Voltari Corp and the madness of crowds

Every now and then, just when you think you’ve seen it all, the stockmarket demonstrates its endless capacity to surprise. Witness the recent move in Voltari Corp (Nasdaq: VLTC), which has rocketed from under $1 to $16.2 in 3 weeks:

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Normally I wouldn’t focus too much on the gyrations of penny stocks but in this case, I think the move has really gone beyond egregious and it perfectly encapsulates the periodic insanity and suspension of rational thought that can occur in bull markets (especially when combined with a high short-interest and low float). In that sense it is an instructive case of ‘madness in action’ and worth exploring a little further.

So what exactly does Voltari do?

Let’s start at the beginning: what does the company do? In its own words (from the 10-K):

Voltari Corporation (“Voltari” or the “Company”) empowers our customers (including brands, marketers and advertising agencies) to maximize the reach and economic potential of the mobile ecosystem through the delivery of relevance-driven merchandising, digital marketing and advertising solutions, primarily over smartphones and other mobile devices. Voltari uses advanced predictive analytics capabilities and real-time data management (including sophisticated data curation and modeling) to deliver the right content to the right person at the right time. Voltari’s unique combination of technology, expertise and go-to-market approach delivers return-on-investment for our customers.

So Voltari is an ‘ad tech’ play, of which there are a fair few listed comparables (YUME, SZMK, TRMR, LOOK, etc). The history of the company is fairly intriguing: it has gone through a number of corporate names, most recently ‘Motricity’, and through the years has compiled a hodge-podge of digital advertising assets (including the assets of the former Infospace), without generating much (read: any) in the way of profits.

In fact, a quick history of the financials is predictably messy (there is a reason this stock was trading sub $1). Voltari lost $29mm in FY14, $25mm in FY13, and $28mm in FY12, despite revenue ‘recovering’ from $9mm to $12mm last year (it was $133mm in FY10). As of Dec’14, the company had just $6.4mm cash (down from $25mm in FY13 and $52mm in FY12); it burnt ~$19mm in FY14, up from ~$13mm (from continuing ops) in FY13. While losses and cash burn are likely lower in FY14 (due to restructuring, lower impairments, and headcount cost cuts), I find it hard to see how Voltari doesn’t lose $10mm+ and burn a similar amount of cash at least this fiscal year – suggesting, even pro-forma for the recent capital raise, a still urgent need for capital (current pro-forma cash is ~$9mm). Frankly I am shocked that management hasn’t conducted an accelerated offering yet, given the extent of the rally.

In any case – Voltari is an ad-tech company with zero scale, de minimis revenues, near-zero cash, negative shareholder’s equity, and poor prospects for surviving another year. Despite this, it’s current enterprise value is ~$194mm (~$162mm market cap + $41mm pre shares less ~$9mm pro-forma cash) – not an insignificant number, and a cool 16x sales. YUME/SZMK/TRMR (which are all profitable or getting there, and mostly growing revenues) all trade at ~0.3-0.7x sales, for reference. So, if it’s clearly not fundamentals, what is driving this insane move?

First and foremost, the involvement of Carl Icahn. The proximate cause of the super-spike was the disclosure that Icahn’s investment company, Icahn Associates, had increased it’s stake in the firm from ~29% to ~52% (and ~61% including warrants), via his participation in a rights offering, back on April 1. Of course, the price of that rights offering was $1.36 (or $0.97 for minority, non-Carl Icahn investors). Icahn bought ~4mm additional shares (90% of the offering) – which, less fees, netted $4.6mm for the company.  Fully diluted shares outstanding (including shares, in-the-money options and warrants, vested + unvested restricted stock units, and the new shares from the recent rights offering), now total ~10mm shares. So at $16.2, the market is telling you that the additional $4.6mm cash from Icahn has created ~$148mm in shareholder value – in 3 weeks. Of course, Voltari management was happy to get the cash at $1 a share three weeks ago, hence the offering – so something fishy is going on here.

