Business

Whitney Tilson: Only Bubble Rivaling DDD Is TSLA

The following is from an email sent by Whitney Tilson of Kase Capital to ValueWalk. For further context see- Tilson Loves 3D Systems As a Short and  Whitney Tilson On DDD ‘Mark my words – This Will End Very Badly’; Still Short Tesla

Whitney Tilson

About to land in Orlando – here for 48 hours at the ICR XChange Conference (www.icrxchange.com), where 115 consumer-oriented companies (mostly retailers and restaurants) will present. It’s a great conference if you’re interested in this sector. I learned a lot at last year’s (my first).

Whitney Tilson K12 Questcor Pharmaceuticals QCOR
Courtesy of Kase Capital

1) I was at the Consumer Electronics Show in Las Vegas for a day last Tuesday – my first time – and really enjoyed it. My takeaways:

a) CES was a total blast for a gadget fiend like me.

b) I met with the CFO of a small-cap company that is one of my newest stock positions (I’ll be publishing an article about it soon).

c) I have more conviction than ever in my short positions in 3D Systems Corporation (NYSE:DDD) and Tesla Motors Inc (NASDAQ:TSLA).

 

2) Re. DDD, it had the largest booth in the 3D printing area of the convention hall (which included maybe 15-20 companies), filled with all sorts of printers, ranging from the new Cube (which it says will retail for under $1,000) on up. The printers were all furiously at work – but doing little more than producing little plastic trinkets. I was really expecting to find myself lusting after one of these machines, but was sorely disappointed. I understand 3D printing’s usefulness for industrial uses like producing prototypes – a business that’s been around for many, many years – but utterly fail to see any chance of widespread consumer adoption like. Yet the hype and valuations in the sector presume that 3D printing is going to be as revolutionary as the iPhone or iPad. What a crock!

 

My other big takeaway from spending an hour in the 3D printing area of CES was the fierce competition – more than a dozen companies were showing off 3D printers that appeared very similar to those of DDD. Heck, there was even a low-end, generic Chinese manufacturer with a printer for $499. In short, this looks like a business that is already becoming highly commoditized – which likely explains why DDD’s margins have declined for each of the past two years.

 

So far, though, “investors” don’t seem to care, having bid the stock up in a speculative frenzy such that DDD now trades north of 20x REVENUES!

 

3) During CES, DDD announced that it appointed will.i.am as its Chief Creative Officer. This ranks up there with the silliest things I’ve ever seen. When (not if) this stock collapses, we’ll look at this as a sure sign of the top… I challenge you to read the press release and keep a straight face. Here’s the beginning:

3D Systems (NYSE:DDD) today announced that will.i.am, global entertainer, entrepreneur and philanthropist, joined 3DS as its Chief Creative Officer. In this leadership role, will.i.am will inspire, shape and drive all of 3DS’ initiatives to mainstream the use of 3D printing through major collaborations with creative brand partners, innovative global campaigns and educational grand challenges designed to grow the popularity of 3D printing.

The addition of will.i.am to the 3DS team brings tremendous talent, vision and influence, and underscores the company’s commitment to democratize 3D printing. 3DS plans to leverage will.i.am‘s international creative industry network to immediately extend its reach into select high-end fashion accessories houses, leading entertainment and life style brands and key corporate sponsored educational and sustainability initiatives.

Note that will.i.am was an early 3D visionary, having featured a 3D Printer in his Dec. 2012 video for the song “Scream and Shout” with Britney Spears. Alas, the printer used in the video was a MakerBot Replicator (MakerBot was purchased by DDD competitor, Stratasys, last June):http://youtu.be/kYtGl1dX5qI?t=3m26s
4) This deal reminds me of BlackBerry Ltd (NASDAQ:BBRY) (TSE:BB)’s deal with Alicia Keys, announced a year ago when BBRY was at $16.60 (it closed Friday at $8.76). Below is an article about it that begins:

When Alicia Keys was first named global creative director at BlackBerry on Jan. 30, 2013, much derision was made at her expense for tweeting from an iPhone just days before the announcement  – and maybe even once again a few days after, in an apparent hack scandal.

