From Bloomberg.com:
Equipped with technology drawn from Wall Street and a trader’s appetite for risk, Cantor is now charging into sports betting in Las Vegas. The business — conducted in a section of a casino called a sports book — is characterized by volatile swings in profit and loss, competitors like the MGM Grand and Caesars Palace (CZR) and expert gamblers known as wise guys.
“I have friends who run sports books,’’ says Joe D’Amico, owner of All American Sports, a Las Vegas handicapping service. “I got to tell you, none are without stomach problems.’’
While Wall Street firms are no strangers to Vegas — they have long helped casino developers raise money — Cantor is the first to explicitly set itself up as a gambling operation. With a $150 million investment, the New York-based bond brokerage has taken control of and retooled seven sports books. They are owned by the Venetian and the Palazzo — part of Sheldon Adelson’s Las Vegas Sands Corp. (LVS) — and other casinos.
Nugget: Patagonia´s Chouinard
To be sure, these initiatives also serve as effective branding. Part of Patagonia’s appeal stems from its commitment to the environment. Consider the clever reverse psychology of its recent advertising. Last November, on Black Friday—the unofficial American holiday of consumer gluttony—Patagonia took out a full-page ad in the “New York Times” with the bold-face headline “Don’t Buy This Jacket.” Below a picture of the fleece jacket in question, the ad copy listed, in grueling detail, how much water was wasted and carbon emitted in the course of its construction.
“I’ve never seen a company tell customers to buy less of its product,” marvels Harvard Business School professor Forest Reinhardt. “It’s a fascinating initiative. Yvon has the confidence to pull it off.” In fact, Chouinard says the ad boosted Patagonia sales—though he argues it didn’t drive more overall consumption, but rather stole existing customers from his competitors.
Reinhardt co-authored a Harvard Business School case study of Patagonia in 2010. Like many of the other business-school professors I spoke with about Patagonia, he seemed genuinely impressed by Chouinard. Which is logical: In one sense, Patagonia’s current success stems from classic business-school principles. The brand has maximized what B-school types refer to as WTP, or willingness to pay. Patagonia’s perceived quality and do-gooder aura convince customers that its goods are worth a higher price.
Ryan Morris and the Value of the Activist Option
Ryan Morris of Meson Capital has been showing up on my radar frequently over the last six months (often through SumZero). From what I have read, he seems very capable and his write-ups have struck a chord with me. There is something about his approach that makes me think of the old Buffett partnership letters. I can´t really pinpoint what it is that makes me make the connection, but I think it is really his general approach. Morris is focused and and he looks for opportunities in obscure situations, often derived from misconception. But most importantly, if he needs to, he will get active. It is my opinion that the ability to take on an activist role, can be highly valuable for an investor and I base this opinion on Warren Buffett´s Partnership letters.
In the Partnership letters, you can find two detailed accounts of Buffett´s approach to activism in the cases of Sanborn Map and Dumpster Mill. I really love those two accounts and I find myself reading those sections every now and then. The way I see it, one of Buffett´s competitive advantages was a ”decision-tree” -approach. The process would be something like this:
(1) He recognizes mis-pricing in a security.
(2) He takes on a position, putting it in the “Generals”-category.
(3) If there is a correction, he can sell and monetize his profits.
(4) If the divergence increases or the price lingers, he can add to his position until he gets into a control position and can exercise his influence to extract the value out of the its assets.
The brilliance with this approach is that once you enter a position, the price movement does not really matter. Up or down, either way will give you options to work with. Buffett explains in his first half letter in 1964:
What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it. This doesn’t do much for our short-term performance, particularly relative to a rising market, but it is a comfortable and logical producer of longer-term profits. Such activity should usually result in either appreciation of market prices from external factors or the acquisition by us of a controlling position in a business at a bargain price. Either alternative suits me.
In order to do this the companies he invests in (1) must be small enough for him to be able to get to a control position and (2) the incentives and possible actions of other blocks of shareholders and the executive management must be clear.
Now consider this quote from Mr. Morris:
InfuSystem Holdings Inc (Nasdaq: INFU) is an interesting example of what I mean by no competition because of “structural factors” above. When I made it a large position in November, it was only about a $25M market cap and the shareholders were mostly hedge funds managing $100M+ and it was a sub 1% position for them.
The assets are great, but the performance has lagged due to the CEO and board of directors (who have granted themselves roughly 18% of the shares over the last 4 years while the stock has declined 75%). It made no economic sense for any of these holders to try to do something about this, as being an activist takes a significant dedication of time and effort so it wouldn’t make sense to triple a 1% position. Because I could make it a much larger position to my fund, it was proportionally worth it to “bang the brick wall down with my head” and do something about the situation. I’ve been so lucky to work with some great and supportive partners for this investment.
