Archives for June 17, 2018

SA Interview: Focusing On The Numbers, Not Just The Story, With Peter Kaye

Feature interview

Peter Kaye is an analyst at an investment advisor with >$1B AUM. He has completed all three levels of the CFA program. He primarily focuses on value and GARP strategies. We emailed with Peter about how to take advantage of a deal break and mispricing when investors write off an entire country as well as how (and why) investors can “shadow” a hedge fund manager’s portfolio.

Seeking Alpha: Can you discuss how (and why) investors can incorporate actual numbers into their investing rather than solely qualitative arguments? Can you give an example?

Peter Kaye: Good question. I find a lot of people get very attached to a story rather than actually looking at the numbers. I like using Microsoft (NASDAQ:MSFT) or Cisco (NASDAQ:CSCO) during the tech bubble as examples. Microsoft, for instance, is one of the best businesses ever: dominant position in software, very high switching costs, very high margins and tons of free cash flow the company can use to either buy back shares or reinvest in the business. It made a great story as well: software was (and is) eating the world, and there was the potential for multiple decades of growth ahead of the company.

That’s all well and good, but look what happened if you’d bought shares in 1999: you wouldn’t have broken even for 16 years (this is why numbers matter)! The simple fact at the time is that the shares were pricing in a perfect future. One can actually perform a fun exercise with some of the companies in the tech bubble where you put yourself in 1999, and run a DCF on the company you’re looking at using the company’s actual free cash flow that they generated over the next 18 years. You can see how far the valuation of many companies strayed from their intrinsic value during that time, and it really makes you think about the high flyers today.

Investing is all about probabilities because the future is inherently uncertain. The reason that value investing works, over time, is that low expectations are just easier to beat. Cheap companies either have management work hard to stop being cheap, or another company comes in and does an acquisition, or the business improves on its own. There are multiple ways to win there, whereas for a company whose intrinsic value is completely reliant on future cash flows that need to grow a lot, there are a lot of ways for that company to disappoint.

As to how investors can incorporate numbers? Always ask for proof of a qualitative claim, and always remember that the price you pay (relative to value) is the greatest determinant of long-run returns. In order to figure out the value, you need to run some numbers.

SA: The phrase “this is priced into the stock” gets thrown around a lot – how do you determine what is (or is not) priced in? Are there specific factors or examples?

PK: My own personal way to check this is to run a simple DCF of the company. The idea is simply that, similar to a bond or any other financial asset, the value of a company is the present value of the free cash flow it generates over time. This is true simply because of math: if you buy a company for $1 and it generates $2 of FCF for a year, your return will mathematically be 100%. You’ll probably never find 100% free cash flow yields anywhere, but the principal is the same (higher free cash flow, now or in the future, means higher returns). This is why looking at free cash flow (and numbers!) matters.

Let’s say a company has sales growth of 5% and generates 10% free cash flow margins. Let’s assume that continues forever, and run a DCF using those assumptions. If that results in a stock price of $100 and the current price is $50, then we can say the market is pricing in significantly worse results, and we can then delve into why that is. The model may well be wrong, and the market might be right, but now at least you have some questions to ask and research to do.

The process works the other way as well: if the stock price is $100 and the DCF gets us to $50, then the market is pricing in either faster sales growth or much better margins, and we can then delve into why that might be and whether those assumptions are realistic.

I’ll walk through a simple example.

I know that analog semiconductor businesses should grow at 1.5x to 2x GDP due to increased technological content in pretty much everything around the world. GDP growth around the world is expected to be between 2 to 3% over the long run, so we know that at the low end, analog businesses should grow sales at 1.5 x 2% = 3%.

I know that analog semiconductor businesses have high barriers to entry and it’s a pretty consolidated industry, so margins tend to be quite high, with Texas Instruments having the highest margins due to scale (semiconductors are basically a manufacturing business so economies of scale are an important part of the business). A company like NXPI has averaged roughly 20% free cash flow margins, and that’s a little lower than some other larger names, and higher than smaller names, so that fits with the scale dynamics I discussed earlier.

So we can put the two together: grow sales at 3%, and slap a 20% free cash flow margin on it, and whatever value that gives us is sort of a floor valuation for a long-term investor. In NXPI’s case, this results in a valuation of about $98 per share using a 9% discount rate.

Now what can go right here? GDP growth could be faster. Analog businesses could grow at 2x GDP instead of 1.5x. Margins could increase as the business grows. So there are multiple sources of upside to this value that I can quantify if I choose to, but I can simply say they’re “free” upside if the stock price is trading below my conservative estimate of fair value.

After going through the above analysis, I can say that what is “priced in” to NXPI is a darker future than what I believe will happen over the long term (say 5 to 10 years).