Bulls in recent days have been trumpeting Icahn’s large stake as a vote of confidence in the company’s technology, and suggest an acquisition or forced sale could follow. This thinking could not be more wrong-headed. Voltari is much more akin to a failed venture-cap company than the juicy activist targets Icahn is known for. Icahn first invested $50mm in Motricity pre-IPO in 2007, then another $50mm (via shares, pref shares, warrants, etc) in 2012, thereby raising his stake as he doubled down at lower valuations; he invested at least another $25mm in other follow-on offerings, etc. In a rare piece of footage, he described his investment in Motricity as basically a family obligation (“I was talked into it by my son”) – Brett Icahn, the son, still sits on Voltari’s board (as does Icahn’s son-in-law). Here is the link to the footage: http://dealbook.nytimes.com/2008/03/13/icahns-family-ties-bind-him-to-sinking-motricity/

Hence, we must view the recent ‘vote of confidence’ in Voltari via the $4.6mm capital injection in this context. Icahn had already tipped $125mm into this sinking ship; he has family obligations involved and at this point another few million does not move the needle for him or his investment cost basis. Yes, it is a case of ‘good money after bad’ but the absolute $ amount – both relative to his fund, and relative to his original investment – is so small as to be essentially a very cheap option (and oh, how that option has played out!). The massive rally in the stock in the belief that this investment says anything at all about the prospects of the company, is, therefore, profoundly misguided.

Secondly, there is some contention that because of years of losses, Voltari has some attraction for its NOL (net operating loss) hoard (which can be used to reduced taxes when a company actually returns to profit, in some cases). At ~$187mm of NOLs, the argument goes, this could equate to a chunky per share value (~$18.5 per share) if it could be monetized. However, this thinking is similarly confused given a) Voltari would need to generate significant profits to utilize the tax advantage (which seem unfeasible in the next couple of years); and b) the value of NOLs are severely limited if the company ever gets acquired (as the bull case would suggest is an opportunity). These so-called ‘section 382 limitations’ (referring to the section of the corporate tax code) limits the value of acquired NOLs to 4% of the ‘fair market value’ of the company before an acquisition – thus even if the company could sell itself at the current price ($16 a share), only ~$6.5mm (~65c/share) of NOLs would go to the acquirer (4% x rough market cap at $16/share) – clearly a far cry from the $187mm in purported value, and again, this presupposes an acquisition at the current crazy price. The only other option for Voltari to extract something from the NOLs would be for it to acquire a money-making business, the profits of which could be offset by the NOLs. However, as discussed above, Voltari has barely enough cash to last the year, let alone make acquisitions.

So, the two tenets of the bull/daytrader’s thesis are, well, garbage (just like the stock). Why, then, is the stock on a rocket ship? The simple explanation is a combination of a heavy short-interest, a low float, and an irrationally exuberant, bubbly environment. Daytraders have now taken over and the stock will eventually retreat to a $1-2 a share, where it belongs; but for the moment it is caught in the grip the kind of violent mania that only a bull market can sustain. The Voltari case – however and whenever it ends – should be Exhibit 1 whenever anyone tries to defend the efficient market hypothesis.

(Postscript: it is interesting to consider what Icahn does from here. Tthe recent rally has been so violent – and on such large volumes – that Icahn is in the curious position of being almost breakeven – which would have been marked at a 99% loss just a few weeks ago – and almost inconceivably, able to trade out of his position in a single day. Post the rights issue, Icahn owns ~4.74mm shares, worth ~$77mm at today’s prices; and 95.5% of the pref shares outstanding, which have a liquidation preference of ~$39.3mm (and currently trade at a premium). Of course, he cannot redeem the pref shares since the company has no cash; but he could certainly dribble out stock into the market to at least recoup some of his equity investment (the stock traded ~27mm shares yesterday, so, temporarily at least, the liquidity is there). This would necessarily crater the stock once an amended 13D was filed disclosing the sales – but this would just put the stock back where it was a few weeks ago, and Icahn would have saved himself – and his investors – a boatload in the meantime. I would not put it past Icahn to try something like this).

Disclosure: no position in VLTC (but short LOOK and suffering an incredible mount of pain)

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“Even when you win, you can’t win” – Netflix edition

For me the most memorable scene in the classic action movie The Matrix is where Neo (Keanu Reeves) enter the Matrix (computer-generated reality) for the first time and fights his mentor, Morpheus (Lawrence Fishburne), in a kung fu battle. Morpheus uses the experience to explain how the Matrix works to the rookie: “[The Matrix] has the same basic rules like gravity. What you must learn is that these rules are no different than rules of a computer system. Some of them can be bent, others can be broken.”