Pinnacle Airlines (Nasdaq: PNCL) has a similar structural issue where the board owns basically no stock and the other holders are large. In general, there is a nearly total competitive void in microcap companies that need a change of direction at the board level, which is another reason why I have been increasing my involvement in that and why I think there is a significant source of excess return there.
Now here is Buffett´s discussion on his investment in Sanborn Map:
The bulk of Sanborn’s business was done with about thirty insurance companies although maps were also sold to customers outside the insurance industry such as public utilities, mortgage companies, and taxing authorities.
…
For seventy-five years the business operated in a more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort. In the earlier years of the business, the insurance industry became fearful that Sanborn’s profits would become too great and placed a number of prominent insurance men on Sanborn’s board of directors to act in a watch-dog capacity.
…
Prior to my entry on the Board, of the fourteen directors, nine were prominent men from the insurance industry who combined held 46 shares of stock out of 105,000 shares outstanding. Despite their top positions with very large companies which would suggest the financial wherewithal to make at least a modest commitment, the largest holding in this group was ten shares. In several cases, the insurance companies these men ran owned small blocks of stock but these were token investments in relation to the portfolios in which they were held.
The tenth director was the company attorney, who held ten shares. The eleventh was a banker with ten shares who recognized the problems of the company, actively pointed them out, and later added to his holdings. The next two directors were the top officers of Sanborn who owned about 300 shares combined. The officers were capable, aware of the problems of the business, but kept in a subservient role by the Board of Directors. The final member of our cast was a son of a deceased president of Sanborn. The widow owned about 15,000 shares of stock.
The Sanborn story plays out with Buffett buying the widow´s shares and additional shares on the open market, he teams up with other disgruntled investors and they set up a plan to split the business (the mapping business and the securities portfolio). The board opposes, but a proxy fight scenario is unlikely as Buffett and co. are almost certain to win it, would that situation occur. In the end the SEC approves a plan to sort of spin-off the securities portfolio.
Now, consider Morris´ situation with Pinnacle. As with Sanborn situation, the incentives of the Board of Directors at Pinnacle aren´t necessarily in line with the common shareholder. The biggest client (Delta) is also the biggest claimant. In a chapter 11, whose interest is management and BoD going to look after? Here´s Mr. Morris on the subject:
To reduce risk, I have formed a 13D group with another large shareholder to get a voice for shareholders. Hopefully that voice is on the board that currently owns a mere 1% of the company, or if necessary through an equity committee should they decide to file chapter 11. As was the case with HearUSA, chapter 11 is not the same as equity being wiped out. Pinnacle is definitely more messy and less certain than the aircraft lessor situation in 2009 but I am also more sophisticated an investor and don’t make the position size as big. It definitely fits the criteria that I like where most everyone else is panic selling for reasons that look valid at first glance, but metaphorically once you do some real research you find yourself alone in the library and that the covers of the books are very different than the contents.
For the sake of argument, here are two other quotes from the SumZero interview:
I have evolved in a more activist direction over the last year and a half because the big risk factor that you can’t control just with research is that of the stewards between you and the assets of the company you own. If you have a great asset but a board of directors and CEO who don’t know how or don’t want the value of those assets to accrue to shareholders, then you have a problem as an investor. So I have been increasing my ability to use this tool when necessary to change the risk/reward profile of an investment. For smaller companies, which I really exclusively look at for competitive reasons, it is particularly important because the range of management quality is so wide. I got into this tack first by having some bad experiences with my positions and reacting and now people I know tend to contact me and ask for help. So if any readers out there have a cheap company that will stay cheap because the directors aren’t acting in the shareholder’s best interests, let me know and maybe I can help!
Another aspect of this passive-with-an –option-to-control approach is that the control situations are behaviorally different from the ‘Generals’. Here´s Buffett discussing control situations in a Partnership letter:
Of course, this section of our portfolio is not going to be worth more money merely because General Motors, U.S. Steel, etc., sell higher. In a raging bull market, operations in control situations will seem like a very difficult way to make money, compared to just buying the general market. However, I am more conscious of the dangers presented at current market levels than the opportunities. Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from these dangers.
And Ryan Morris:
I am not actively short them, but I don’t understand why people are valuing so many cyclical stocks like Caterpillar (NYSE: CAT) as if they are not cyclical. I think the market has become more superficially focused than ever as evidenced by, for example, dividend stocks being the highest performing category last year. The current dividend on a stock is nearly meaningless but if the market just prices things that are immediately apparent then it explains this kind of behavior. It creates a good buying environment for my “bad perception/good reality” style of investing but it also means that things that appear ugly will get cheaper for a while.
Now, on to Dempster Mill. Here´s Buffett´s own recap of the investment:
This situation started as a general in 1956. At that time the stock was selling at $18 with about $72 in book value of which $50 per share was in current assets (Cash, receivables and inventory) less all liabilities. Dempster had earned good money in the past but was only breaking even currently.
