Value Investing

Forage Capital 3Q16 Letter To Partners: Moats, Amazon And Google

Davud Kim’s Forage Capital letter to partners for the third quarter ended September 30, 2016. Also check out David’s

“Longing on a large scale makes history.” – Don DeLillo, Underworld

Also see


Dear Partner,


From inception on July 14, 2016 to quarter-end, Forage Capital returned -0.6% (net of all expenses but gross of fees1) vs. +0.9% for the S&P 500 Total Return Index. Amerco (UHAL, -11.1%) and Oaktree Capital Group (OAK, -4.8%) were the two largest detractors from our returns, while MRC Global Inc. (MRC, +26.9%) and Alphabet Inc. (GOOG, +5.8%) were the two largest contributors.

We owned Alphabet for a few weeks before I sold it at a modest gain, which gain I ascribe entirely to luck. Sometimes I’ll buy a stock that seems compelling at first itch while looking for reasons to sell it. In Alphabet’s case, I found a few. I mentally organize Google’s Ozymandian sprawl by visualizing a layered ecosystem that looks, reductively, something like this (you’re looking down on a layered cake):

forage capital

Forage Capital

Platforms proffer apps/utility to users and simultaneously capture and convey user data to deep recurrent neural networks, bolstering machine learning algorithms for purposes of offering relevant ads and experiences to users, whose increasing engagement a) attracts more ad revenue and b) prompts third party developers to enhance and program more apps, drawing further user engagement, pollinating neural nets with still more training data, and so on. Most of Google’s internal development efforts and acquisitions enhance some layer of this flywheel.

Machine learning is so hot right now, but it’s actually been a central and purposeful part of Google’s narrative from the very beginning2 (the Company hired its first Director of Machine Learning in 2001), enabling the scale automation required to someday blanket interstices of daily life with an invisible and ubiquitous search utility that will function as the “third half of your brain,” as Sergey Brin once put it.

Charlie Munger once remarked: “Google has a huge new moat. In fact, I’ve probably never seen such a wide moat.”

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Few would dispute Google’s dominant advantage in PC-centric search; but, a far more pertinent concern is search’s continuing relevance in the increasingly curated digital lives that alternative platforms have enabled. Smartphones now account for 65% of all digital media time after having stolen significant share from desktop over the last three years.3 Nearly 90% of that mobile time is spent in self-contained apps (which increased usage informs customization, making for still better experiences and more usage…), with Facebook and messaging apps accounting for nearly a third of all mobile consumption vs. just 7% for Google’s mobile Chrome browser and YouTube.4 Consider that, according to a recent survey commissioned by BloomReach, 55% of US consumers now start their online shopping on vs. 44% a year ago, while the percentage that begin their product searches on Google (and other search engines) has dropped from 34% to 28% over the same period.5 Amazon product searches are particularly pernicious for Google because, in terms of purchasing intent, they are about as bottom-funnel as you can get. App usage cannibalizes time that would otherwise be spent on Google search – we can impute that the average person conducts fewer searches per month on a smartphone than she does on a PC/laptop.6 Accelerated search revenue growth over the last three quarters has been fueled by loading mobile search results with more ads, a tactic that has natural limits and has now anniversaried. We can probably assume, based on management’s refusal to answer basic questions related to mobile query growth, that growth in search queries is materially below that of search revenue.

Facebook is increasingly challenging Google’s dominance at the bottom of the marketing funnel. On its last earnings call, Priceline (OTAs are major keyword spenders on Google) – whose performance advertising ROI (mostly keyword purchases) has compressed for several years – mentioned that, while it has traditionally used Facebook for brand advertising, it was looking to work with Facebook on more “performance-oriented” placements. Meanwhile, Expedia’s engineering team is collaborating with Facebook’s on dynamic ads,7 with spend “now getting to real significance.” [For what it’s worth, I ran a little uncontrolled experiment of my own, launching dual campaigns through AdWords and Facebook for my blog ( – SUBSCRIBE NOW!), and achieved far superior click-through rates on FB]. Furthermore, Google faces formidable challenges competing against Microsoft and AWS – who have nurtured capabilities and developer/user ecosystems up the stack – in enterprise cloud, without even considering the cultural incongruence of an anthropoid-phobic organization meeting the high-touch service expectations of an enterprise.