To my mind, this is an apt analog for valuing stocks. Most of the time, companies trade on a multiple of future earnings, or more precisely on a multiple of expected future cashflows (themselves a function of future earnings in most cases). Where higher earnings and faster growth is expected, a higher multiple is accorded; the same goes for greater visibility, or predictability of future earnings. The idea that earnings power, or cash-generating power, drives equity valuation is so fundamental to the accurate valuation of all enterprises that if it did NOT apply to the vast majority of traded equities, capitalism would cease to function (how would you rationally value businesses otherwise?). It is the very glue binding capital providers (investors, banks, venture capitalists, etc) to capital employers (companies).

But, as in life, the stockmarket is a product of human emotion as well as rational calculation, and so markets are periodically subject to bouts of mania and speculation (bubbles in bull markets and massive crashes in bear markets) that most all end in tears. For short (or sometimes long) periods this can apply to the whole market, or large segments of it. But even when most of the system exhibits mostly rational pricing, there remain pockets of outright irrationality where the normal rules clearly do not apply. Hence, as in The Matrix: some rules can be bent, and some can be broken.

I’ve always found it fascinating how two companies in the exact same industry, producing the same product, can be valued so violently differently as to make all kind of rational explanation impossible, forcing analysts to jump through all kinds of intellectual hoops to try to justify valuations that most sane, neutral observers could not fathom. General Motors (GM) vs Tesla (TSLA) is perhaps one such intriguing pair: GM produces ~10mm vehicles a year and is valued by the market at ~$60bn, or ~3x current year EBITDA; TSLA is hoping to produce just 100k vehicles by the end of this year, yet is valued at $30bn, and trades at 55x EBITDA. I’m not trying to decry TSLA’s valuation specifically – rather, I just hope to demonstrate that despite the common product, the market is employing two fundamentally different sets of methodology to value these two companies (and the analyst pool, common to both companies, has bought in to both at the same time…).

In this sense, localized manias – sometimes isolated to particular sectors or even single names (‘cult stocks’) – exist all around us, surrounded by otherwise reasonably-valued, ‘normal’ stocks. What makes some companies so lucky? Why do they get to trade at astronomical valuations? A massive share price premium is effectively a free gift from the market that can help expensive companies create their own reality (by funding, through rich stock, the acquisition of less fortunate companies at cheaper multiples) – what’s the secret sauce?

While the variants are numerous, most localized manias exhibit some combination of the following: a revolutionary new product or technology that promises ‘disruption’ of existing large markets; the opportunity for a long growth runway into such large markets (‘blue sky growth potential’); clever management that massages and markets the company into ‘story stock’ (often by focusing attention on non-standard performance metrics that suggest higher future potential and therefore valuation); and, of course, the ability to execute and deliver on growth promises.

Most cult growth stocks exhibit all of the above but fail to consistently execute on their promises (when measured over years), and so generally tend to devalue to more defendable valuations as the mania dissipates. Sometimes this happens gradually, over years; more often these stocks are repriced viciously in short periods (a number of SaaS and biotech stocks suffered this fate last March, for example). Occasionally the very best names defy the odds and continue to hit high growth expectations (or maintain the mystique, at least), quarter after quarter, year after year. An incomplete shortlist of these kinds of names would include Amazon, Tesla, Under Armor, Salesforce.com, and, of course, Netflix. But it is important to remember that these few cases are the exceptions: in most cases, reality catches up with the manias, whether it takes a quarter or many years, and rationality returns to the pricing mechanism of the market.

For those looking to benefit from the irrationality of the market (other than riding the wave and hoping it continues), you can try to figure out when the party could end. This is difficult, to be fair, but eminently achievable, and amply compensated by the potential rewards. Furthermore it is intellectually valuable as an exercise to help avoid investing mistakes on the long side (ie, not falling victim to manias yourself).

Keeping this in mind, let’s look at Netflix (NFLX). In many ways it is the quintessential ‘story stock’: it offers a heady combination of disruptive technology, high growth now and ‘blue sky’ potential growth going forward; it generates a boatload of revenue but no profits (and burns a ton of cash); it guides investors to look at company-defined metrics (‘contribution profit’) rather than GAAP financials (which are ugly); it has a brilliant management team pulling the strings rather expertly; and, perhaps most importantly, it is readily visible and tangible to retail investors (crucial to a real cult stock is the irrational investor who loves the product and so blindly invests).