The qualitative situation was on the negative side (a fairly tough industry and unimpressive management), but the figures were extremely attractive. Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years. Just why any particular one should do so is hard to say at the time of purchase, but the group expectancy is favorable, whether the impetus is from an improved industry situation, a takeover offer, a change in investor psychology, etc.
We continued to buy the stock in small quantities for five years. During most or this period I was a director and was becoming consistently less impressed with the earnings prospects under existing management. However, I also became more familiar with the assets and operations and my evaluation of the quantitative factors remained very favorable.
By mid-1961 we owned about 30% or Dempster (we had made several tender offers with poor results), but in August and September 1961 made, several large purchases at $30.25 per share, which coupled with a subsequent tender offer at the same price, brought our holding to over 70%. Our purchases over the previous five years had been in the $16-$25 range.
On assuming control, we elevated the executive vice president to president to see what he would do unfettered by the previous policies. The results were unsatisfactory and on April 23, 1962 we hired Harry Bottle as president.
As Buffett explains in his letters, once in control it’s not a mispricing problem anymore, but more of an asset conversion problem. Accordingly, now it all comes down to execution. In an earlier letter, Buffett had talked about the new CEO Harry Bottle (allegedly recommended by Charles Munger) :
There is one final point of real significance for Buffett Partnership, Ltd. We now have a relationship with an operating man which could be of great benefit in future control situations. Harry had never thought of running an implement company six days before he took over. He is mobile, hardworking and carries out policies once they are set. He likes to get paid well for doing well, and I like dealing with someone who is not trying to figure how to get the fixtures in the executive washroom gold-plated.
Morris became active at Infusys Holdings after holding the position for four years. Here´s the first paragraph from the cover letter:
As stockholders of InfuSystem for as long as the past 4 years, we have been disappointed with the performance of the Company as the stock has lost almost half its value. This culminated with the write down of the entire goodwill balance in 2011. At the same time as the Company’s value has eroded, we believe the board of directors and current executive management have enriched themselves with excessive stock and cash grants. In summary, we believe that the current direction of the Company and the current board of directors are not in the best interests of stockholders.
And here are quotes from Morris, after he became the executive chairman of Infusystem Holdings:
“Our prime mandate is to create value for all shareholders,” says new Executive Chairman Morris. “Further, we believe that our personal economic fates should continue to be entirely tied to performance. Accordingly, new board members will be compensated solely in stock options. “
—
“We are pleased to have someone of Dilip Singh’s stature to serve as Interim CEO,” Mr. Dreyer said. “Dilip has nearly 40 years of operational, executive management and board experience with global Fortune 500 companies and a proven record of overseeing profitable growth in rapidly emerging sectors.”
Perhaps I am struck by a severe case of confirmation bias and undoubtedly, as these comparisons also demonstrate, these situations are not identical. But in both cases these two investors are focusing on investments in which they see themselves having a competitive advantage against their counter-parties.
I have no knowledge on Morris’ performance but I do like his style. It will be interesting to follow him in the future.
Links:
Meson Capital Partners
http://www.mesoncapital.com/managing-partner
http://www.mesoncapital.com/focused-value-investing
A thread on Ryan Morris on the Corner of Berkshire and Fairfax forum
Write-ups
http://seekingalpha.com/article/238515-near-term-uncertainty-makes-siga-technologies-a-low-risk-buy
http://www.manualofideas.com/files/content/moi201202_small-cap_fmd.pdf
Other
http://sumzeroresearch.wordpress.com/2012/03/16/interview-with-ryan-morris-pm-meson-capital-partners-part-1/
http://sumzero.com/news/34
http://sumzeroresearch.wordpress.com/2012/03/19/interview-ryan-morris-meson-capital-partners-pt-2/
http://finance.yahoo.com/news/pinnacle-stockholders-representation-issue-open-140000728.html
The Bottom Line
ROE is an important metric used to help judge how well a firm is turning shareholders’ invested capital into earnings. Breaking ROE down into a series of ratios can be even more telling, as it adds precision to the analysis by showing just how a firm is achieving its overall ROE. The Penman-Nissim framework complements other means of profitability analysis because it gives a clear and accurate picture of a firm’s core operating profitability and its use of leverage. (For more, see Profitability Indicator Ratios: Return On Equity.)
Nugget: Eddy Lampert on Same store sales (SSS)
From the 2005 Letter to shareholders:
If we take a simple example of a single store, then a comparison of SSS from year to year is fairly straightforward. If a store does $1 million in sales at a 10% operating margin this year, generating $100,000 in operating profit, and does $1.1 million in sales next year at the same operating margin of 10% generating $110,000 in operating profit, it will report a 10% increase in SSS. Now, let’s add another dimension. Imagine that this same store spent $500,000 to improve the store experience during that year. The 10% increase in SSS generated an additional $10,000 in profit. Whether the $500,000 investment makes sense or not in hindsight will depend on the future performance of the store. Obviously, if the store only improves by the $10,000 in profit, the $500,000 investment doesn’t make sense. I believe that companies that pursue SSS growth at any cost often fall victim to these traps.