There’s also a broader, more ambitious point that merits some consideration (more than I will give it here). A review of US information industries – telephony, radio and television broadcast, film, and other media – since the turn of the 20th century reveals a Schumpeterian cycle in which innovative communications technology or anti-trust action dismantles a competition-stifling incumbent industry structure, catalyzing a period of chaotic industrial openness and competition that inevitably and eventually assumes the same expansive, monopolistic posture of its overthrown predecessor.

Despite its decentralized origins, the online ecosystem is traversing a similar path. While there’s nothing centrally planned about it, the self-reinforcing nature of demand-side scale economies almost demands ineluctable convergence towards winner-take-most systems.

And what began as rapid consolidation around relatively siloed chokepoints – e-commerce (Amazon), search (Google), social (Facebook), messaging (FB/WhatsApp) – is transitioning to territorial battles over ever-expansive platforms that blur previous competitive boundaries.9 10 That infantile scrawl of mine above could just as easily apply, with few edits, to Facebook, Apple, Amazon, Snapchat (really) and a host of others. Given the concentrated benefits of platform economics and the tendency for new platforms to cannibalize the ones that came before, it’s unlikely that everyone will capture equivalent value.

Advances in machine learning empower cross-silo competition. While early advantages in processing might and unrivaled access to data hoisted Google to the forefront, a sudden surge in ML enabling technology – parallel graphics processors used for gaming are now low-cost commodities (embedded with ever-increasing software functionality) coopted for AI applications; sensor-enabled mobile objects have dramatically proliferated – over the last 3 years, has narrowed Google’s lead in massive data capture,11 and enabled competitors to catch up in ways not possible just 5 years ago, complexly amplifying attendant industry structure permutations and value capture uncertainties therein.

Anyways, the point is that while Google’s incumbent advantages might position it well for future platform dominance, I am less confident in that outcome than I was before I put on the position, and I don’t believe that ~28x earnings (ex. stock comp)12 offers the right odds relative to other opportunities I am more capable of understanding.

I guess I should talk about a stock that we actually still own.

[Aside: The pithy way to express an investment idea in a letter like this is to highlight only the upside potential. I think many investment managers do this because they understand that readers prefer strength and consistency over diffidence and nuance. Plus, writing can be a pain, and it’s easier to frame an idea by its merits than by is lack of demerits. But of course investing isn’t about defending beliefs but rather sizing bets according to offered odds, and it’s impossible to accurately weigh those odds by foreclosing on information that runs counter to a clean narrative. So I’ll do my best to err on the side of balance, although I’m sensitive to the fact that this will sound tonally weird to readers who are used to being “pitched.”]

Get your throwing tomatoes ready…I bought some Amerco (UHAL) shares after the Company reported a disappointing 2Q. If you haven’t had the pleasure of undertaking an inter-city move yourself, you’ve probably at least seen, behind the wheel of one of UHAL’s obnoxiously tattooed self-moving trucks, the stressed-out visage of somebody who has. You can broadly divide the self-moving equipment rental market into two categories: a highly competitive, commoditized intra-city market and a “moatier” inter-city one. Unlike intra-city moves, in which you drop off the rented truck at the same location from which you picked it up, one-way moves require a network – if you’re moving out of New York City, you want a dealer nearby your new home in Cicero, IL who will take the truck off your hands.

UHAL’s network of 20k+ rental locations,13 and its nearly 60 years of experience optimizing a network tailored to oneway moves, is the Company’s primary advantage over its two largest peers, Budget (1,450 dealers, 21k vehicles) and Penske (~2,300 dealers), who operate just a fraction of that number – the more rental locations you operate, the more convenience you offer the self-moving customer; the more customers, the more incentive independent dealers have to plug into the UHAL platform, etc. Based on my checks, competition amongst these three appears rational today, though there have been bouts of irrational pricing in the past.14

With a byzantine scheduling platform and an automated on-hold operator promising to “…provide [me] with outstanding service in 2015,” Penske seems sorely out of touch and literally out of date. Meanwhile, Budget Truck Rental – a sideshow in the Avis complex – has been tiptoeing back from its truck rental business for years.15 Various self-storage REITs have tried and failed to seriously compete in one-way truck rentals, with the CEO of one self-storage REIT16 confessing to me that the self-moving rental equipment business was “a loser” for them that required a huge amount of work and occupied far too much time. So apparently, this is a tough market to crack. To be clear, some of U-Haul’s 20k+ pick-up/drop-off locations seem, quite frankly, ridiculous – I mean, a food mart? And if you go by the online customer reviews, UHAL will win no blue ribbon from Buffett for “delighting” its customers. But, when it comes to service, price, and convenience, there’s a delicate balance to be struck and ensuring a proper balance of equipment type (the Company has 7 varieties of trucks vans) by season and local market conditions across a dense network, takes years of iteration and experience that money can’t buy.

