Allan Mecham’s Arlington Value Capital portfolio commentary for the fourth quarter 2014.
Also see Part I here: Allan Mecham’s Arlington Value Capital 2014 Annual Letter
Allan Mecham unloads Berkshire Hathaway
We unloaded most of our BRK position in 2014. Our decision was driven by outside opportunities and a diminishing gap between price and value. I’m happy to report that over roughly 41 months of ownership, our unconventional BRK holding outpaced the S&P in fine fashion, registering a gain of more than 170%. The premise of our BRK thesis always rested upon minimal risk concurrent with a high probability of adequate return, analogous to a 3-yr T-bill yielding 15%. Such an unusual opportunity (carrying almost zero chance of major loss) and associated large position size should be considered an anomaly rather than a regular occurrence.
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Allan Mecham adds Sony
Sony is a new holding, initiated midway through the year. A staid culture, bloated cost structure, and bureaucratic mismanagement have long been hallmarks of SNE, and good reasons for avoiding it. However, new management, led by C-suite execs, Kazuo Hirai and Kenichiro Yoshida, seem committed to accountability, return on capital, and a willingness to make tough decisions.
SNE is a large company that generated $65+ billion in 2014 sales. This ample revenue stream was produced by numerous businesses: Movies, Music, Games, Sensors, Electronics, Phones, and even a financial arm. SNE’s unwieldy sprawl provides comfort via diversity, and opportunity via refocusing resources.
In our view, SNE is heading in the right direction: focusing on businesses with solid competitive positions and prospects for profitability, and shrinking or exiting divisions that don’t. This is an uncommon approach?shrinking rarely brings out the champagne bottles like chasing growth, yet in SNE’s case, it’s a blueprint for success.
We’re often drawn to opportunities like SNE: a simple idea, with a handful of sound assets hidden under bloated costs and inefficiencies. When bloated costs and sound assets clash with sharp management and a cheap stock price, opportunity lies in wait.
While Consoles and Sensors have been standout performers of late, we think SNE’s Entertainment arm is a particular gem, littered with iconic assets that are both durable and valuable (worth over half of SNE’s market cap in my opinion), and likely to grow in value over time. Though profits can fluctuate from year to year (depending on financing arrangements, box office success, syndications, etc.), the underlying assets are unique, long-lived, and impossible to duplicate.
Investment success doesn’t require SNE to make cutting-edge breakthroughs to spur growth, rather, simply aligning costs and a culture of accountability will create substantial shareholder value. A 2014 Jefferies report highlighted some eye-opening facts that show both the problem and the potential:
- SNE’s SG&A costs represent 33% of sales (dwarfing competitors) and represent 230% of 10-year cumulative operating profit.
- SNE’s SG&A spend was greater than its market cap.
- SNE’s R&D spend is on par with Apple, yet SNE fails to generate 50% of Apple’s revenue.
- If SNE’s SG&A were inline with Samsung and Panasonic, operating profit would increase to $7.5b vs. $1.3b today.
At this point, we feel that we’re past the cross-your-fingers stage. Management has taken action on a number of fronts, having cut the dividend, exited the PC business, slashed costs, and shrunk divisions, showing us that there’s mettle behind the message. Best of all, if things go awry and the old status quo creeps back in, SNE’s bargain priced shares should provide protection against major loss.
Allan Mecham long on Alleghany
Having long followed Y, we were giddy buyers as the share price dipped (ever so briefly) midway through the year.
Started as a railroad rollup nearly 100 years ago, Alleghany ran highly leveraged into the teeth of the Great Depression, requiring a rescue by JP Morgan. The founders died penniless.
Today Y is predominantly in the insurance business, though it seems the scars of its history have been imprinted on its culture. In fact, Y is commonly criticized for being overly cautious and conservative; a catnip-like critique to fund managers attuned to Ben Graham’s two rules of investing (rule #1, don’t lose money; rule #2, don’t forget rule #1). The criticism seems to miss the long-term message of Y’s track record: a plodding opportunistic history of financial acumen akin to the tortoise outpacing the hare.
Prudence litters the firm: premium volume to capital is sensible, loss reserving is conservative, the investment approach makes sense, and smart incentives are in place. We’re happy to be co-owners at current prices, accepting adequate prospective returns, even if unspectacular.