In reality, the calculation of SSS becomes even more difficult. Individual retailers are opening, closing, and remodeling stores all the time. In this context, the simple comparison of a single store breaks down. Let me explain. Imagine that a new store opens on January 1, 2006. In the first year of operation, this store would be excluded from a company’s calculation of SSS because most calculations only include stores that have been open at least a year. A retail store matures over time and the first year of sales is often at a level that is a fraction of its potential. If we assume that a store opens at 60% of potential and matures to potential over four years, we know that this store will grow by 67% over that period of time (from $6 million to $10 million, let’s say). On that $10 million-in-sales store that opens at $6 million in year 1, the SSS increase over the next three years will average 18.6% per year, with the higher growth rates occurring in years 2 and 3 rather than year 4.
At the end of that period of time, the $10 million store may be at a relative steady-state, and let’s say it is earning at a 10% operating profit, or $1 million per year. The key question is not how well the store did from a SSS standpoint but rather how much money was invested to generate the $1 million profit. If the store cost $5 million to build, a $1 million profit represents a 20% pre-tax return on investment, which is attractive. However, if the store cost $20 million to build, the 5% return on that investment would not be attractive at all. Nevertheless, regardless of cost, the store would still have reported 18.6% compounded growth in SSS.
Complicating things further and bringing things even closer to reality, the more stores that are opened relative to the outstanding base of stores, the higher the SSS metric a company can produce, regardless of whether the new store openings make economic sense or not. If the mature stores (i.e., those that are over four years old) grow at a 1% rate and the new stores grow at the 18.6% per year rate (remember, it is likely that in years 2 and 3 the rates are materially higher than the 18.6%), then mathematically it is simple to show that the more new stores that are opened, the higher the SSS calculation. Only after a period of years will one know whether the new store investments actually made sense and actually contributed to the creation of value.
Alisher Usmanov and his 30% Arsenal shareholding
This post has been superseded by an updated version. I have left this here for completeness, but please refer to the ‘Take 2′ version posted on February 20.
Alisher Usmanov is very close to owning 30% of Arsenal Holdings shares. By the time you read this he may even have got there. Does it matter? Here’s a bullet point summary.
Nugget: Nike Digital Sports
From the article “Nike’s new marketing mojo” at CNN Money (Febuary 2012):
“This hive is the home of Nike Digital Sport, a new division the company launched in 2010. On one level, it aims to develop devices and technologies that allow users to track their personal statistics in any sport in which they participate. Its best-known product is the Nike+ running sensor, the blockbuster performance-tracking tool developed with Apple (AAPL). Some 5 million runners now log on to Nike (NKE) to check their performance. Last month Digital Sport released its first major follow-up product, a wristband that tracks energy output called the FuelBand.”
Profile: Nintendo
What caught my interest?
A rough thesis on Nintendo by Moore_Capital54 on the Corner of Berkshire and Fairfax forum:
Over the last 2 months we have built a significant position in Nintendo.
I thought I would share this idea with the board as it is the type of contrarian value investment that I love and reminds me of others which have produced fantastic results for us over the years.
What we have here is a company that is currently valued at a market cap of $19.5B USD. However, Nintendo holds over $13B in cash and liquid securities. When subtracting the cash we get an EV of only $6.5B.
Our thesis is that the earnings power of the business on a normalized basis, works out to roughly $2-3B a year.
We can go on and on about what Nintendo has done wrong, and how they desperately need a hot product. History teaches us that at least once every decade, Nintendo is able to launch such a product and when it does it produces significant FCF. FY 2011 Nintendo produced $800mm of FCF, and this was considered a terrible year.
Another catalyst is the dividend reinstatement which was suspended on September 29th, but historically ran around 1-2B a year. A reinstatement would mean the current valuation would produce between 5-10% dividend yields.
I expect NTDOY to double over the next 24 months quite easily, with very little downside risk.
Enjoy!
Why is Mr. Market pessimistic?
Nintendo has been one of the worst performing stocks in the Japanese equity markets this year. They are coming off their worst year in 30 years. They actually lost money for a full year. This is either a rare opportunity to buy the Big N at trough valuations, or this is the end of the company as we know it. Investor sentiment indicates that most people believe Nintendo is doomed just like Sega, Nokia, or even Research in Motion.
http://www.industrygamers.com/news/nintendo-wont-be-the-next-sega-and-why-you-should-buy-shares-game-trader/
Other resources
http://finance.yahoo.com/q/ks?s=NTDOY.PK+Key+Statistics
http://www.tuck.dartmouth.edu/digital/assets/images/05_shah.pdf
http://www.nintendo.co.jp/ir/en/library/events/120127qa/03.html
Profile: Level 3 Communications
What is the internet backbone?
