons, helping to fine-tune what gets presented to users and the algorithm itself. As Apple accumulates more feedback from its users it should be able to improve its algorithm to the point where it is competitive. But it’s vital that this happens ASAP. A critical point is that the algorithm doesn’t have to be as good as Pandora’s but it has to be better than it is or things will never work out.
A second order result of poor song selection is that on iTunes radio you quickly run up against your station song skip limit. This is detrimental to new user conversion, hitting the skip limit on multiple stations makes people much more likely to abandon the platform out of sheer frustration.
With regard to the skip limit, it’s worth pointing out that Pandora (pictured above) at least gives you a nice, short explanation of why you can’t keep skipping, and how to listen to more music. iTunes radio on the other hand provides only the somewhat terse message: “You can skip six songs per hour on each station.” Being nice and helpful still counts for something in this world, not to mention it’s cheap. Apple, take note.
As my girlfriend was kind enough to point out, one good thing about Apple’s message is that it tells you how many how many songs you are allowed to skip per station. Pandora’s by contrast is ambiguous and can make users nervous about using the skip button.
While we’re on the subject of niceties, another nice thing about Pandora is that they provide suggestions of similar artists you might like to make a station for (pictured above). Something akin to this would be especially helpful for iTunes radio because it would minimize user loss due to the frustration that occurs when you run up against the skip limit. Put another way, I’m already mad when I run out of skips, I don’t want to have to think about what else I might want to hear. Anyone familiar with the paradox of choice will immediately recognize the value of this or any feature that minimizes the users cognitive workload.
Fix The Feedback Interface! (Ease of Feedback)
“What I propose is a road map to modify our man-made systems to let the simple – and natural – take their course. But simplicity is not so simple to attain. Steve Jobs figured out that ‘you have to work hard to get your thinking clean to make it simple.’ The Arabs have an expression for trenchant prose: no skill to understand it, mastery to write it.” – Nassim Taleb, Antifragile
User feedback is not only an important part of tuning the song selection algorithm, it’s an integral part of the user experience as well. And so the fact that iTunes radio serves up an inferior interface puts it at a disadvantage on both fronts. I call it inferior is because it’s simply more difficult to use. It takes two clicks to perform any preference action aside from skipping the song. First you have click this little star button (pictured above), and then chose one of three menu options (pictured below). Pandora by contrast offers every single preference option just one click away. It’s hard to express how this little difference can be such a big deal. Steve Jobs would get it. The only other way I can think to put it is that people are really, really lazy. I want to feel like I’m in my favorite armchair listening to the radio, not organizing my iTunes library. Easy – get it?
The other problem is that the feedback options aren’t sufficiently granular. The positive feedback options are ok. You can choose between, “Play More Like This” and “Add to iTunes Wish List”. On the negative side however, your only choices are, “Never Play This Song”, and to skip. This dichotomy comes to feel like a nuisance, especially when you run out of skips. Additionally, the “Never Play This Song” button is ambiguous. Are we never playing this song again on just this station, or on all stations? I suspect it’s the former but the ambiguity will definitely make many users hesitant to use the button at all. The fix for this is that every preference action be only one click away, and non-committal / non-threatening.
This failure, yes the failure of the iTunes radio user interface is surprising for two reasons. One, this is what Apple is supposed to be good at. Two, they have Pandora to copy! And therein lies the solution. I don’t know whether the thumbs up / down interface is patented, but it shouldn’t take hiring Dan Brown to come up with some alternative symbols. This should have been a layup and they blew it.
Make it an App! (Accessibility)
iTunes radio isn’t easy to find, and thus far maybe that’s a good thing. In fact, I would wager that half of Apple users have never opened the platform, simply because they don’t know where it is. More importantly, even after you figure out where it is, it’s annoying to have to go into iTunes to get it. This could be easily remedied if Apple would make a separate App for the radio. Even if that app were just a shortcut to bring you into the radio part of the Music App, it would go a long way to making the product user friendly. Make it preinstalled, make it easy to see. You’ll be amazed how many new users you get.
Tim Cook should have been draping the bloody carcass of Pandora across his shoulders at the last Apple event, as proof that Apple is still primus inter pares. Instead, iTunes radio is languishing in the depths of OS 7 – a blemish on an otherwise unparalleled legacy of delivering products that recognize the primacy of user experience above everything else.