But before diving into the current picture, it’s worthwhile taking a quick survey of where Netflix came from, for the company’s current situation is a function of the various transformations it has gone through. Started as a mail-order DVD rental business, Netflix’s first vision – ‘Netflix 1.0’ – was a pretty good business: it provided a convenient service better than the lethargic competition (ie, Blockbuster) and prospered in the early-mid 2000s. DVD rentals was truly a business with scale (regular readers will know I am obsessed with operating leverage), since adding 10 customers doesn’t require you to buy 10 more copies of your DVD library.

Unfortunately for Netflix, the market changed, DVD rentals were going the way of the dodo, and so Reed Hastings (Netflix CEO) and co made the ingenious move to invest heavily in becoming an ‘over-the-top’ provider of on-demand video content (‘Netflix 2.0’). This worked great, initially, and subscriber growth accelerated. But unfortunately the studios – who initially had sold over-the-top content rights for a song, since the subscriber base started very small and presented little threat – quickly realized that the more Netflix grew, the more over-the-top threatened cable subscriptions and hence the value of their content, and therefore began to jack up the cost of their content to Netflix dramatically. This never-ending, negative leverage cycle – the more subscribers you attract, the more expensive your content acquisition became – threatened to destroy Netflix 2.0.

So management – brilliant as they were – decided to reinvent the company, again, around the provision of original, unique Netflix-created content (House of Cards, Orange is the New Black, etc), and in effect becoming “the HBO of the internet – or, as you probably guessed, what I call “Netflix 3.0.” Strategically, this is where we are now.

The quality of the new programming was, thankfully, very high, and Netflix continues to attract subscribers quickly; in fact Netflix for the last couple of years has been pushing aggressively to replicate their model internationally (mostly because the US market is becoming saturated). Unfortunately, though, non-Netflix content acquisition costs didn’t come down as much as they hoped, mainly because a) a number of competitors (Hulu/HBO Go/CBS etc) have entered the space, often the media companies themselves, creating bidding wars for content; b) as more Americans ‘cut the cord’ and cancel their cable subscriptions, the value of content in a 24/7 broadband world has skyrocketed (not just for Netflix but to all of the media companies); and c) expanding internationally costs more in licensing fees than just distribution in the US alone. Additionally, the creation of top-quality programming requires, well, a lot of money – so the net result is content acquisition – now a combination of original Netflix content and licensed from other studios – continues to outpace revenue and subscriber growth quite dramatically.

The net result of all these gyrations can be summed up by a few simple stats. In 2007 (the tail-end of ‘Netflix 1.0’), Netflix had ~7mm paid subscribers, generated $1.2bn revenues, made ~35% gross profit, spent 28% on opex, and generated ~8% operating margins. Additionally the company generated a modest amount of free cash flow (~$50mm) and had no meaningful long-term content liabilities. This is decent if not stellar financial performance. By 2014 – squarely in ‘Netflix 3.0’ mode – the company has grown the subscriber base astronomically to ~57mm (roughly 40mm in the US), and revenues to $5.5bn. But gross margin has contracted to 32%, and opex has kept up with sales growth, such that operating margins are actually lower (~7%) – despite the mammoth growth in sales and subscribers. More worryingly, the business has been consistently cash consumptive (burning ~$130mm in cash in FY14), even though content acquisition costs (and attendant cash requirements) only accelerate into the future. The company has $9.5bn of content liabilities, of which~$4.2bn are not even on the balance sheet yet – these liabilities have grown at roughly twice the pace of revenues since 2007. This picture would be scary enough – except that it doesn’t consider that DVD rentals – a business that will eventually disappear – still generates ~15% of Netflix’ revenues and ~35% of their ‘contribution profit’ (a non-GAAP measure that excludes content acquisition costs)…that is still a huge chunk of the company’s business, for a segment likely destined to melt away.