The Internet backbone refers to the principal data routes between large, strategically interconnected networks and core routers in the Internet. These data routes are hosted by commercial, government, academic and other high-capacity network centers, the Internet exchange points and network access points, that interchange Internet traffic between the countries, continents and across the oceans of the world. Internet service providers (often Tier 1 networks) participating in the Internet backbone exchange traffic by privately negotiated interconnection agreements, primarily governed by the principle of settlement-free peering.
Industry drivers
Rapid growth in demand
But the most important development of the past year may well be the fundamental changes that are reshaping the communications industry – changes driven by the explosion of demand for online video, gaming, and the streaming of movies and live events. What we are witnessing is nothing short of an information and content revolution, and our industry is being transformed by customer demand for more and more bandwidth and for online delivery of a wide variety of content.
…
The explosion of demand for rich content has created unprecedented demand for bandwidth, and
we believe that there is no company in our industry better positioned to benefit than Level 3. We
designed and built our company to fully harness the benefits of Internet technology, beginning with the
construction of the first international communications network to be completely optimized for Internet
Protocol (IP), an accomplishment for which our company was honored as a Computerworld
Smithsonian Laureate and inducted into the Smithsonian Institution. And today, we combine the reach,
reliability and scalability of our IP backbone network with our state of the art content delivery network
(CDN) and our Vyvx Services for Broadcast.We believe that we are now beginning to see the clear implications of our investment in IP
backbone capacity and in our CDN. Our unique assets, our significant operating leverage and the
commitment of our employees are becoming apparent in our financial results.
Industry consolidation
At the same time, a world of lightning-fast innovation and precipitous price drops is a world in which the winner takes all. The technology leader has the lowest costs and, therefore, the lowest prices. That brings more traffic, which cuts costs, which reduces prices, which brings more traffic, and so on. “We watched it with Intel and microprocessors,” Crowe says. “We watched it with Dell and computers. Sooner or later, somebody is going to end up with 70, 80, 90 percent of the Internet backbone. How that happens is always tough to describe, but it’ll happen. You can show mathematically that one company will get supernormal market share. It’s a network effect on steroids.”
And Level 3?
He looks at the floor with an aw-shucks smile. “That’s what Level 3 is built to do.”
- “Surviving the Fiber-Optic Fire Sale” by Frank Rose, Wired magazine (2004).
Longleaf
Longleaf Partners (Southeastern Asset Management) is the largest equity holder (they hold debt as well). Following are comments from their quarterly letters regarding Level 3 in chronological order:
2Q 2002
After the close of the quarter, the Partners Fund, together with Berkshire Hathaway, Legg Mason, and Longleaf Partners Small-Cap Fund, completed a private placement in Level 3 convertible notes. Although typically we neither own corporate bonds nor do private placements, this was a compelling opportunity that the Fund’s Öexible policies allowed us to pursue and that we did not want to forego. The ten-year notes position Longleaf ahead of the common equity, pay a 9% cash coupon, and are convertible at any time to common equity at $3.41 per shareÌa price that is under the stock’s current level, and is far below the company’s growing intrinsic value.Level 3 owns the best Ñber telecommunications network in the industry. Importantly, most of its competitors struggle with huge debt levels and further signiÑcant capital expenditure requirements. Many are now in bankruptcy. Customers are universally worried about their service providers’ reliability,
Ñnancial integrity, and ability to provision future needs. Level 3′s superior network infrastructure, its servicing capabilities, and its capital resources position the company to become the clear industry winner. As we said in the press release announcing the placement, “”We invested in Level 3 to take advantage of consolidation opportunities in the telecommunications arena. We believe these opportunities are substantial. Level 3 is uniquely and competitively positioned, and its management team, led by Jim Crowe, is most able.”3Q 2002
Our investees’ competitive advantages improve the probability that the growth in corporate values will be a meaningful part of our future investment returns. Specifically, our newly acquired and unique assets are:
…
– the lowest-cost provider of broadband wholesaling (even after competitors’ debts get washed away in bankruptcy) through Level 31Q 2003
Level 3: Purchased Genuity at a price that was immediately value accretive, adding high margin revenues over a uniquely low fixed cost communications system. Stock rose 5%.2Q 2003
All of the stocks in the portfolio rose during the quarter. The largest contributor to performance was Level 3 Communications. In June we converted our bonds into equity, receiving additional shares to compensate for the interest payments we were giving up. The company strengthened its financial position when we agreed to convert and take the net present value of those future interest payments. This stronger balance sheet further improves the quality of the equity which we now own. Because our investment in Level 3 has been extremely successful in the twelve months since we did the private placement, the company is the Fund’s largest holding.3Q 2003