Before I wrap up, let me be clear about something; Pandora is overvalued. But not because it doesn’t make any money, it’s overvalued because intelligent investors wouldn’t pay $5 billion plus for a startup with a replicable product that’s surrounded by competitors looking to take a bite out of it. Not the least of which (Apple) also happens to be the distribution platform for 1/3rd of its users. Pandora has been granted a stay of execution thanks to Apple’s shoddy implementation of what has the potential to be a far superior product. However, as I have demonstrated, the road to Pandora’s ruin is not complicated. Apple could implement most of the changes in a weekend. The only question is whether the giant in Cupertino has enough of its former mojo to strike the killing blow sooner than later.
Tile Shop Holdings, (TTS) is a tile retailer that went public in September of 2012. Since then, it has benefited form the markets re-infatuation with anything housing related and currently trades at a ridiculous 26x EV/EBITDA. In the past month the share price has declined 29% due to an earnings miss and allegations by short seller Infitialis research that the company’s products contain hazardous amounts of lead. After reading Infitialis’ otherwise excellent report, and hearing the company’s response on the most recent earnings call; I deem it unlikely that any action by regulators will be forthcoming. With that in mind, I wrote this article to demonstrate that, even without the threat of poisoning its customers, Tile Shop has issues that, from an investor perspective, are just as poisonous as lead. These include, a fundamentally flawed business model, an overleveraged capital structure, aggressive expansion strategy, declining insider ownership, management misconduct, and oversight failures – all packed into a company that is overvalued in even the rosiest scenario imaginable.
Margins & Model
“Everyone sort of lives with their rulers in the past and doesn’t look at coming changes.” – Stanley Druckenmiller
TTS exhibits gross margins close to 75% – this is simply not sustainable. The biggest reasons for this are that tile is by and large a commodity product, and retailing it is a business with low barriers to entry. Home Depot, Lowes and even smaller competitors can just as easily buy it from vendors, and sell it for cheaper. But even if it wasn’t a commodity product, the company’s margins are way higher than those of other national retailers that sell highly differentiated goods. For instance, Apple sports a gross margin of around 40%, and remember, they invented the iPhone! Other premium brands with lower gross margins include Coach 72%, Lulu Lemon 50%, and Abercrombie & Fitch 62%. TTS isn’t selling Gucci loafers or Louis Vuitton bags, and its margins will come to reflect that as it tries to become a national franchise.
The best case a reasonable TTS investors should hope for is that it can replicate the gross margin of U.K. based Top Tiles, and achieve a 60% gross, a margin that would leave TTS firmly on the wrong side of profitability.
The other problem at TTS is the SG&A spend. As a percentage of revenue it was ~ 56% in the most recent quarter. And while management is hopeful they can bring that down to the historical 50%, they give no indication of having the ability or even the intention to lower it any further (despite helpful hints by sell-side analysts to suggest otherwise). This high margin-operating model may have worked for a few specialty stores in Minnesota but as the Tile Shop is soon to learn, what works in the minors doesn’t always cut it in the big leagues.
Capital Structure & Strategy
For FY 2013, the company has plans to expand its store count by 17 stores, and hinted at another 20 in 2014. With only $3.85 million of cash on hand as of September 30th and $85.4 million in debt, the company is taking a big risk attempting such an aggressive expansion. Simply put, the company is overleveraged and any bump in the road may be detrimental not only to equity holders but also to lenders willingness to extend credit.
In addition to the daredevil capital structure, investors should be concerned with the speed of the undertaking. Difficult as growing a business is under any conditions, it becomes exponentially more difficult when you try and do it quickly. Issues such as inventory management, location selection, employee quality and supervision, to name just a few, don’t get any easier to manage when you have Wall Street eying you with a stopwatch. Sprinting ahead at full speed increases the odds of a stumble, a stumble TTS cannot afford.
Never underestimate strong ownership is what I like to say, and I can’t say that about TTS. As of November 2012 Nabron International, a trust controlled by the Chan brothers (one of which is a former Enron board member), was the largest single stakeholder with an interest in ~36% of the outstanding shares. As of June 18th 2013, Nabron had reduced its interest in the company to ~20%, a near 56% reduction in a little over six months. Similarly JWTS, the private equity firm managing the SPAC, has reduced its stake from 13% in November 2012, to 8.4% as of June 10th. Finally, despite receiving share-based compensation, CEO and founder Robert A. Rucker has also reduced his stake from 19.9% in November 2012, to 15% as of June 2013.