SA: In your bullish thesis on Workiva (NYSE:WK) you said “A SaaS business is effectively a business where each customer is like a bond” – can you unpack that thought process? How can investors in SaaS companies determine if their “bond” will default or is AAA?

PK: As I said above, the value of any financial asset is the present value of the free cash flow it generates. The same is true of a customer! For most businesses, there is only one cash flow: a single sale. For a SaaS business, with recurring revenues, there is a cash flow stream, and we can value that stream. Each customer brings in revenue, and there are COGS to expense, and the net of the two is the cash flow per customer. If we see that the company has customer retention of say 80%, then we know that the average customer life is 1/(1-0.8) or 5 years.

We can then compare that to the cost to acquire that customer to see whether the business makes sense. In Workiva’s example, the company earns a lot from customers, and it doesn’t cost them too much relative to what they earn, to go acquire them. Thus, it makes sense for Workiva to spend as much as possible acquiring all these customer “bonds” and sitting on them. This dynamic is why it can make a lot of sense for growing SaaS businesses to actually post operating losses as they grow: they’re investing in getting highly profitable customers!

One can look at the customer retention rate to see the likelihood of “default”, but it’s a difficult thing to really measure. Lots of factors weigh on it like switching costs, customer service, competitors’ products etc. One has to just make a best guess as to how happy the customers are and how long they’ll stay with the company. If the company’s customer retention rate has been high historically (and there aren’t a bunch of customers on free or discounted software…) then that should give some confidence that customer life will be decently long.

SA: Can you discuss how an actual or expected deal break can be a potential long idea?

PK: Deals are usually bought by M&A arbitrage funds who attempt to profit from the spread that deals trade at. The problem is that when a deal fails, these funds have to sell the stock. For widely held deals, or illiquid stocks, this can create a huge wave of technically motivated selling that has nothing to do with the fundamentals of the company.

I start licking my lips when I see things like this happen: the best thing to be in the whole world to me is a buyer from a forced seller. When people have to sell, they make dumb emotional decisions, and that’s where an investor with a little patience can profit!

The other advantage of a broken deal is that you can see where, roughly, the private market values the company. If a strategic acquirer was perfectly willing to pay $100, but the deal failed because of regulatory reasons or financial reasons, then you can make a decent guess that the business is probably worth around $100 to a strategic acquirer.

That doesn’t, of course, mean you should rush out and buy the company. The deal might fail for a lot of different reasons, and the case might be that it’s just a bad company with a declining business. You always have to do your homework, and establish what you think the intrinsic value of the business is before you buy it.

I would say that companies like Monsanto (NYSE:MON) or NXP Semiconductors, if their deals fail, would be great examples of businesses that are fundamentally sound, have interesting growth drivers, and would likely trade off severely due to forced selling because there are a lot of arb funds in those names. I do hold NXP, and I bought Monsanto when it traded way off earlier this year to ~$115 which is what I estimate fair value is for the company as a standalone.

I would say as a closing comment that this same “forced seller” dynamic is why spinoffs tend to be fertile grounds to look: large investors might receive some shares in a small company that is too much of a hassle to worry about, so they sell immediately regardless of whether that is a financially prudent decision.

SA: One of your best calls was on Polaris Infrastructure (OTCPK:RAMPF) – can you discuss how opportunities are created when investors write off an entire country as being uninvestable or too complicated to analyze?

PK: Polaris was a company that went bankrupt, and actually had a lot of forced sellers in it. The bondholders got converted into equity, and then had to sell as holding equity was outside the mandate of their funds. This caused the price to decline from about $10 CAD after the restructuring to about $6.50 or so when I started covering it. It was clear that the asset was very good and that the problem had simply been a financing one.

One seemingly big risk of course was that the company’s only producing asset was located in Nicaragua, which is a bit of a scary place for western investors.

My dad was a corporate banker for 27 years without a single loan loss, which is pretty impressive in my view. He lent to some of British Columbia’s biggest corporations, including a number of our large mining companies, and he saw first hand that country risk is real. Investors like to discount politics, but it can play a huge role in everything from changing tax rates to a government effectively nationalizing a project.

Because of this, it’s pretty critical to spend some time evaluating the politics of a country and its history and culture to try and figure out what’s really going on. The nice thing about humans is that no matter where they’re from, they respond to incentives, so it’s really figuring out what their incentives are.

In the case of Nicaragua, the thing that stood out to me was that it was 100% in their national security interest to stop relying on oil, and start generating domestic renewable energy. They don’t have the engineering or the capital to do this, and so it seemed unlikely to me that at this relatively early stage in their development, Nicaragua would choose to shoot itself in the foot and start nationalizing projects (which would then scare off foreign capital).