Although Level 3 has been the largest contributor to the Fund’s year-to-date return, the stock declined 19% during the quarter. Our appraised value of the company was unchanged and our corporate partners remain some of the most capable we have seen. Level 3′s revenues fell primarily because of management’s effort to eliminate the unprofitable portion of Genuity’s business (Level 3 acquired Genuity earlier this year.) Our appraisal assumed this run-off, and our expectation for the company’s cash flow growth is unimpaired. Level 3 has also announced a plan to replace its bank debt with bonds to provide a more flexible financial structure to aid in purchasing additional customer revenues to run over Level 3′s fixed cost structure4Q 2003
Level 3, which is the Fund’s largest position, made important strides. In June we exchanged our 9% convertible notes for equity. The company successfully integrated the Genuity business it purchased and restructured debt for a more flexible financial structure. The management team plans to pursue further organic revenue growth as well as larger scale through acquisitions that make financial sense. Level 3 was the third largest contributor to the Partners Fund’s return, and the stock remains undervalued when compared to our appraisal.1Q 2004
Level 3 Communications hurt the Fund’s results. Lower operating cash flow expectations for 2004 precipitated a 29% price drop. The managed modem business will decline because AOL is decreasing its Level 3 business following revisions in AOL’s dial-up growth expectations. In addition, pricing competition in the Internet Protocol segment has remained terrible for longer than anticipated. Although demand for IP traÇc is growing, revenues are flat. On the other hand, transport revenues are rising at a healthy rate. Our appraisal of Level 3 remains well above its price because we believe that beyond 2004 the company will make up in broadband what it loses in dial-up service, will benefit as pricing becomes more rational, and will continue to see massive increases in demand with the growth of newer applications such as voice-over-IP and wireless communications.2Q 2004
Level 3 detracted from the Partners Fund’s return both for the first half and in the last three months. Early in the year the company reduced expectations in its managed modem business because of the decline in AOL’s dial-up traÇc. Price competition continued to neutralize the rapidly growing Internet Protocol (IP) volume. In response to Level 3′s announcements in the first quarter, we reduced our appraisal to reflect lower cash flow in 2004, but our long-term assessment of the company and its prospects remained sanguine. We believe that expanding capacity utilization from both broadband customers and new services such as voice-over-IP will create firmer pricing in the next few years, and that Level 3 is strongly positioned to be a low cost beneficiary.3Q 2004
Level 3 has been the largest detractor from Fund performance, falling 26% in the quarter and over 54% this year. It’s our view no news other than the ongoing short raid precipitated the recent decline. The company’s strong growth in demand for its fiber backbone capacity continues to be offset by stiff price competition. Based on our appraisals the stock is the most undervalued in the portfolio.4Q 2004
After being one of the largest positive contributors to 2003 performance, Level 3 detracted from 2004 results. Level 3 fell 40% for the year despite a 30% fourth quarter rally. We believe the company is the lowest cost and highest service level provider of fiber optic backbone services, but faced two specific challenges in 2004. The managed modem business that serves dial-up customers suffered from a re-sizing of ports by AOL. While broadband usage increased demand for fiber backbone capacity at rates approaching 100%, price competition driven by overcapacity left revenues flat. These two dynamics hurt our appraisal of the business by pushing cash flow growth further into the future, but the stock price fell much more dramatically. We remain large owners of Level 3 because we believe that top line growth is a question of when, not if. Strong broadband demand should continue since only about a fourth of U.S. homes currently have this type of connection. Additional services such as voice over IP and video on demand will further increase capacity utilization. As this combined growth absorbs capacity, prices should stabilize because competitors with older networks cannot justify capital outlays at today’s prices. We believe that Level 3 has the longest staying power while waiting for pricing to turn because:
– Their cost structure is the lowest in the industry.
– The structure of the company’s leverage is formidable with no bank debt, and its first notes not due until 2008. The company recently bought back much of its obligation for 2008 after a successful placement of 2011 notes.
– The company has been adding customers, and incremental revenues have contribution margins of 60%. The potential to buy another, weaker competitor as they did with Genuity offers additional revenue opportunity.
– The management team led by Walter Scott and Jim Crowe has a strong operating and capital allocation history, they have practiced conservative accounting, and they are substantial owners.1Q 2005
Level 3′s performance hurt the Fund’s return during the quarter, falling 39%. The company announced a higher cash burn rate for 2005 than many expected, as well as higher capital expenditures related to growth in new business. Given this growing demand coupled with Level 3′s low cost position among its competitors and the long overdue consolidation occurring among telecommunications service providers, we believe that Level 3′s stock remains undervalued and that its prospects over the next three to five years are compelling. We acted on this belief by participating with six other firms in the private placement of a convertible bond that is due in 2011 and yields 10%. The offering raised $880 million, which will allow Level 3 to maintain over $1 billion in cash reserves throughout the year and to have flexibility to act on opportunities that may arise. The quarter-end portfolio of the Partners Fund does not reflect this purchase, which closed April 4th and reduced cash reserves by 2.5%.3Q 2005
The two primary stocks that have hurt Fund performance for the year, Level 3 and Disney, are actually in better shape today than at the outset of 2005.
