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