But Thursday’s (Jan. 2) news that Keys was ending her one-year partnership with the brand comes at a time when BlackBerry is the only party with egg on its face. The company is capping off a tumultuous 2013 that saw the company seeking, and ultimately rejecting, a $4.7 billion takeover bid from Fairfax Financial Holdings, a house-cleaning of its top executives, including CEO Thorsten Heins, chief marketing officer Frank Boulben and chief operating officer Kristian Tear, among others, and the failed launch of the BlackBerry Z10, a would-be competitor to the iPhone.

“BlackBerry and Alicia Keys have completed our year-long collaboration,” the company said in a statement Thursday. “We thank Alicia for her many contributions including providing creative direction for the BlackBerry Keep Moving Project which attracted more than 40 million visits, advocating for women in STEM and launching the BlackBerry Scholars Program. We have enjoyed the opportunity to work with such an incredibly talented and passionate individual.”

In the first few months of 2013, Keys was singled out as the latest in a trend of celebrities – particularly musicians – taking on “creative director”-like roles at major brands like Diet Coke (Taylor Swift), MasterCard and Bud Light Platinum (Justin Timberlake), Intel and Coca-Cola (Will.i.am), Monster Audio (Keys’ husband Swizz Beatz), and just last month, PepsiCo’s Aquafina Flavor Splash (Austin Mahone). But just how meaningful were these partnerships, which were carefully worded so as not to seem like glorified endorsements?

5) The only bubble rivaling DDD is Tesla Motors Inc (NASDAQ:TSLA), which wasn’t at CES, but a major emerging competitor, BMW, was – and it was showing off two very impressive cars, the new i3 and i8, that I believe are the “twin Tesla killers”. I took a test drive of the i3 and checked out the i8 in the showroom – see my photos below (that’s my dad with me in the third picture).

The i8 is an AMAZING car that is directly aimed at the high-end current Tesla buyer (and at $137k fully loaded, it’s not much more expensive), while the i3, a great car priced around $43,000 (before incentives), will be a strong competitor to the new Tesla X – and it’s already hitting the market now, more than a year ahead of the X!

The i8 (which will start being delivered mid-year and, I hear, is sold out for two years) has an electric motor in the front with only 20-22 miles of range – but that’s enough for the great majority of trips for the guys who’ll be buying this car. And unlike Tesla, it doesn’t need a special charger – just plug it into a regular outlet (or ideally a regular 220 outlet) and it fully charges overnight.

In the back of the i8 is a gas engine which is always on standby so if you hit the accelerator, both motors fire at once, giving the car extra power. It also kicks in to charge the battery. On a full tank of gas, it has a 300 mi. range and is expected to get 90-100 miles per gallon “under normal driving conditions.”

I really enjoyed the i3, which though purely electric, has an optional gas engine that will charge the battery, taking the car’s range from 80-120 miles to 150-190 miles.

6)  Here’s an article entitled: 5 ways the BMW i8 is better than Tesla Model S. Here’s the summary:

The Model S is an important EV but as a car, I reckon the i8 better in just about every way. We’ve much to discuss, so let’s jump right in.

1. The i8 is sportier than the Model S

2. The i8 is better looking than the Model S

3. The i8 can travel further than the Model S

4. The i8 is supported by a nation-wide network of dealerships

5. BMW is cooler than Tesla

7) I was asked three questions on the ValueInvestorsClub message boards about NFLX (my replies are at the end of this post):

Question 1: On your point 3, could you please elaborate on your definition of a ‘light’ business model? I believe NFLX spends billions a year on the rights for the content it distributes and every new market it enters requires upfront capital to build an attractive library as its current rights are not global. How is that a capital light business?