All of these investors obviously have better places to put their money than TTS equity – why don’t you?
Management & Conduct
As short sellers Infitialis mention in their report, the CEO of TTS was convicted of fraud in civil court related to divorce proceedings from his now ex-wife. For me, this isn’t a good thing but it’s not necessarily the end of the world.
The other management issue brought to light by Infitialis is the fact that the former Senior Vice President of Operations, Mr. Joseph Andrew Kinder is on probation due to his involvement in a domestic dispute – another bad sign. Since then, it appears Mr. Kinder has been demoted in favor of the recently hired Chris Homeister. Mr. Homeister was previously Senior VP at Best Buy, a company with a poor record of competing on the national stage.
Last but not least, in 2012 the company was found to have a material weakness in its disclosure controls and procedures. As I understand it, the company didn’t have enough people in place at headquarters that were financially competent, nor did they have a sound process for closing the books at the end of year.
In and of themselves none of the aforementioned issues is detrimental to the company’s future. However, when taken together, the picture sure isn’t pretty. At the very least, it should cause investors to think twice about the business they are buying into, as well as the team that will be managing it.
Now, for a moment, lets try and forget about all the things I just mentioned. Let’s put on our optimist hats, and see if we can make the current valuation make sense.
Looking out to FY 2016, I put together the below valuation model that makes the following (heroic) assumptions.
First and foremost, TTS EBITDA margin goes to 30% of revenue. Historically the company has earned about 27.5%. Therefore this assumption extremely generous, especially given that its peers are earning EBITDA margins around 12%. Gross margin remains at the princely 74%, well above peers, while SG&A reverts back to 50% of revenue.
TTS expands its footprint to an average of 150 fully operational retail locations in FY 2016. This would correspond to a 23% compound annual growth rate for stores. To achieve such a rapid expansion without any margin contraction is highly unlikely, but hey we’re looking on the bright side here. Not only does the store count expand, but also increases revenue per store to $3.00 million per store or 7% more than they did in 2012.
We’re going to assume an 11.5x EV/EBITDA multiple in 2016. That’s a higher than what Home Depot currently commands, and it’s a national franchise with a honed operating model, experienced and competent management. I also assume debt will increase to $150 million to finance this growth, while cash moves up to $20 million.
What’s the result of all this future gazing? Despite our psychedelic concessions to the gods of delusion the company still stands ~ 17% overvalued based on Friday’s closing price.
Stepping away from never, never land for a moment, I’ve put together a set of sensitivity analyses to get a sense of where more realistic assumptions might value TTS. Below are two sensitivity analyses that still assume the generous revenue per store and store growth assumptions included in the first model but employ more reasonable margins and enterprise multiples.
Highlighted in peach are the areas that I consider plausible scenarios. As you can see, even the most optimistic forecasts of this subset still expect the company to be overvalued by around 50%.
In addition to the all the fundamental problems, from a more technical and/or psychological standpoint, whatever lollapalooza effect was propelling the stock to its previously astronomical levels has clearly broken-down, and when that magic’s gone, it’s hard to get back. In sum, for TTS the party is over, and the hangover is just beginning.
“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine–that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.” –Edwin Lefevre in Reminiscences of a Stock Operator
My first impression of the above quote is that it’s genius. And then I think about it a little more and decide that it’s absolutely meaningless. And then I think it might be genius again. I still can’t decide.
What do you think?
“Value investing is at its core the marriage of a contrarian streak and a calculator.” – Seth Klarman
Body Central Corporation (Ticker: BODY) is a retailer of women’s clothing focusing on the middle market, late-teens to early-twenties customer. Since their IPO in 2010, the stock has been something of a rollercoaster. Its latest turn has been sharply downward after reporting disappointing results in Q2 of this year. Indeed, since August the shares have declined roughly 45% and the stock now trades at ~90% of book value and ~30% of sales. At first I was very intrigued by the fact that the company was trading at a discount to book value, was cash flow positive and carried no debt. But then I started to wonder, does book value even matter?
I’ve come to believe that as with many things, the relevance of price to book value for a retailer is a matter of degrees – the lower the better, of course. In BODY’s case a price hovering around 1x book value does not imply a margin of safety for several reasons. The most obvious is goodwill that we should almost always assume to be worthless when contemplating a liquidation scenario. Other considerations are the need to write-down inventories, and operating leases – which are effectively off balance sheet liabilities. In sum, for a retailer, an investor shouldn’t expect any margin of safety above 75% of tangible book value.
