Scott Miller’s Greenhaven Investors Q3 excerpts – see full letter below

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NEW INVESTMENTS This past quarter we made two new investments, both of which can be classified as “invisible” with interesting set-ups. There is a long, detailed write-up at the end of the letter, but given the following fact pattern, I think we can all agree Gaia (GAIA) is largely invisible. GAIA is covered by just one sell side analyst who did not published for several months. The company has changed its name and its sub-$150M market capitalization makes it largely not investable for large funds. This year, Gaia sold its two largest divisions, changed CEOs, bought back 40% of the shares in a tender offer, and until last month had a PDF with the words “place holder” come up when you clicked on their investor presentation. There are plenty of invisible companies, so why Gaia? What is the set-up? As outlined in the write-up below, 75% of Gaia’s market capitalization is covered by cash and real estate, the company could be profitable today if it chose to grow more slowly, and it is acquiring customers at one-third of their lifetime value in a large and growing market. Gaia is 38% owned by its CEO, who previously built a Fortune 500 company. It can grow 50%+ per year, has a fully funded business model, and generates 80%+ gross margins. This has not been a profitable investment to date, but based on the growth opportunity ahead combined with the “downside protection” that the balance sheet provides, I like the set-up and think significant appreciation is possible. The second “invisible” opportunity we pursued was to be both long VMware and short VMware. Generally speaking, being long and short the same company would only make the broker a handsome return. How and why did the fund do this? Context is helpful. Dell is a private company, and they are in the process of buying EMC, a public company that owns 80% of VMware, another public company. To finance the transaction, Dell could not pay EMC shareholders 100% in cash, so they gave EMC shareholders $24.05 per share in cash and .11 DVMT shares per EMC share. DVMT is a newly created tracking stock meant to track the performance of EMC/Dell’s ownership of VMware. Dell effectively had to let EMC shareholders retain some of their VMware ownership through the tracking stock. The main difference between the publicly listed VMware and DVMT is that if Dell faces bankruptcy, DVMT will be impaired, so there is Dell credit risk associated with DVMT and not with VMware. But Dell’s earnings and bond prices indicate that bankruptcy is not a near- or medium-term concern. We bought the DVMT shares when they were trading on the pink sheets as “when issued” shares – meaning that they would eventually turn into DVMT shares on a given date – and also shorted a proportional amount of DMVT shares. At the time we made this investment, the difference in price between our “invisible”-when-issued DVMT shares and the economically equivalent VMware shares was approximately 40%. One reason the discount may be so large is that Dell carved out the ability to buy back tracking stock shares over time, so they had no incentive to “talk up” the shares or opportunity.
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This investment is referred to as a “pair trade” and we are effectively not exposed to the VMware business and are indifferent to its price (we are also short VMware). Rather, we will benefit if the “tracking stock” discount gets smaller, which implies a convergence in the price of VMware and DVMT. It is not clear there is an “appropriate” tracking stock discount overall, but the Liberty tracking stocks and others typically have a 15-25% discount. So yes, this stock was largely invisible (pink sheet, when issued, tracking stock) but it was also a 40% discount to the publicly traded, visible comparable. This investment is not directly correlated to the overall market and does not rely on earnings growth or multiple expansion to be profitable. I prefer it to cash. I like the set-up here as well, and time will tell if we are rewarded. …………… SHORT POSITIONS We continue to have a very small number of short positions. Given current nosebleed valuations and lack of growth prospects on many consumer goods companies, it is possible we will increase the number of shorts as the year progresses. The two primary short positions the fund currently holds are Tesla (TSLA) and Lands’ End (LE), for similar reasons. Tesla is a cult stock that needs continuous access to the public markets to finance a broken business model. The unit economics are broken, and Tesla loses money on each car sold. The likelihood of delivering the Model 3 on time with 20% margins as advertised is very, very, very low. The competitive landscape is intensifying with the Chevy Bolt and a slew of other electric cars entering the market. I have yet to hear a justification for the Solar City acquisition that makes any sense for Tesla shareholders (other than Elon Musk, who is also a Solar City shareholder). Elon Musk has some incredible accomplishments, but at current valuations, Tesla is a stock built on what I would argue is a vulnerable myth of his unquestioned genius. To date, the short is moderately profitable, but we have tried to short the stock before with little success – so time will tell. The markets will fund Elon’s broken model… until they won’t. Lands’ End has a leadership problem like Tesla, just