 

Question 2: I know you are long NFLX now, but why were you short NFLX for so long as it went up (and covered near the high as the catalyst(s) played out)?

 

Has your investment process for sourcing/filtering/due diligence/analysis evolved changed? The points you lay out are interesting conceptually, not sure I would base a short thesis on just those descriptive factors though without predictive event path (and making sure you have the right capital to have staying power via LPs and borrow/cost), but I am very interested in your response. Most true alpha shorts (as well as transformational longs) have a series of predictive factors, and being able to find the hook or why your loss potential is capped within fundamentals and technicals, outside of valuation or the above make for a good short.

 

Question 3: How is this a “winner-take-all” business?  Isn’t streaming TV shows and movies potentially a commodity?  I don’t see how Netflix, Inc. (NASDAQ:NFLX) dominates Amazon.com, Inc. (NASDAQ:AMZN) in this space long-term.  AMZN is probably the most loved company in America (or the world).

 

8) A friend read my responses and added this:

 

Another particular example on the “light” aspects of the business model.

 

We have heard from good sources that NFLX literally has ZERO staff in all of Scandinavia. They launched it in October 2012 and acquired the rights (Scandinavia, like Latin America, is sold as a single market) and did advertising and everything but they literally do not have a single employee in any of those markets.

 

We also believe they have at least 1mm (perhaps 1.5mm) customers in a market of 12 mm households and those customer pay closer to $10 per month (because of the Kroner translation) meaning this business already generates $120mm with no additional operating expenses – other than content rights.

Question 1: On your point 3, could you please elaborate on your definition of a ‘light’ business model? I believe NFLX spends billions a year on the rights for the content it distributes and every new market it enters requires upfront capital to build an attractive library as its current rights are not global. How is that a capital light business?

 

Answer: By light business model, I mean it doesn’t produce a physical product or service — no manufacturing plants, no inventory, and no people required to grow (other than maybe a few customer service people in a call center).

 

For Netflix, when one additional person signs up for the service, that’s $96/year of revenue for the company — and it’s almost entirely pure pre-tax profit. The contracts with content providers are all fixed fee — Netflix doesn’t have to pay any more to them if it has 50 million subs vs. 40 million. This is what I mean by a light business model.

 

Your point is well taken, however, that Netflix has to spend a lot of money signing deals with the content providers — in this way, a company like LinkedIn or Facebook as an even better/lighter business model. But they trade at 18x and 19x sales vs. 5x for NFLX…

 

To the related bearish argument that the content providers aren’t stupid — if they see that NFLX has 50M subs vs. 40M, they’ll just charge proportionately more so all the benefits of NFLX’s growth will accrue to them, not NFLX — this argument is totally wrong. I put this question to Reed Hastings over dinner two years ago and he said, “If my subs grow 25% and content providers try to increase fees by 25%, I can just say no. To buy content, all I have to bid is $1 higher than the next highest bidder? And who’s that bidder? Hulu, with 1/10th the number of paying subs as us?”

 

NFLX is like Costco — it doesn’t promise its customers that it will carry everything (if I recall correctly, on average Costco carries 5,000 SKUs vs. over 100,000 for the average Wal-Mart). NFLX can pick and choose, play content providers off each other, etc. — and that’s exactly what it does.

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Question 2: I know you are long NFLX now, but why were you short NFLX for so long as it went up (and covered near the high as the catalyst(s) played out)?

 

Has your investment process for sourcing/filtering/due diligence/analysis evolved changed? The points you lay out are interesting conceptually, not sure I would base a short thesis on just those descriptive factors though without predictive event path (and making sure you have the right capital to have staying power via LPs and borrow/cost), but I am very interested in your response. Most true alpha shorts (as well as transformational longs) have a series of predictive factors, and being able to find the hook or why your loss potential is capped within fundamentals and technicals, outside of valuation or the above make for a good short.