That being said, Polaris will always (at least until it gets an asset somewhere else) trade at a discount to peers with safer assets. Investors should expect higher returns from a company with assets in Nicaragua vs. a company with assets in the US or Canada. For that reason, Polaris is not my largest position: there is a chance, however small, that they could see 100% of the value of the company wiped out if Nicaragua chooses to nationalize their asset.

Indeed, right now we are seeing the cost of being in Nicaragua for Polaris as the shares have sold off due to extreme levels of political unrest in the country. For the time being, I don’t see how this unrest will impact the company: people still need electricity, and their customer is a large state utility. Where this could get ugly is if the current dictator’s government falls, and the new government embarks on a radical bout of political changes.

I think this selloff in Polaris shares is overdone, but I can certainly empathize with it. I have no concrete answer as to what the country will look like in a year, and that certainly highlights the risks in investing in emerging markets. That being said, long term I expect the company to do just fine.

More broadly, I think that unless investors have some special on the ground knowledge, they should take a dim view of many geographies. 90% of the time, investments in places like Russia or Egypt or Iraq can work out, but 10% of the time, you lose everything or close to it. That risk of permanent capital loss means that a company in a risky geography should probably be weighted in such a way as to allow for the investor to stomach losing 100% of what they put in.

So in summary, I would say that countries don’t necessarily present opportunities; individual companies present the opportunity. It’s more that investors need to pay very close attention to the risks involved, and I would say that as a political science major, most people discount politics a little too much.

SA: How, when, and why can investors “shadow” a hedge fund manager’s portfolio rather than invest directly?

PK: Great question. I think other smart investors are the best source of investment ideas, period. I follow a lot of managers from Bill Ackman (despite his recent terrible performance) to Allan Mecham at Arlington Value. These guys (and I follow maybe 30 to 40 different managers) are my filter. I don’t shadow a single manager’s portfolio, I take what I think are the best ideas from all of them!

If you think about it mathematically, here’s why it saves a ton of time. Each manager has a number of analysts, and each manager might have a universe of 500 stocks they know well. There will be some overlap of course, but even with 50% overlap, that still means a universe of 250 x 40 = 10,000 stocks around the world that they’re looking at. They then do the work and pick the best ideas and stick those in their portfolios.

I then look at those portfolios, and let’s say there’re 30 stocks in each, that means 30 x 40 = 1200 stocks, but often there’s some overlap, so say it’s 600 stocks. 600 stocks are enough to keep me busy for a while, but these managers have gone the extra step and done the screening of the 10,000 names for me, which saves a ton of time. They’re all smart people, so I trust that the stocks in their portfolios are on average pretty good.

I then look at their position sizing and when they added them, and I try and focus on the largest one, or the ones they’re adding to, reason being that I want to look more closely at their higher conviction names or the ones they think are undervalued now. So let’s say that gets you to 100 names, that’s still a lot of due diligence to do to narrow that down to 20 or 30 to stick in your own portfolio.

The reason you don’t shadow blindly is that often managers are wrong. I knew that Bill Ackman going into Valeant was wrong, and I thought he was way too early in Chipotle (NYSE:CMG). Einhorn’s investment in AerCap (NYSE:AER) is not one I would have made, just because I don’t really like that sort of financial/capital intensive business generally. For each name I put in my own portfolio, I conduct my normal due diligence and do my own valuation so that I am fully comfortable with what I own and I can trade it myself rather than relying on other people to think for me.

So as you can see, I would only use other managers as a filter; you still have to do all the work yourself before you actually invest.

I would also point out that there is no shame to looking to others to find ideas. As a great example of this, in The Big Short, many of the investors who foresaw the crisis heard about the short housing trade from Greg Lippman at Deutsche Bank, and then did their own due diligence and entered the trade.

Many others who were not profiled in the book but made money on the theme, likely heard about it from friends or other fund managers in the industry. This is a great case of how one of the best trades of all time didn’t have to be your idea, you just had to be listening to other smart people.

Some of my top ideas right now including NXPI (Elliot Management), TripAdvisor (NASDAQ:TRIP) (GreenWood, Greenhaven Road, PenderFund Capital), Workiva (Pat Dorsey), Polaris (PenderFund Capital), EnviroStar (NYSEMKT:EVI) (Greenhaven Road), Rolls Royce (OTCPK:RYCEF) (ValueAct) and many of my other best ideas in the past were sourced from people I admired in the industry.

SA: What’s one of your highest conviction ideas right now?

PK: Aside from NXPI or Workiva, I have two high conviction ideas.

TripAdvisor

I have a fairly sizable investment in TripAdvisor, which jumped 20% after earnings (a great example of what happens when expectations are non-existent!). The basic thesis here is pretty simple actually. The company has two businesses, the core hotel review business and a non-hotel attractions business, and the market isn’t really getting what’s actually going on with them.