a different kind of leadership problem. Lands’ End is a spinoff from Sears, which has a hedge fund manager as a CEO; this seems to work as well as a retail manager running a hedge fund. In the case of Lands’ End, there is $280M of net debt for a company that generated less than $10M in adjusted EBITDA (down 75%) in the first six months of the year (before the quarter the CEO stepped down). More importantly, when we initiated the short position, they had a CEO who hailed from Ferrari and Dolce & Gabbana, living in New York City and commuting to Wisconsin. Aside from the likely “fit” issues of the Italian CEO commuting to Wisconsin, she was trying to dramatically increase the fashion profile of the dowdy Lands’ End (I can say that because I am dowdy myself). The company was launching new lines emphasizing slimmer clothes and stiletto heels, having expensive fashion shoots, and establishing a Fashion Week presence – a long distance from the canvas boat bags and Midwestern flair the company is known for. This strategy seemed highly unlikely to succeed, and is perhaps best described as a head scratcher. As of now we don’t know the final results, but at the end of September, the CEO resigned and now the company is being led on an interim basis by co-CEOs, another set-up that rarely succeeds. The shares have sold off, but we remain short Lands’ End. The fund is also short a company that is losing its largest contract and has displayed little ability to manage through the process. Management continues to spin tales of how they will replace lost revenue. Once again, time will tell. ………………. Gaia, Inc. (GAIA) – ($7.75) Gaia is certainly an invisible company. Why do I say this? For starters, the presentation on their investor relations website until last month simply linked to a blank document entitled “Place holder.” The company did not even broadcast audio or slides for the sole investor conference they held this year. GAIA is covered by only one sell- side analyst that published infrequently. As if trying to be forgotten, the company even changed its name this summer (from Gaiam). Background and History Ultimately, Gaia is a “trust me” story, and the person telling the story is Jirka Rysavy. Rysavy is not a 30-year- old Unicorn CEO with great PowerPoint skills, limited skin in the game, and no history of execution. Rysavy was a competitive runner in Czechoslovakia before immigrating to the United States in 1984 virtually penniless. He founded Corporate Express, an office supply company rollup that used a combination of efficiencies and reduced catalogs to increase inventory turns and make the cutthroat office supply industry a profitable one. In fact, it was so profitable that Corporate Express became a Fortune 500 company. His successes, as well as his alternative lifestyle, are summarized well in the following article: (http://fortune.com/2008/06/17/the-strange-origin-of- staples-big-deal/). Rysavy has a strong entrepreneurial streak. In addition to founding Corporate Express, which was eventually sold to Staples, he also founded a natural food store, which eventually became Wild Oats and was bought by Whole Foods. He also founded a publicly traded business known as Gaiam that realized more than 90% of its business through the “branded products” segment, essentially yoga-related items such as pants, mats, and other yoga lifestyle products. After branded products, travel was the second largest component of the business, and there have been a few odds and ends including a solar-related business that was spun off, and a yoga DVD business that was sold (not without a multi-year lawsuit by the buyer). Additionally, over the last three years, there has been a small but growing video streaming business. The vast majority of Gaiam shareholders owned Gaiam because of the promise of growth and profitability in the branded products division. The old conference calls logs feature a steady drumbeat of apologies for losses in the video streaming business and a pledge to effectively grow more slowly to reduce the losses. TRANSFORMATIVE TRANSACTION In the second quarter of this year, Gaiam announced a series of transformative actions. The company sold its large branded business for $167M and its travel business for $12M, leaving the former runt of the litter – the video streaming business (Gaia) – behind with a large pile of cash. The company promptly announced a tender offer (for almost half the company) at a 34% premium to the year-to-date average trading price of the stock. The tender was not fully subscribed, but in July, Gaia did buy back 40% of the company in one fell swoop. Understandably, a beleaguered shareholder base interested in branded products and not video streaming voted with their feet and sold their shares back to the company at prices they had not seen in years. ACTIONS SPEAK LOUDER THAN WORDS As part of the tender offer, the founder Rysavy indicated he would not sell any of his shares; upon conclusion of the tender offer, he effectively owned more of the smaller company, increasing his ownership from 24% to 38%. He also went from Chairman to an operating role and has become the CEO of the video streaming business. In essence, Rysavy has sold off the businesses that other owners were focused on, and doubled down on the small “unprofitable” business, which seems to be a strong indication that he believes the streaming business has real potential. At current prices his 38% stake in the company is worth more than $40 million. SILENCE IS DIFFICULT In the investment profession, we are trained to look for gaps or holes in a story. Management will rarely identify the fatal flaws of their own business. Instead there is a centuries-old tradition of spinning the positives to shareholders and hoping to buy enough time to fix the weaknesses of a business. The management team of Gaia is not making it easy for investors to connect all of the dots. At the time of the tender offer, management did a “non-deal” roadshow where nobody was given a physical presentation. Instead participants were given iPads to view the presentation. There is no PDF on their website and no “copies” of the presentation were distributed. In addition, the deal to sell the branded business closed on July 1 while the quarter ended on June 30. The net result is that the earnings through June 30 were “messy.” The company did not make any effort to explain the earnings numbers or to normalize them. This includes making adjustments for a lower share count (15M vs. 24M) and higher cash balances ($60M+ vs. $6M). The company is clearly not putting a promotional spin on their results or prospects. One plausible reason for the company’s silence is that the dots just don’t connect. If that is the case, one should not own the shares. If Rysavy had tendered even a portion of his shares, that would be my conclusion. However, he did not tender. If not tendering shares is doubling down on the idea of video streaming, leaving the Charmian role to become the CEO is a step towards tripling down. Could there be other rational reasons for silence? Three of them come to mind. The first is that if the business plan is fully funded, and there is excess cash because the tender was not fully subscribed, it is in Rysavy’s interest to avoid doing anything to boost the share price so he can buy more. A second reason could be the recent litigation the company has endured. In 2013 Gaiam sold GVE entertainment for $51M. The sale included Vivendi Entertainment, which the company had purchased in 2012, as well as distributed content from companies such as WWE, NFL, Hallmark, National Geographic, and Discovery. The sale of GVE led to extensive litigation and ultimately a $10M payment from the company to the purchaser of the company, Cinedigm. The lawsuit centered around representations the company made during the sales process. One interpretation of the company’s reluctance to put information in an investor presentation or discuss the information on widely available conference calls is a desire to avoid future litigation. A third explanation that has been offered by longer-term shareholders is that management prefers to under promise and over deliver. During this time of transition, their silence is in line with their lack of promotion. WHAT IS THE BUSINESS? VIDEO STREAMING Now that we have the investment set-up, let’s look at the business. Gaia refers to itself as a conscious media company. Similar to Netflix, content is delivered via streaming over the internet. Gaia’s content is far more niche than Netflix and ranges from streaming yoga classes to guided meditation, to nutrition, to parenting, to the paranormal. In the words of one member: “Gaia is an incredible portal into the realms of the esoteric. Everything from meditation and astrology to ancient civilizations and the paranormal, it’s all in one place. I’m able to expand my perspectives every day at home, plus it makes for great conversation with my friends. Thanks Gaia, keep fighting the good fight!” In a world of hundreds of cable channels, Gaia’s content in many ways is so niche it does not even merit a cable channel. However, given the streaming technology, there is a vibrant and viable business with a real value proposition here. For example, if you live nowhere near a yoga studio, online classes are actually pretty attractive. Information on holistic nutrition and conscious parenting could easily be worth more than $10 a month to a parent. If you are a follower of one of the Gaia gurus, all of their historical content and all of their new content in one place is quite a resource. In terms of how it works, the “stars” of Gaia are paid on the number of subscribers they attract to the platform. This is a low-cost customer acquisition strategy which aligns the gurus with the platform and provides reasons to retain gurus on the platform. DOWNSIDE PROTECTION Besides an owner of 38% of the company who has chosen to be an operator, what do we have? What are we buying and what are we paying for it at these prices? There are four primary assets of the company. 1)$60M+ of cash. The company has been reluctant to state exactly how much cash would be available after settling the escrow conditions on the sale of its businesses. In the non-deal roadshow before the tender offer was complete, the company indicated $they would have $60M. Given that the tender offer was short by $17M, this would imply $77M. On the earnings call, they reiterated at least $60M. 2)A building that is less than 20% occupied by Gaia. Management estimates a value of at least $20M for the building. In 2015 the video streaming segment recorded $1.9 million in rental revenue related to the portions of the building it did not occupy, and the majority of that was from third parties that presumably negotiated arms’ length leases. The company paid $18M for the building almost 10 years ago. It is 150,000 square feet on 12 acres with a cafeteria and a gym outside of Boulder, Colorado. Based on the income and location, the management estimate appears reasonable. 