But let’s not exaggerate the competitive strengths of UHAL’s one-way self-moving business.

Since every value investor letter requires at least one obligatory Buffett pearl, I offer the following from Berkshire Hathaway’s 1991 Annual Letter:

“An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.

In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.”

Margin compression during the latest quarter suggests that UHAL is unable to pass rising new truck prices through to customers.17 By management’s own admission, the only way for Amerco to recoup rising input costs is to improve equipment utilization and, while a two-sided platform helps, assiduous attention to matching truck supply to demand in local markets is the predominant driver of excess returns. UHAL cannot self-perpetuate greatness the way vaunted franchises can – it lies closer to the “business” side of the “business-franchise” spectrum. Of course, there are many companies that do not meet the requirements of a franchise, but have nonetheless delivered significant value over time (Wal-Mart, Dollar Tree, GEICO, Ryanair, and Interactive Brokers, to name just a few) by operating with Spartan efficiency and continuously leveraging a low-cost advantage. UHAL may not have the industry heft of Wal-Mart and Ryanair to incessantly pressure suppliers, but the Company’s done a fine job efficiently managing a complex task, responsibly pacing truck usage with growth.18 UHAL doesn’t separate self-moving and self-storage profits, but we can take an educated stab at self-storage EBITDA by applying average self-storage peer margins over the last decade to UHAL’s self-storage revenue and backing into equipment rental EBITDA. Doing so, I estimate average self-moving after-tax unlevered cash returns on gross capital in the mid-to-high teens over the last decade.

I was going to put this paragraph in the footnotes, but bear with me, as I think it’s worth understanding how used truck pricing impacts the income statement. An increasing proportion of UHAL’s rental fleet is owned (capex) vs. leased (opex) compared to 5-6 years ago,19 (equipment costs now manifest as depreciation expense rather than as operating expense and at least partly explains why EBITDA margins are much higher today relative to the past20 – truck pricing is now in the “DA”), and so some of the recent EPS growth has been juiced by gains on used equipment during what has been a healthy market for medium truck sales. While at least one major truck dealer says that medium-duty truck volumes are solid and UHAL management claims that used truck pricing is stable, note that the Company reduced the carrying value of some older equipment ($9mn) in FY10 and realized some losses on equipment sales in FY2007 ($3.5mn) and FY2006 ($9.2mn) – small numbers, but keep in mind that the fleet size is nearly 50% larger today and a greater mix of it is on balance sheet.

LTM gains on equipment sales are around $2.30/share on an earnings base of ~$24. This may not seem worthy of main-body mention given no evident signs of medium-truck weakness, but it’s worth considering the triple whammy hit to earnings should medium truck pricing materially deteriorate, prompting: 1) lower residual value estimates (i.e. increased depreciation expense), 2) fair value mark downs on its used trucks, and 3) used trucks sales below their depreciated book value, since there is historical precedent for all three. So while self-storage revenue is reasonably cycle-invariant (see below), a key component of the cost structure (truck prices) certainly is not. However, there’s also quite a lot of offsetting flex in UHAL’s self-moving cost structure – the used market for medium-sized trucks is pretty liquid (as far as equipment goes) and of course, in a weak pricing environment, the Company’s balance sheet and cash flows position it to add to its fleet at cyclically advantageous prices. Eighty percent of UHAL’s operating expenses are related to personnel and more than half of UHAL’s 26k employees work part-time. Commissions to independent dealers (11%-12% of self-moving rental revenue) are of course variable, while repair and maintenance costs on trucks generally flex down with rental revenue. These levers cushioned profitability in FY10, when, despite a slight decline in self-rental revenue and lower gains on equipment sales, the Company significantly reduced its fleet maintenance and repair costs by retiring older equipment and dramatically increased U-HAUL segment operating profits and margins.

