Whitney Tilson Explains BKS Reversal; T2 up 26% YTD

From Whitney Tilson of T2 Parters:

Our fund rose 1.5% in April vs. -0.6% for the S&P 500, +0.2% for the Dow and -1.4% for the Nasdaq. Year to date, our fund is up 25.8% vs. 11.9% for the S&P 500, 9.0% for the Dow and 17.2% for the Nasdaq.


On the long side, we were having a lousy month thanks to Netflix, Inc. (NASDAQ:NFLX) (-30.3%), SanDisk Corporation (NASDAQ:SNKD) (-25.4%), Grupo Prisa (B shares) (-23.7%), Goldman Sachs Group, Inc. (NYSE:GS)  (-8.0%), and Citigroup Inc. (NYSE:C) (-7.4%) – until the last day when Barnes & Noble jumped 51.7% (discussed further below). Other winners on the long side included American International Group, Inc. (NYSE:AIG) (10.4%) and dELiA*s (10.0%).

Our gains for the month came entirely on the short side thanks to Nokia (-33.5%), First Solar (-26.5%), and Tesla (-11.0%), partially offset by Interoil (17.6%)


Barnes & Noble

You might be scratching your head, asking, “Weren’t you guys short Barnes & Noble, Inc. (NYSE:BKS) ” Yes, we were for quite a while, but last week we covered our short position and bought a 2% stock and 2% call option position – only the fifth time in our 13+ year investing history in which we went long something we were previously short (given how well it worked out the four previous times with Fairfax, Wells Fargo, General Growth Properties, and Netflix, we should do it more often!). In the past, there’s been some period of time between our switch, but in this case we covered our short in the morning and then, after further thought, went long in the afternoon.


Allow us to explain our rationale: we’d made a little money this year being short Barnes & Noble and were already thinking of covering when two things caught our attention: 1) we saw that Jana, a firm we know well and respect greatly, took a large (11.7%) stake in BKS; and 2) we read a write-up (attached in Appendix A) on our favorite value stock idea website, Value Investors Club, which made a compelling case that BKS was deeply undervalued. The crux of the argument was that the superstore and college bookstore businesses were worth almost the entire stock price of $11, meaning that investors were getting a nearly free call option on the Nook, which is doing remarkably well. The clincher for us was the realization that with more than 2/3 of the stock controlled by insiders, 67% of the float was sold short (87% if you include Jana’s new stake), so even a hint of good news could trigger the mother of all short squeezes.


The key to both the bull and bear cases on Barnes & Noble is the Nook. A major pillar of our investment thesis on the short side was that it would fail to gain traction in the marketplace and simply burn cash and destroy value. To Barnes & Noble’s credit, however, that hasn’t happened: while the Nook is still losing money, it is an excellent product that elicits rave reviews from commentators and customers and hence has come out of nowhere to take 27% of the eReader market – an incredible accomplishment, given the ferocious competition from Amazon’s Kindle. We can’t say for sure how much it’s worth, but it clearly has significant value, as Microsoft’s investment showed.

Such a rapid shift in opinion on a stock is unprecedented for us, but when we encounter new data/analyses that convince us we’re wrong, we throw our pride and usual stubbornness out the window and act quickly. We don’t claim to be infallible, but do try our best to seek out contrary opinions, keep an open mind, and be willing to identify and fix mistakes.

Netflix tumbled in April, but is still up 15.7% year to date and is our 4th biggest winner this year (after Howard Hughes, Iridium and Barnes & Noble). Our view on the company hasn’t changed much since we first bought it last October – we’re comfortable with a 5-6% position size – but the stock price has been extremely volatile, ranging from $62 to $129 in the six months we’ve owned it, so we’ve done much more trading than we normally do, first trimming aggressively and banking a lot of profits as the stock skyrocketed earlier this year, and then adding to our position recently after it fell sharply.
The company reported very strong Q1 earnings a week ago: revenues grew 21%, domestic streaming subscribers jumped by 1.7 million to 23.4 million, international subscribers grew by 1.2 million to 3.1 million (up 282% year over year), and total unique subscribers grew by 2.9 million to 29.1 million (including the DVD-by-mail business).
So why was the stock down so much? Netflix’s guidance for Q2 was weaker than expected: a projected gain of only 190,000-790,000 domestic subscribers and 385,000-935,000 international subscribers. Bears see this as the beginning of the end of Netflix’s subscriber growth, but we see it as typical second quarter seasonal weakness combined with the company being very conservative in its guidance, setting a bar that should be easy to clear. We believe what the company wrote in its earnings release – “We see nothing new or particularly concerning this quarter to date in our member viewing, acquisition and retention. All are healthy.” – and have no reason to doubt Netflix’s guidance of “about 7 million…domestic streaming net adds” for all of 2012.
On the competitive front, there is no shortage of announcements and activity from various companies like Hulu, HBO, Verizon, Comcast and Amazon, but we are not seeing any impact on Netflix’s business – for now. We’re keeping a close eye on this.
Speaking of Hulu, we read with interest the news last week that one of its original owners, Providence Equity Partners, is selling its 10% stake to current owners ABC and News Corp. for about $200 million, which would value Hulu at approximately $2 billion. According to the article, Hulu “has become a profitable business with tens of millions of users and two million paying subscribers.”
Subscriber-based businesses are often valued and compared to one another based on market valuation per paid subscriber, so for Hulu the math is easy: a $2 billion valuation divided by 2 million paid subscribers = $1,000/sub.

The rest of our letter, in which we discuss SanDisk and Grupo Prisa:

T2 Accredited Fund Letter to Investors-April 2012