3)A media library with more than 7,200 hours of content. The company currently is paying approximately $5,000 per hour of content. At a conservative value of $2,500 per hour, the library would be worth $18M. 4)170,000 current video subscriber customers. Given the lack of disclosure about churn rates and types of customers, putting an exact value on existing subscribers is difficult, but it should be north of $100, which is 10 months of revenue associated with a subscriber. greenhaven-gaia-1Our shares were bought at a market capitalization of $120M, meaning that 75% of the market cap is covered by cash and a building. Thus we were paying $30M for 7,200 hours of content and 170,000 subscribers. On the face of it, a reasonable proposition – but to get at all excited you have to believe that the model works and the business can grow profitably. HOW THE VIDEO STREAMING BUSINESS WORKS The basic model is to pay up front to acquire customers and then collect revenue over the coming months to more than recover the cost of acquisition. In essence, the company must acquire customers for less than their lifetime value. The person with the most knowledge on how the business works is the CEO and largest shareholder and again he has not connected all of the dots for minority shareholders, but this is what he has said about acquiring customers:- “We have a discipline. We don’t really ever go as we trend the lifetime value, which is kind of retention multiplied by our cash margin, is not based on revenue like most other people who we calculated based on our cash margin which let’s say it’s about 80% right now. And we never spend more than half of the cash – customer value and we spending actually spending much less, and some of the better channels are actually more like now 25%, 30%. So it’s – that’s kind of why you can go faster you spend a little more, so we kind of try to manage to grow such that we can go over 100%, but we don’t plan to do that we want to be disciplined to this kind of model.” The margin of safety in the model is that they do not spend more than 50% of the lifetime value of a customer. A subscriber can download an app, log in directly to the website, or access the content through a variety of partners including Amazon, AppleTV, Roku, Verizon, and Comcast. The business also has negative working capital as subscribers pre-pay. WHAT IS THE UPSIDE? The company does not provide a precise market size but gives several touchpoints. There are currently 218M streaming video customers worldwide across all services including Netflix, Amazon, Hulu, etc. The company cites Bespoke Research Group, estimating 300M video streaming customers, and Gaia research indicating that 55% of subscribers are interested and willing to pay for at least one Gaia topic. The company also stated that 60% of Netflix subscribers use other services. Netflix has grown to more than 80 million subscribers in 2016, which is up over 3X from 2012. The reality is that the value proposition for video streaming services is very high. Gaia will never get to a fraction of the total addressable market, but there are indications that it is large enough to support far more than the 170,000 subscribers the company has today. One useful reference point is that 33% of subscribers are international and the only language currently supported is English. Simply expanding into new languages should provide a meaningful boost to subscriber count. At one million subscribers, this business is worth multiples of today. Is one million subscribers achievable? It would be far less than 1% of video streaming customers. As proof that niche streaming platforms can be much larger than Gaia, there is a Japanese Anime streaming company that has 700,000 paying subscribers (http://www.animenewsnetwork.com/news/2015-10- 22/crunchyroll-sumitomo-announce-partnership-to-create-company-to-co-produce-anime/.94495). Gaia content would appear broader than Anime, covering yoga, healthy living, spiritual growth, and truth seeking and has gone from a standing start to 170,000 subscribers in three years. Given the growth in SVOD, their distribution on Apple, Amazon, Comcast, Verizon, Roku, and the increasing trend towards using streaming services, a subscriber base in the low millions is in the realm of possibility. A 7% share of that subset yields 11.5M subscribers. The business is profitable at 170,000 and worth a multiple of the current valuation at 1M subscribers. GAAP ACCOUNTING – CURRENTLY PROFITABLE Under GAAP accounting, all of the expenses associated with acquiring new customers are expensed when they are incurred, but revenues from new customers are realized over their lifetime, which may be several years. Thus there is a mismatch between when the expense is recognized and when the revenue is received. Essentially, the more you grow in the short term, the greater the losses are. However, the company has indicated it could be profitable within 90 days if they reduced spending on advertising and chose to grow more slowly. When the video streaming business was part of Gaiam and was mainly viewed as a source of losses, there were pressures to reduce advertising, which slowed growth and reduced profitability. In Q3 2015 the company had approximately 120,000 subscribers, and video streaming was able to generate in excess of $1M in EBITDA for the quarter. The important point here is that sufficient scale