 

Answer: mojoris, the short answer is yes, I’ve learned and changed. I was short NFLX from approx. $80 to $180, saw the error of my thinking and got out, and at least didn’t suffer further when it peaked over $300. (Alas, I wasn’t clever enough to short it from $300 to $53.)

 

All the pain on the short side on the way up made me do more analysis and I concluded that NFLX was a terrible short because it’s a MUCH better business than I’d given it credit for. That, in turn, positioned me to go long it.

 

To read what I published at each point in time, this is what I posted on the NFLX thread recently:

 

I’m in the same boat as other short sellers, having taken hideous pain on the usual suspects: TSLA, HLF, DDD, GMCR, etc.

 

But I got one thing right: I flipped around and went long NFLX at $70-$80, bought more in the $50s and have had a 7x run in the past 15 months. Sadly, I’ve sold all the way up, maintaining a 3-4% position most of the way — but it’s been enough to offset TSLA anyway…

 

And I’m still long a 3.2% position. I know all the short arguments — I went public with them in 12/10: http://seekingalpha.com/article/242320-whitney-tilson-why-were-short-netflix (also see Reed Hastings’ response (http://seekingalpha.com/article/242653-netflix-ceo-reed-hastings-responds-to-whitney-tilson-cover-your-short-position-now), my cover in 2/11 (http://seekingalpha.com/article/252316-whitney-tilson-why-we-covered-our-netflix-short), and my pitch on why I went long (www.tilsonfunds.com/NFLX-10-12.pdf).

 

Read the last one carefully. I beleive that my original short thesis (and your current one) was/is wildly wrong. Netflix is an insanely great business with a light business model and a huge moat — I think it could end up being a global winner-take-all business. If so, a $22B market cap and 5.3x sales will prove to be really cheap.

 

But even if you don’t buy any of this, with so many crappy companies out there with far worse business models trading at even higher valuations, why short Netflix? Telsa is an automobile manufacturer for Pete’s sake and trades at 10.8x sales, and DDD trades at 20.8x sales!

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Question 3: How is this a “winner-take-all” business?  Isn’t streaming TV shows and movies potentially a commodity?  I don’t see how NFLX dominates AMZN in this space long-term.  AMZN is probably the most loved company in America (or the world).

 

Answer: Per my reply to avahaz, it’s extremely expensive to buy streaming content. What NFLX did starting in 2011 is incredibly bold — it signed contracts worth billions of dollars over time for high-quality streaming content (total assets in 2010: $982M; 2011: $3,069M — I’ve never seen anything like this). NFLX bet that this would translate into: 1) millions of new customers; and 2) a huge moat around its business — and the bet appears to be paying off, which is why the stock has gone parabolic.

 

Think about it: if you want to compete against NFLX, the price of admission three years ago was $1 billion, but now it’s $5 billion (very roughly speaking). How many companies have that kind of money? Not many. Amazon does — but how much incremental revenue is Amazon generating from its streaming service? ZERO (or pretty close to it — maybe a few extra people sign up for Amazon Prime because of the free streaming service that comes with it, but I’d bet very few). How long will Amazon be willing to incur HUGE losses when there’s no evidence that it’s gaining any traction? (Look at the Sandvine reports — NFLX accounts for 1/3 of ALL downloading, followed by YouTube — and Amazon isn’t even measurable.)

 

Right now, NFLX is in a beautiful virtuous cycle that, if it continues, leads to NFLX continuing to be 10x or more the size of its nearest competitor: it’s attracting the vast majority of people who sign up for a streaming service (I’d guess 80%). For every million new subs, that’s $96 million of revenues and I’d guess $90 million of pre-tax profits. Netflix then takes most of that $90 million and buys more great content, which in turn attracts even more subscribers. Lather, rinse, repeat.

NFLX’s revenues are growing about $800M/year and it’s plowing most of that into new content. Who can compete with that???

I’m not saying this is a slam dunk: the valuation is high and lots of things can go wrong, which is why I keep trimming it to keep it in the 3-4% position size range.