The other cash flows of interest21 are the rents that UHAL collects from its 24.9mn square feet of owned and managed self-storage facilities. The self-storage industry is highly fragmented, with UHAL + the four largest REITs owning just 15% of 40k-50k total locations in the US (and the top 100 owning 19%).22 Entry barriers to this business vary by market, can be highly sensitive to zoning and land use regulations, and hostage to the whims of local planning committees, so good politics is often good business.23 The industry has experienced consistent occupancy and pricing growth over the last several years,24 but there are mounting over-supply concerns (see here). Last quarter, Public Storage mentioned that it was increasing its original forecast of incremental 2016 supply by 20% (though conditions this varied by market)25 and, while publicly traded operators have continued to take price on existing customers, selfstorage facilities are discounting move-in rates in some weaker markets. If UHAL’s occupancy and rental rates were to drop somewhat below its depressed 2008/2009 levels, we might pencil in a per-share earnings dent of ~$2. 26 Of course, in such an environment, you should also expect to see weakness in medium truck prices and self-moving rental revenue.

Self-moving and self-storage demand are reasonably un-cyclical. During the last recession, self-moving revenues declined -1.8%/-0.1%/-1.9% in fiscal years ending March 2007/2008/2009. There is a common belief that self-moving activity is tied to housing activity, but actually, that relationship is not even remotely borne out when comparing US Census moving rates to self-storage equipment transactions. Meanwhile, the two largest publicly traded self-storage REITs experienced same-store NOI and rental income decline by just low-single-digit percentages in 2009 (following lsd-% growth in 2008). UHAL was solidly EBITDA-profitable every quarter from September 2007 to December 2009, with self-moving + self-storage EBITDA margins troughing at 20.7% in FY 2009 (from 23.7% in FY 2006). There’s cross-selling logic to pairing self-storage with self-moving (1/4 of UHAL’s self-storage customers also rent equipment and a significant proportion of independent dealers also simultaneously operate self-storage facilities), but with self-storage REIT peers trading at low-20s multiples on EBITDA and UHAL consolidated trading at 7x,27 you might wonder whether a “value-unlocking” REIT separation makes sense. In theory, backing out self-storage at 20x implies around 5x EBITDA for equipment rentals. Well, FUHGETTABOUTIT! Amerco insists on keeping the two businesses together under the same corporate umbrella and with 52% of the Company’s share owned by the founding family, there’s really nothing to be done about it.

But while crying foul, we might also consider how UHAL’s equipment rental business offers unique advantages as a self-storage industry consolidator.28 By fusing stand-alone facilities with its existing self-rental network, UHAL can simultaneously leverage and bolster its equipment rental moat and realize greater facility-level ROI than a pure-play self-storage operator could. Furthermore, cyclical considerations aside, there’s also a significant opportunity to improve woefully undermanaged,29 family owned properties that still haven’t discovered Google AdWords. Paid and organic search results are critical to driving self-storage occupancy, and local scale enables multi-facility owners30 to effectively leverage digital marketing spend in secondary and tertiary markets.

And finally, this wouldn’t be an inter-generational family-owned business without some related party transactions, which, in UHAL’s case, means some fees, expenses, and receivables due from family-owned entities, on whose behalf the Company manages some self-storage properties. The numbers involved are small,32 however, and I think overridden by the family’s sizeable stake in UHAL shares.

OK, let’s bring this puppy home: UHAL’s core business is very difficult to replicate, the job it performs is cycle resilient, and has generated robust returns on invested capital over a long-period of time. This is paired with another not-so-cyclical asset of average quality that’s probably near a cyclical peak. There are some related-party transactions, but management’s disproportionate share ownership mostly aligns them with minority shareholders. The Company is rationally levered, with debt maturities responsibly paced and interest expense well covered by profits.33 The sources of earnings weakness last quarter don’t appear to impugn the structural strengths of the core self-moving business, whose asset utilization remains strong with more opportunities for improvement (but we shall see). Given the balance of strengths and weaknesses relative to its 15x trailing earnings multiple,34 the odds seem favorably tilted. If you disagree with me, I’d love to hear from you and understand your objections.

Yours Truly,

David D. Kim ([email protected])

P.S. This letter sort of got away from me and consumed way more time than I intended. Going forward, I won’t be so verbose.