I don’t want to get too bogged down in the details here; the market has already made its judgement (the stock ripped 18% yesterday to a new high, with the market cap now $34bn). At this point there are two basic tenets to the bull thesis, and the stock won’t go down until one or both of those tenets are seriously challenged. They are: that Netflix’ subscriber growth opportunity is still massive (the ‘blue sky’ growth argument); and that – perhaps like Amazon – there is tremendous operating leverage built into the model once Netflix is the dominant player (hence we should not be worried about low profitability at the moment).

Let’s dig a little deeper into the first point. How massive, really, is the subscriber growth opportunity? As mentioned, Netflix ended last year at ~57mm subscribers; as of 1Q, they are near 62mm, over 40mm of which are in the US. There are only 117mm households in the United States, so we are already at ~35% penetration; and, assuming at least some keep their cable, use other subscription services, or frankly borrow their friends’ Netflix passwords (I’m guilty!), I really don’t see how much more growth there is in the US. In fact the company acknowledges this implicitly (via the push to international) and explicitly (by reporting growth in US subs has tailed off in recent years).

As for the international opportunity – clearly the absolute number of potential subscribers is much larger, though the cost of getting to them is also, exponentially larger (given different geographies, licensing requirements, more competition, and less broadband penetration). In fact the company has not yet generated any profits internationally and it remains very much an open question whether the Netflix model can work abroad. Nevertheless – in terms of pure subscriber adds, there is certainly green grass to be enjoyed overseas.

But what about the second – and I believe more important – pillar of the bull thesis? At this point, I think we really have to reconsider how much pricing power/operating leverage Netflix will be able to extract. Consider: direct over-the-top competition is only increasing (cf, the launch of HBO Go, Hulu, CBS streaming, and likely some kind of Apple solution in the future); and the cost of content is still accelerating. Price hikes were achieved last year, but as competition increases and other unbundled solutions become more available, the inelastic demand enjoyed by Netflix so far will likely dissipate (this, at least, is how consumers behave in other crowded, competitive markets). And on the cost side, is it really reasonable to believe that content costs will come under control at some point? If you don’t believe revenue/subscriber growth goes on forever, this is what you need to believe to think Netflix has a viable business (let alone a stock worth buying up here).

But consider the nature of Netflix’ cost base. Outside of marketing (which could, at some point, exhibit a bit of positive leverage), the vast majority is content acquisition (incidentally – this is why Netflix reporting ‘contribution profit’ by excluding content costs is a complete joke on the market and all analysts who parrot it). We have discussed why external content costs are unlikely to go down (in fact how they have gone up as fast as, or faster than, Netflix’ subscriber growth); this is a big problem when subscriber growth slows. As for internally-generated content – this is a fairly inelastic cost item on a per-unit basis (which is bad if you are trying to achieve scale). Whether Netflix has 50mm or 100mm subscribers, the cost of making high-quality TV series is basically what it is – TV shows are not iPhones. And the more subscribers you have, the more different shows you need (to support the more diverse interests of your base). This is another reason why Netflix’ content costs are accelerating so dramatically (they keep making new, expensive shows). I guess if Netflix’ subscriber base fell massively, the company could get away with making fewer shows, though in that case clearly the company would have bigger problems. But otherwise – I just don’t see how the company ever generates real operating leverage from the model. There is simply too much competition.

There is one way Netflix can extricate itself with honor from all this: forget about external content, abandon the plans for world domination (via aggressively adding subscribers at any cost) and become, truly “the HBO of the internet.” With a smaller, loyal subscriber base the company could focus solely on a limited amount of high-quality content, and charge a premium price as a result – this would be sustainable, as content costs would come down dramatically, and the need to increase advertising spend continually to enter ever-more markets would also be lower. Of course the company will not pursue this angle as then Netflix would have to be valued as a boutique media company (think AMC Networks, Lions Gate, or Starz perhaps) – all of which are valued by the market in the $3-$5bn range (Netflix is at $34bn currently). Even in the most optimistic case where Netflix is valued akin to HBO – and really this is beyond extravagant, as HBO’s catalog has been built over 30yrs – we are talking about ~$20bn in absolute $ in an acquisition scenario (at least that is what Fox was apparently valuing HBO at, when they thought about buying Time Warner last year – this was ~10x HBO’s EBITDA). Of course, independent, standalone valuations would be lower, and even then – this is ~40% below where the market is currently pricing the company.