For prospective BODY investors, the relevant question (at the risk of stating the obvious) is, will this company be profitable? The answer, I really don’t know. The new CEO is trying to reinvigorate the store format, and based on the Q2 earnings call, seems very enthusiastic about what’s been achieved. That said, anyone remotely familiar with the retail market will note that the word transformational has taken on more a ominous connotation after the JCP / Ron Johnson debacle – retailer’s grand visions are now trading at a discount on Wall Street.
Another factor that should give investors pause is the company’s expansion plans. As of Q2 they remained committed to expanding the store count by 25 or approximately 10% of the total store count by the end of the year. My two cents is that management should be focusing on their core business and maybe buying back shares if they are REALLY confidant, rather than distracting themselves with an expanding footprint.
As a value investment, BODY rates highly from a contrarian perspective. Retail is an out of favor sector, and BODY can justifiably be characterized as being at the bottom of the retail barrel. The calculator side of the marriage is more mixed. Declining sales comps, an aggressive expansion policy, and unproven management don’t add up to a margin of safety. On the other hand, stripping out the expansion, the firm remains cash flow positive, and management seems to be working to address the issues. Net-net I think this investment offers better than average prospects but not a substantial margin of safety. Therefore I would advocate a small position at most, if any at all.
For more information on the most recent quarter check out this article by 501 analysts on SeekingAlpa.com
At first glance QC Holdings Inc. (Ticker: QCCO) gives every indication of being cheap, its underfollowed, small, and subject to grave uncertainty. And yet to the best of my understanding it still seems to have a generous valuation.
QC Holdings Inc. management divides their business into three segments – below I break them down by revenue for FY 2012:
- Financial Services = ~82%,
- (Payday loans ~66% & other financial products ~16%)
- Automotive = ~13%
- E-Lending = ~4.4%
QC derives roughly two-thirds of its revenue from the financial services segment. And 66% of total revenue from the payday loans business. This is a problem for the firm because the payday loan business looks to be in danger of going extinct.
For those who don’t know, a payday loan is a loan secured by the personal check of an individual. These are dubbed payday because the loan is usually structured to mature on the date of the individual’s next paycheck. Because these loans have a high rate of delinquency, and associated costs, the interest rates charged are substantial, if not astronomical.
Unfortunately for QC, the business is under attack on multiple regulatory fronts. The first of which is from potential ballot initiative in the state of Missouri. This initiative would effectively outlaw payday lending throughout the state. As one-fourth of the companies’ payday stores are located in that state, and their activities generated 33% of gross profit in 2012 – that would be a big problem. Not only because of the loss of revenues and profit but also from the costs of closing approximately 100 locations.
At present the initiative is still in the process of gathering the necessary signatures to be placed on the ballot in 2014. A similar initiative was submitted in 2012 but failed to accumulate enough signatures to be put to a vote. What’s required is signatures totaling 8% or more of the number cast for governor in 2012, in six of Missouri’s eight congressional districts. That comes out to about 162,000 signatures, depending on which districts you pick. I haven’t found any way of monitoring initiatives accumulated signatures so it’s hard to say how likely it is that this initiative will pass but the possibility is real.
The other threat to payday lending is new legislation at the federal level. The Dodd Frank act created the Consumer Financial Protection Bureau (CFPB) to protect customers from unfair lending practices. The act gives the CFPB broad powers to regulate finance companies. Unfortunately for QC, payday loans appear to be low-hanging fruit for the young agency looking to justify its existence. So far the agency has only produced a white paper on the subject but it has made clear its intention to take some action soon. No one knows what that action will be but from my reading of the white paper, a best guess is that they will limit the number of repeat uses by individuals and/or mandate a cooling off period between loans. This is better than an outright cap on interest rate levels, which would effectively stop the business in its tracks. But it can still have a significant impact on profitability and the specifics of it will matter.
Taken together, I think it’s fair to assume that regulation of some form will adversely affect QC’s core business in the near future. Whether this is a 50% decline in profitability or an 80% decline is very difficult to say but the danger is there.
In 2011 QC purchased Canadian based E-Lending underwriter for $12.4 million. Though the company’s management seems optimistic about the acquisitions prospects, and the Internet lending business has been exploding, the segment has yet to generate a profit. Further evidence that the business is not performing up to expectations was the failure to achieve the performance target of an earn out payment in 2012.