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Hints of firmer prices in Level 3′s IP and Transport businesses have begun to show in the most recent quarter’s financials. In addition, Jim Crowe and the company’s competitors have begun to see better pricing. We have not adjusted our appraisal yet, but are encouraged by the positive signs.1Q 2006
Most of the stocks in the Fund rose during the quarter with the largest contributor being Level 3. As the company reported higher operating cash flow for 2005 and increased guidance for 2006, the stock price responded. The financial results reflected our long-held belief that growing demand and industry consolidation eventually would stabilize pricing. Also, the company made a very important acquisition of Wiltel, and announced a smaller but favorable acquisition of Progress Telecom. The stock rose over 80% in the quarter and the convertible bonds purchased last year were up 50%.2Q 2006
Rallies in many holdings that began the year at the lowest P/Vs have driven much of the strong performance in 2006. Although Level 3′s stock fell 14% in the second quarter, both the equity and the convertible bonds have made significant gains this year. The combination of top line growth, increased operating cash flow and several solid acquisitions has generated value appreciation. In spite of the stock’s large rally, the price remains at less than 60% of our appraisal.3Q 2006
The Fund’s strongest performers for the year continued to do well in the third quarter. The combined bond and equity position in Level 3 has made the biggest impact on returns in 2006; the stock was up over 20% in the quarter. Operating cash flow has grown as pricing declines have slowed. The company’s acquisitions have enabled Level 3 to broaden its offerings from wholesale fiber backbone access to direct customer connectivity in many metro areas. Our appraisal has grown, and we believe that given the business’ operating leverage, the pace of value growth will be substantial. As the low-cost producer, Level 3 is also well positioned to make value-additive acquisitions in an industry that needs further consolidation.4Q 2006
Level 3 almost doubled over the last twelve months. Internet usage has grown with ever-increasing video, voice and data demand. Not only has higher capacity utilization slowed price declines, but the acquisitions that Level 3 has made, including Wiltel, Telcove and most recently, Broadwing, have helped consolidate the industry’s overcapacity while expanding Level 3′s direct reach to customers in metro areas. The stock remains well below our appraisal of corporate value, and that appraisal continues to grow at a fast rate.1Q 2007
Level 3 was the largest contributor to the quarter’s results. The company’s competitive strength continued to grow as did its stock price. During the quarter we converted the 2011 notes into equity, receiving the full face value of all remaining interest payments as well as a premium for early conversion. Adept balance sheet management by the company has played an important role in the success of this investment.3Q 2007
After a substantial rally early in 2007, Level 3 declined 20% in the third quarter, making it the largest detractor for both the last three months and the year. The integration of the Broadwing acquisition has been more cumbersome than anticipated, creating longer provisioning times for orders. 2007 revenues have been delayed, but next year’s sales should reflect the built backlog and growing demand. The longer term outlook for the company remains strong.4Q 2007
Level 3 had the largest impact. The company announced that orders were taking longer to provision resulting in revenue growth in the single digits versus the previously estimated mid-teens. We lowered our appraisal to reflect the delayed cash flows and to assume no improvement in the longer provisioning time. The combined third and fourth quarter stock declines made Level 3 the biggest detractor of 2007. The stock trades at a material discount to our conservative assessment of intrinsic value even though the prospects for Level 3′s future are much more certain than in recent years.1Q 2008
The telecom
industry as a whole, and cellular operators in particular, fell. Level 3′s value grew in the quarter in spite of the stock’s 30% decline. The market overlooked the company’s progress in reducing its backlog of new customers and improving provisioning times. This positive news was overshadowed by the announcement of COO Kevin O’Hara’s departure. We are confident that Jim Crowe, the CEO, is the right person to lead the company and grow its value, and we are glad that CFO Sunit Patel, who previously planned to step down, has decided to remain in his role.4Q 2008
Level 3 (“LVLT”) is the low cost provider among the primary internet backbone transport companies as well as a major competitor in direct internet service to businesses within most major metro areas. Unit demand is growing rapidly, especially with increasing movement of voice, data, and video over the internet. We have assumed lower growth in business services over the next year due to the economy. Concerns over slower growth and the company’s debt hammered the stock price, which fell 74% in the quarter. The company bought over half of its debt maturing in the next two years at significant discounts. Level 3 successfully raised $400 million for this purpose, and the Partners Fund was among the investors offered the opportunity to buy 2013 notes with a 15% coupon, convertible at $1.80 per share. LVLT is cash flow positive with depreciation and amortization outstripping capital expenditures. Jim Crowe and Sunit Patel have continued to ably manage the company’s capital structure while growing the business.2Q 2009