Thus, Netflix is trading, to me, anywhere between 2-8x its ‘fair’ value – hence my contention that it is the ultimate story stock, breaking most all the normal valuation rules applied in other parts of the market. At this point I should mention – I am NOT short Netflix stock. While I clearly am skeptical the company can ever grow into and thus justify its valuation, as long as the market focuses on subscriber growth at the expense of all else, it is impossible to accurately time the short. However – the point at which subscriber growth meaningfully slows; or the market turns its focus, belatedly, to earnings power, will be an opportune time to short the stock (even if your absolute starting point is much lower).

Smoking cigar butts, or how betting on obsolescing technologies can make you money

Yesterday, the Wall Street Journal reported that digital music sales revenue overtook physical CD sales for the first time in 2014 (CD sales -8% YoY to ~$6.82bn, digital music including subscriptions +7% to $6.85bn). I found this statistic of interest for a number of reasons, namely: 1) Almost $7bn is still generated by selling CDs (when was the last time you bought a CD or even saw a CD store??); and 2) despite the massive rise in digital music consumption, it remains mostly bereft of revenues (the ~$7bn revenues represent a tiny fraction of total digital music use, given rampant pirating). Also, from a business perspective, it is important to realize that profitability in the CD/physical business remains much better than in digital, given higher price points (many albums are still $25-30 versus digital music subscriptions which may be a few dollars a month for unlimited use).

But away from the music business, this kind of report has broad explanatory power with regard to how we perceive the adoption of new technology (and by extension, how the market misvalues old technologies). Digital music made its first appearance in the late 1990s, but really went mainstream with the launch of Apple’s iPod in 2001 – a full 14 years ago. Tech experts had been proclaiming as soon as the iPod became a hit  – say, from 2003 on – that the physical music business was doomed; these calls were repeated post the iPhone intro in 2007. Certainly a number of pure CD retailers, like HMV or Tower, have departed from the scene. But nevertheless, the format itself has continued to defy pundits and exhibited the quintessential ‘long tail’, enjoying a corporate Indian summer that has extended over years while still generating significant (indeed much more reliable and higher-margin) earnings for record companies. I bet that CD sales will continue to be meaningful – at least to the record companies – for at least another 5-6 years, thereby stretching to two decades beyond the date many ‘experts’ thought the format was well and truly dead.

This kind of genteel decline – where supposedly-obsolete technologies/products/services nevertheless continue to exist and generate solid earnings for much longer than the market expects – can be observed in other industries too. Hard-disk drives (HDDs) are a prototypical example: the main players, Western Digital and Seagate, have been throwing off tons of cash for years, well after pundits thought solid-state flash-based drives (SSDs) would displace HDDs in CPUs worldwide. Gamestop, the retailer of console games and hardware that derives most of its profits from the resale of used games, continue to pump out the profits, again, almost half a decade after digital game downloading arrived to disrupt the market. Meanwhile in Japan, flip-phones and fax machines remain two highly profitable business lines for companies like Panasonic and Sharp – some years or (in the fax machine’s case) decades after newer, better technologies came along to disrupt the market. In fact, Panasonic and NEC have exited the global smartphone market due to ferocious competition, but still make flip-phones that generate steady profits at home in Japan.

While it may seem counter-intuitive at first, there are two very good reasons for why dying technologies and industries tend to prosper much longer than you might think. Firstly: the perceived rate of technological change is much faster than the mass adoption of those changes. This may seem obvious, but the consequences are profound. The 21-yr-old college student who hails an Uber from their smartphone (or smartWatch) while considering which Airbnb to stay at for their spring break may be the front line for new technology adoption, but the vast majority of the marketplace is older, more set in their ways, and only adopt the latest technologies at a lethargic pace. What is new, exciting, and destined to disrupt and dominate according to Wall Street – itself largely composed of the cutting front edge of new-technology adopters, by the way – is to most all the rest of the population foreign at best and threatening at worst. To go back to the fax machine in Japan example: articles have suggested it retains a loyal following precisely because it is older, reliable, and frankly, not new or threatening. Since the people writing and thinking about new technologies are precisely those invested in them (or at least interested in and engaged by them), there is a massive problem of perspective, or cognitive bias, against aging technologies. As a result, the cries of ‘out with the old, in with the new’ tend to be perpetually overstated, for those doing the shouting only make up a small sliver of the broader market.