has been achieved, which means that growth from here on is optional, not required. Given that the company has almost 50% more subscribers in a business with high gross margins and high fixed costs, it is reasonable to believe that if they wanted to reduce growth and investment in content – effectively entering a steady state – Gaia could generate $5M+ in annual EBITDA. Put another way, ex cash, ex building, ex media library, we are paying somewhere around 3X EBITDA for the option to try and grow the business. WHAT COULD WE HAVE – ASSUMPTIONS Given the cash, the building, and the media library, our downside is somewhat protected, but to be fair a portion of the cash will be used to grow the streaming business. For this to be an asymmetric opportunity, the streaming business has to work. Can it? There are three primary assumptions that matter. The biggest assumption/variable by far is how long can the company retain customers? At $10 per month, a customer that sticks around for 36 months is far more valuable than one who sticks around for one month. The second assumption that matters is how much will the company have to pay for a customer? The third key assumption is what will happen to content costs? Let’s look at them one at a time. Retention: The company has indicated that subscribers who focus on different areas of content have different retention rates. Those with the shortest retention rates are yoga subscribers, which average about 14 months. The group with the longest retention rates is called “Seekers” and they average over three years. The company has indicated that retention metrics are improving. Customer Acquisition Costs: If the company can acquire millions of customers at substantially below their lifetime value, there is an attractive and viable business here assuming they can control their other costs. Content Costs: One of the largest differences between Netflix and Gaia is the content costs. For Netflix, content costs are approximately 70% of revenue. For Gaia, it is below 20% of revenue. There can be a number of reasons for this including the company acquired niche content at attractive prices and conscious media stars make a lot less than Hollywood stars. Given the lack of relative scale, the Gaia model falls apart if content ever approaches Netflix levels. IS THE MODEL REALISTIC? When we model five years out, the one thing that is certain is that the model will be off. However, in the spirit of John Maynard Keynes who said that “It is better to be roughly right than precisely wrong,” we can try to connect the dots. Does the business model make sense? If our assumptions on the primary metrics of retention, customer acquisition costs, and content costs are approximately correct – can this investment be profitable? The short answer is yes. We can triangulate between their stated customer acquisition costs, stated retention rates, and stated gross margin goals – and the model can work. Below assumes 35% attrition rates and customer acquisition costs of $90, which is higher than historical. greenhaven-gaia-2 Pre-tax profit should be a reasonable proxy for cash flow in the growth phase – and with $60M plus in cash, the company assertion that the business model is fully funded appears reasonable. As the model shows, if these assumptions hold, the company will have pre-tax profits in 2019. Importantly, this is while still investing heavily in growth while expensing all customer acquisition costs up front. The pretax profit in 2021 is almost what we are paying for the stub today. If you attach a 10X multiple to it and assume the cash and building stay where they are today, it implies a value of more than $300M or nearly triple today’s value. Obviously the actual results will differ from the model – but the point is the dots can connect. In conjunction with the actions of Rysavy selling off the other businesses, buying back 40% of the company, not tendering his shares, and assuming the CEO role, the model reveals a substantial opportunity here – and Rysavy is the one with the most information. UNKNOWNS There are dozens of unknowns here – from retention numbers to how the video streaming market as a whole will play out to how big of a competitive threat youtube will become? Importantly, however, Rysavy has a history of selling and exiting businesses that are not working. Thirty-eight percent of the cash pile is his, and the incentives are aligned such that if the business deteriorates, he will not squander the remaining resources. This is ultimately a bet that a successful operator and capital allocator will navigate those unknowns. With more than half the market capitalization in cash, a company that is virtually silent, and distorted financials, it is easy to pass on the investment. However, as the situation settles, the financials normalize, and the company becomes more transparent, there is the potential for a generous valuation on the video business. With the cash balance and the value of the building protecting the downside, the risk/reward is skewed to the upside. Rysavy also has a history of selling assets when he thinks he has created value. By not tendering shares, he has effectively been a net buyer of the video streaming business; if my model or the company model is even close to correct, I believe he will find a buyer for a profitable subscription business with 80% gross margins and a history of growth. Full letter below q3-2016-final
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