Level 3 bought in more of its near-term maturities. The combination of solidifying its ability to meet obligations over the next several years and the general thawing of credit markets has improved investors’ view of the company. The stock rose over 60% in the quarter and has more than doubled this year.3Q 2009
In the quarter Level 3 reported disappointing revenues primarily caused by internet backbone customer deferred spending. As the economy improves and capacity utilization rises, cable operators and other wholesale customers will have to spend to manage growing demand. Level 3 announced a new board member, Rahul Merchant, who has a wealth of experience in the telecommunications and technology industries including being on the Sun board. Although the stock fell 8% in the quarter, it has almost doubled in 2009.2Q 2010
Level 3 declined 33% in the quarter and is one of the largest detractors for 2010. The company reported disappointing results. Changes made in the business over the last year have not yet shown significantly positive revenue results. We believe the company’s additional sales staff and growing productivity will translate into increased contracts and revenues. Additional sales will deliver substantial operating profit improvement because of the company’s high contribution margin.3Q 2010
Level 3 has irreplaceable fiber assets, and demand for bandwidth is growing rapidly with the increasing movement of data and video across multiple platforms. The company’s pace for adding new direct customers has been disappointing. The contribution margin from increasing top line growth is substantial. Translating obvious demand into strong organic revenue growth in the near term will determine success.We are unhappy with Level 3’s operating results and stock price. You can assume that we are neither oblivious nor idle.4Q 2010
Level 3 fell 36% for the year but had a 5% gain in the fourth quarter following news of becoming a primary carrier for Netflix. Because of the 60+% contribution margin from additional revenues, the growing demand for internet video should add meaningful free cash flow over time. The company has been slower to deliver growth than projected, particularly in the metro business. The short-term cost of hiring and training new sales people has impacted costs but not yet revenues. The transition time from orders to revenues in wireless backhaul has expanded because newer products demand more set-up time, and carriers are taking longer to connect. At this point success depends on revenue growth. Major debt maturities are three years away. Given that the cost to build the network was over $25 billion and that today’s enterprise value (debt + equity) is less than $8 billion, the company’s assets are severely discounted with several possible rewarding eventualities. As we said earlier in the year, we are neither oblivious nor idle regarding Level 3’s results and stock performance.1Q 2011
Level(3) rose 50% in the quarter as EBITDA and margins came in higher than expected, and the company indicated that it expects higher top line growth. Subsequent to quarter-end, the company announced it will buy Global Crossing. The transaction will strengthen Level(3)’s balance sheet, further consolidate fiber capacity, and reduce Global Crossing’s operating costs. Although our appraisal reflects current results, if the combination goes as planned, Level(3)’s value could grow dramatically.2Q 2011
The continuation of strong operating results at several core holdings as well as positive reaction to Level(3)’s announced acquisition of Global Crossing helped performance. Level(3)’s 66% second quarter return took the stock’s first half gain to 148%. Combining these two fiber network businesses provides numerous benefits. Level(3)’s debt cost will dramatically decline as its debt/EBITDA ratio falls from over 6 times to 4 times. Global Crossing’s gross margins will rise meaningfully as the company moves much of its U.S. long haul business to Level(3)’s network. Further industry consolidation bodes well for long-term pricing. We also gain astute partners in the board room as Global Crossing’s majority owner, Singapore fund Temasek, will have three board seats and own roughly 25% of the company.3Q 2011
Level(3), which is up 52% year-to-date, has recently completed its acquisition of Global Crossing. The combined telecommunications fiber company will have lower operating and debt costs as well as larger revenue opportunities. The recent 39% stock decline did not reflect any change to the company’s prospects or the underlying value of its fiber assets. In fact, results released in the quarter included record gross and operating cash flow margins, helping the value of the company grow.
Other Sources:
Nugget: O. Mason Hawkins on Madison Square Garden
From the 2011Q4 letter to shareholders of the Southeastern Asset Management´s Longleaf Funds:
Madison Square Garden: Based in New York, Madison Square Garden (MSG) owns one of the most valuable regional sports networks at a time when live sports content is increasingly important to traditional distributors. In addition, the company owns two of the best franchises in the NBA and NHL (Knicks and Rangers) and the iconic Madison Square Garden arena in which these teams play. The Dolan family controls the company, owns 20%, and has done a tremendous job building network value. The market is punishing the stock because the teams are generating no profits currently, and MSG’s billion dollar arena renovation that will draw higher team revenues is depressing this year’s earnings. The media network generates a valuable cash coupon, and comparable transactions imply a breakup value of the teams and arena over twice the stock’s price. Additionally, programming contracts with huge revenues are being signed, causing the values of big-market NBA teams to explode. Because of the current renovation, 2012 FCF will be negative. Adjusted for the arena renovation, the FCF yield is 7.0%.