The second reason is a direct corollary of the first. Since Wall Street is well, a marketplace – both for capital and of ideas – the newest and hottest products and technologies naturally attract the most interest, both in qualitative and quantitative terms. This manifests itself in a few ways, the most important of which are high market valuations for perceived growth stocks (especially in novel or ‘hot’ industries); more entrants and hence more competition in these markets; and a dearth of interest (and therefore capital) in the perceived ‘dying’ technologies.

And so we get to the core of how dying companies can make you big money. Lack of interest creates low valuations and potentially value stocks (presuming legacy debt is not an issue) – historical studies have demonstrated that value stocks tend to outperform the market (and high multiple stocks) in the long-run. And even more importantly – because of the perceived obsolescence of a given industry, you don’t have to deal with pesky competition (new players don’t want to enter a dying market) and in fact weaker players may exit or leave the market. This leads to the creation of oligopolies which generally enhance profitability.

This is exactly what has happened in the HDD industry: Seagate and Western Digital are the only two meaningful players left, largely because the Japanese (Toshiba and Hitachi) gave up on the market several years ago when they saw the writing on the wall (or at least thought they did). Similarly, other obsolescing markets from flip-phones to fax machines to DVD rentals to used game resale to physical book retailing all exhibit very few remaining players, making to quote Gladys Knight, “the best of a bad situation.” And in reality a number of these businesses are relatively healthy and hugely cash generative, since – as mature businesses – they require lower investment burdens and face less price competition. Warren Buffet famously likened investing in these kinds of businesses to smoking cigar butts that others had thrown away: the analogy is particularly apt in that it captures the general disdain – and hence valuation discount – that these kinds of businesses generally trade at. It is precisely the market’s disinterest that creates the opportunity for outsized returns.

For my part, in tune with this theme, I am currently invested in Barnes & Noble, the last remaining physical book retailer. It is a fairly simple thesis (you can read my thoughts in more detail on my Seeking Alpha page), and fits nicely into the ‘cigar butt’ category: physical book retailing is perceived as a dying business, and yet there is no one else in the business (Amazon of course competes online but for those looking for a physical book-buying experience there is no competition). Despite the rise of the internet there is still a large portion of the population enamored both with real books and the experience of being in a bookstore. BKS has managed to correct operational issues over the last year or so and has decreased losses in the e-reader segment (the Nook), massively. Overall sales trends in the retail store actually posted positive store comps in the most recent 3Q (holiday period), when you back out the impact of the Nook business. Furthermore they are proactively spinning off their college bookstore business (which should actually be a growth business, at some point) in a few months. Despite improving margins, a ton of net cash, and a highly cash-generative core business, BKS trades at a bargain-basement ~4.8x EV/EBITDA, with spinoff catalysts upcoming. To me, it still remains one of the better bargains in the market – all because of the market’s chronic disposition to undervalue supposedly-dying businesses. In this case, though, I’m fine with it, as this is one cigar butt I don’t mind smoking at all.

Disclosure: long BKS

GoDaddy and the eternal optimism of retail IPO punters

The mispricing of securities in the IPO process never ceases to amaze me. Despite reams of historical evidence that most IPOs are overpriced and represent poor medium-term investments, there is an almost-unending stream of retail punters who jump into the next ‘hot’ IPO at almost any price, often on the basis of name recognition alone, only to be sore disappointed in the months that follow. For the life of me I can’t figure out what it is about new merchandise that so excites the masses, but this element of bull market behavior seems immutable. GoDaddy (GDDY), the well-known domain name and internet hosting service (mostly for its raunchy Superbowl ads), is just the latest in a long line, coming public at $20 this week and closing the first day’s trade north of $26, for a cool 30% day one pop. As an example of how fundamentally wrong the market can be (for extended periods), it serves as a pretty fine example.