The hotel business has been declining for a few years, in no small part because people are switching to mobile and mobile monetized at like 20% the rate of desktop. This business is coming close to an inflection point, however, because 1) at some point mathematically mobile dollars start growing faster than desktop dollars shrink and; 2) monetization of mobile is now close to 50% of desktop. The two forces mean that soon, I expect, the hotel business will start posting decent growth numbers again.

There is another advantage to the hotel business’ move to mobile which is that it greatly lessens the power of Google over TRIP. TRIP’s users are very loyal and so if TRIP can keep them on the app it means lower marketing spending and better margins and also a greatly reduced competitive threat.

The non hotel business, which allows you to look up and book attractions and restaurants, is growing gangbusters at 30 to 40% a year, and is rapidly becoming a much larger part of TRIP’s business. We can look at the price that OpenTable was sold to Priceline (now Booking.com) for, and see that this business is quite valuable.

Finally, TRIP has hundreds of visitors and collects huge amounts of data which is valuable to somebody. The company is largely controlled by Liberty Media (LMCB). This creates a very nice floor on the stock’s valuation as if TRIP gets too cheap, it’s likely to be sold at a premium.

So the result is a business whose financials obscure what are actually decent trends within its business (and recall that TRIP is a very high margin business, so additional revenue drops almost entirely to the bottom line). Either the company is sold, or it resumes growth and we should see both improved financials and a good degree of multiple expansion in the stock.

Some of that multiple expansion has already taken place. TrirAdvisor was very heavily shorted and what we’ve seen in recent weeks has likely been driven, at least in part, by short sellers covering. I think over the long term we still have a lot of growth for TripAdvisor as their market is growing strongly and their margins should greatly expand as the business scales. While shares aren’t as cheap as they were at $30, I think for someone with a long term time horizon they still represent attractive value.

I’d note that a lot of people think TRIP and Trivago (NASDAQ:TRVG) are the same thing, and whenever Trivago misses earnings people sell off TRIP. Trivago is a mess (I’ve been short the stock as a hedge for TRIP actually) where they are simply buying customers using expensive TV ads. They don’t have the same market power, user base, customer loyalty, shareholder base, or even the economics of TRIP. Google and Booking.com are likely to crush Trivago and I think it’s a terminal short.

Enbridge

My second high conviction idea is Enbridge (NYSE:ENB), which is the largest energy infrastructure company in North America. The company pays a 6.5%+ dividend (so you get paid for patience) and management has targeted 10% growth in the dividend for the next few years. The company has come under fire recently as interest rates have risen and they’ve faced some political headwinds (a FERC ruling and some opposition to their large Line 3 project), and shares have cratered. There’re also concerns about leverage.

What the market is missing I think is that ENB placed a lot of assets into service last year that haven’t really showed up in the financials yet, and they’re going to do the same this year (of their $22 billion backlog, more than half will be placed in service between last year and this year). The street is also bad at modelling the company as they acquired Spectra Energy and many banks didn’t cover both. What they miss is that Spectra’s Q1 is very strong and last year, ENB hadn’t closed the acquisition until the end of Q1, so you don’t see that strength in Enbridge’s financials.

I think that the market is going to see that the fundamentals of the company are very good, and that they’re going to be able to pay down debt quicker than the market believes (though still more slowly than what ENB was promising after Spectra closed). They are also going to sell some assets to fund their growth, which isn’t a net positive really but it does show that the company has a lot of levers to pull in order to deliver on that growth.

ENB also has a very complex corporate structure, and the plus of the recent FERC ruling is that ENB is more likely to simplify that structure, which should make investors more comfortable with the company.

I think today’s current valuation builds in room for rates to go up to about 4% on the US 10 year, so there’s some margin of safety in the valuation. I think that as debt gets paid down over the next 5 years, you’ll see some multiple expansion as the company de-risks the balance sheet. This sort of setup is a little private equity style: buy something cheap, pay down the debt, and earn good levered IRRs. Because ENB’s assets are regulated, and now with oil at $70, I think there’s very little operational or asset risk here, it’s almost entirely a debt paydown story.

I would caution, though, that pipelines rely on the capital markets to fund growth, and that can create some problems: lower growth means lower valuations, which means growth gets harder to execute because you have fewer financial options. Growth being harder means the potential for further valuation declines, and the cycle continues. Thus, while I have high conviction on ENB, I think investors should size it appropriately in case things continue to go downhill. Every time I’ve had a blow-up, it’s been due to leverage, so I’m very careful to size these sorts of positions carefully.

***

Thanks to Peter for the interview. If you’d like to check out or follow his work, you can find the profile here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Check with individual articles or authors mentioned for their positions. Peter Kaye is long NXPI, WK, RAMPF, TRIP, MON, ENB, EVI, RYCEF and short TRVG.

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