In 2009 the company entered the used care sales and financing market by purchasing several pay here, buy here locations. In essence, these locations help less creditworthy borrowers afford used cars. This would seem like a logical place to leverage the companies underwriting expertise. However, this segment also failed to produce an EBT profit in both 2011 and 2012.
Though QC’s efforts to diversify its product offerings make sense strategically, they have yet to prove worthwhile for shareholders. Lacking any special insight to either business’ prospects, I can only assume they will continue as they have thus far.
At $2.35 per share and ~ $41 million in market-cap QC is trading at 50% of book value and 75% of tangible book value. At first blush this seemed attractive, but when you consider the costs of closing businesses and paying off the non-cancelable leases, (I estimate ~$ 20 million) the margin of safety quickly dissipates.
On the earnings front, the company is trading at ~7x last years earnings. This is cheap but not cheap enough for a company that could see its profitability greatly diminished over the next twenty-four months.
When I started looking QC I expected that the company would be cheap. When I started writing this article I thought it would be too. It took days to get over my biases and realize that it actually isn’t. For me it just goes to show that even in the darkest corners of the market, things can be expensive.
“If I have a book to serve as my understanding, a pastor to serve as my conscience, a physician to determine my diet for me, and so on, I need not exert myself at all. I need not think, if only I can pay: others will readily undertake the irksome work for me.” - Immanuel Kant
As many have noted, people like to write and read about success but for improving failure is often more instructive. Likewise the best failures are the failures of other because they cost us nothing. Conceding that, I would argue that our own failures contain an element of special value, in that they can illuminate our unique proclivities. In this post I’m going to reflect on a few of my more recent errata and hopefully we can both come away with some insight for the future.
The first is something Bill Ackman and I now have in common – we both lost money on J.C. Penny. Like him, this was a company that I felt I’d done the work on. I listened to the earnings calls, created a model of the full capital structure, read market commentary, talked to industry experts and visited my local store. After all that I came to the conclusion that they could probably turn the company back to break even by the end of the year without raising additional equity, and it looks like I was wrong. But being wrong is not why really why I deem this a failure. I deem it a failure because I should never have been making a wager about that company in the first place. JCP is a massive company and as such it’s a virtual playground for big money that has access to more expertise and better information. As a small investor there is easier prey and no reason to work ones butt off trying to hit 250 in the Majors when you could be batting 600 in the minors. It’s all well and good to have an opinion but placing a bet is another story.
My other mistake has been shorting Pandora. My thesis was that with the launch of iTunes radio, the stock would decline due to the perception of increased competition as negative for growth (it’s a growth stock after all). That didn’t happen, instead the stock as rallied and I’m holding the bag. That said – and this is where the nature of markets can make it hard to tell luck from skill – it hasn’t even been a month since the iTunes radio launch and so it remains to be seen whether the Pandora’s growth has actually been affected. Personally, I think it’s a tough call. Apple’s merit is that it’s ad free and Pandora’s is that their algorithm is better. A con for Apple is that the radio feature is relatively improminent, they should have made iTunes radio an individual app as well as integrated it into iTunes. Taken together the services are about equal. So thus far I’ve been wrong from a technical and/or psychological perspective, while the fundamentals have yet to reveal themselves. But all in all, it is kind of an arrogant thesis, and I wagered too much on it.
$NFLX is another short that’s delivered quite a walloping. Here there’s really nothing more than lazy thinking, and no stop to blame. This is another new media company with a high price tag that should have plenty of competition in the long run. Though people have been saying that for years and Netflix has kept chugging along. My thinking now is that I’d hate to close this position out at a loss in what feels like a toppy market (famous last words) – I’ll throw a $352.00 stop on the sucker and close my eyes for now.
If there’s a take away from this rambling it’s not to be so impulsive. I always I do better when I’ve really looked at an idea up and down and then place my wager. Even when I’m just speculating, taking positions at other people’s suggestion feels like wearing someone else’s clothes. Part of that is definitely just a bias toward coherence – it’s easier to feel better about a story you made up than one another person did, even if it explains nothing. But another part goes to something deeper about finding ideas and how to use them. As Warren Buffett has said, a good investment idea is a valuable thing, and we should take them wherever we can find them. But we should also make sure that we understand what that idea is, because without that, we won’t know how to handle it, and how to react if the thesis is proved false. Investing without really understanding is like walking into a blindfolded marksmanship contest – it’s easy to pull the trigger but much more important to know where you’re pointing the gun.