Before digging into the negatives, though, let’s acknowledge the positives (yes, unlike some IPOs, there are actually a few). GDDY has exhibited decent revenue and bookings growth in recent years, posting mid-teens CAGR growth rates in each in the 201–2014 period (somewhat supported by acquisitions, but we’ll leave that for now). While profitability on a GAAP basis remains elusive (mostly due to a large interest burden from the company’s substantial debt), Adjusted EBITDA has grown nicely from $174mm in 2012 to $275mm in 2014 (heavily adjusted, but still – let’s leave for now). More important than the numbers, perhaps, is the business and GDDY’s place in it: the core domain registry and hosting business (around 90% of group revs in 2014) is low-margin and maturing but still growing low double-digits (in lock step with the ongoing growth in shift to online); GDDY is one of the largest players with ~20-25% market share. Better for GDDY is their focus on small businesses – around 50% of which, in the US, remain offline (according to the company), offering further ample runway for growth. ARPU trends are favorable, growing ~10% a year the last two years, and, at ~$115/year, are still lower than their main competition, Web.com (WWWW), where ARPU is ~$165/year, suggesting scope for further growth there too.

Now for the bad. GDDY is not a new company: they have been around, in one form or another, since 1997, and according to the data offered in the prospectus, has not generated a GAAP profit once in the last five years. This is a massive problem for a company in a well-known industry and maturing market that is trying to convince the market to pay a premium multiple. Consider that despite the operational and scale improvements of the last two years, the company is still running solidly loss-making at the operating level; and given how fragmented the market, it is unlikely market share has much room to expand. And while GDDY claims to be a ‘cloud-based provider’ of value-added services, core domains/hosting still represents ~90% of revenues as of 2014 – which, since these markets are competitive and relatively low-margin, suggests overall market expansion could be difficult to achieve as well.

Somewhat ominously, GDDY had previously tried to IPO twice, but PE sponsors pulled the deal both times due to ‘market conditions’ – not exactly propitious for buyers now. Most all the use of proceeds of the offering (~$315mm out of ~$470mm raised) will go to debt paydown, meaning PE sponsors are not cashing out their stakes at the IPO. Normally, I would take this as a positive sign, but actually in this case it makes me think large PE secondary offerings are simply a matter of time, especially if the stock stays up here (mid-$20s).

I guess it all comes down to valuation in the end, and this is where the current price is mind-boggling. Consider, pro-forma for the IPO, the share count will consist of: 23mm class A shares issued in the IPO; 38.8mm other Class A shares already existing; 90.4mm class B shares (held by sponsors and exchangeable to Class A post-IPO); and up to 35mm more shares to be issued under existing incentive plans/stock options agreements (at least 27mm of which have strike prices in the $7-8.5 range). Let’s say pro-forma fully-diluted share count is 179.2mm shares (including just the stock with low-priced options from the above), suggesting a pro-forma market cap (at $26/share) of $4.66bn. (It’s important to note that only ~12.8% of the total share count is in the float (23mm/179.2mm), which – like many recent IPOs – provides a technical bid to the shares in the near-term but will likely pressure prices substantially once the majority of the float enters the market). Given the company also has ~$900mm of pro-forma net debt (even after the paydown post IPO), GDDY is sporting a cool ~$5.55bn EV – or 4x 2014 sales, and 20x FY14 ‘adjusted’ EBITDA.

20x EV/EBITDA – even assuming the EBITDA number is real, which it is not (heavily adjusted by deferred revenue changes and stock comp) – is expensive in a vacuum; but when you look at comps it really makes you wonder. Web.com (WWWW) is the best comp: it is smaller (~3.5mm customers vs 13mm for GDDY) but occupies the exact same niche (small business focused) in the exact same industry (domain name registry, hosting, and value-add web design services, etc). Sure, it is growing slightly slower (7-10% revs + bookings) and has perhaps less scale, but trades at just 10x EV/EBITDA and 2.5x EV/sales. Much larger, more diversified Verisign (VRSN) – which, by the way, has been consistently GAAP profitable and throws off a ton of cash – trades at 11x EV/EBITDA (admittedly the business model for Verisign is a bit different).

If GDDY was an early-stage growth company with an undefined ‘blue sky’ growth opportunity, these kinds of multiples and day-one enthusiasm would at least be explainable. But in response to the listing of a two-decades old business with a history of operating losses, a mostly mature (or at least maturing) market, a large majority of the share count yet to enter the float, the specter of numerous secondary offerings from motivated PE sellers; and, of course, listed comps trading at a fraction of the valuation, GDDY at $26 is beyond expensive. Look out below!

Disclosure: no position in GDDY (but may look to short once borrow becomes available)