Allan Mecham adds Outerwall
Outerwall is a new addition to the portfolio though it shouldn’t be totally unknown to long-time LPs with sharp memories (hint: we owned the predecessor 12 years ago). Though largely considered a business headed for the history books, its core businesses-today-are simple and profitable, and we think will linger much longer than the consensus view.
OUTR’s main business, Redbox, is well known. The little red kiosks dispense DVDs across the US, piggybacking on the footprints of retailers and embedding themselves within their stores (or just outside of them). Redbox’s widespread convenience is married to an unmatched low price, providing a compelling value proposition and a commanding market position, which bearish investors liken to commanding the Titanic. In addition to Redbox, OUTR also owns Coinstar, an automated coin kiosk that allows consumers to trade coins for cash or gift certificates.
OUTR’s businesses have qualities that appeal to us: dense networks and low servicing costs; low cap-ex requirements; little sales and marketing needs; fast cash conversion cycles with minimal receivables; healthy cash flows; and dominant market positions built upon unmatched value and convenience.
The main risk to Redbox is obvious: consumers abandoning DVDs in favor of video-ondemand (VOD) and streaming. In our view this is unlikely. Streaming shows little direct threat, and the higher price of VOD (~$5) versus Redbox (~$1.5) has stifled VOD’s traction. For the gap to shrink, studios would need to suffer lower profits or master release-window alchemy with proper pricing. To date, and despite constant tinkering, studios have been unable to crack the code. We believe the price gap will persist given the supply chain structure and the makeup of studio profits (DVD’s account for roughly 70% of post box-office profits).
Critical to our thesis is OUTR’s cheap price and management’s intention to curtail spending (some risk here), maximize free cash flow (FCF), and return cash to shareholders. Over the last two years OUTR has shrunk the share count by 38%, financed by debt and cash flow. Going forward, OUTR seems intent to continue the trend. To show the potential, let’s look at the figures and make some rough assumptions (for illustration we’ll assume 100% of FCF goes to share buybacks).
Shares outstanding: 18.6 million
Share price: $62
Market cap: $1.15b
Net Debt: $730m
Enterprise Value: $1.88b
Redbox adjusted FCF: $275m
Coinstar adjusted FCF: $75m
Venture Cap Ex: $50m (a reduction from current levels)
Total FCF: $300m
Even assuming FCF declines 12% per annum at Redbox, OUTR would be able to retire 68% of the shares outstanding in 3 years time; if the trend continued, the share count would shrink 95% by late 2019, leaving owners with $170 in FCF per share. This theoretical exercise isn’t a prediction, yet it shows the potential under a shrinking, yet durable OUTR that’s capable of servicing its debt. Alternatively, if OUTR were to choose dividends instead, investors would receive a current 25% yield.
Investors worried about longer-term risk should hope for a steep and sustained drop in OUTR’s share price: if OUTR dropped 50% to $31 per share, and stayed there, management could theoretically buy back 90% of the shares in 2 years’ time. This would accelerate returns and reduce risk.
Our OUTR investment hinges on an unduly cheap stock price as an avenue to channel cash flows. While this proposition is far from ideal on the hierarchy of investment opportunities, and caps potential upside, at a low enough price OUTR offers a simple and safe proposition to create value via share buybacks.
Though OUTR is the investment I wrestle with most, we gain a measure of security from Coinstar’s steady profits and I think the risk is worth taking at the current price.
Allan Mecham on Cimpress
Cimpress isn’t a new holding; rather it’s the new corporate name of the old Vistaprint. CMPR’s multi-year repositioning is starting to resonate with consumers?and pay off for investors?manifest by a growing base of loyal customers and increasing average order values. Meanwhile, growing asset efficiency (a powerful long-running trend) is combining with rising margins to generate high returns on capital and rapid earnings growth.
Further, CMPR continues to widen its moat via advertising to win mindshare and investments that increase quality and lower costs. CMPR’s dominant competitive position, outstanding economics, and first-rate management team give us confidence in its future.
Allan Mecham unloads XPO Logistics
Though XPO holds massive growth potential, we became increasingly uncomfortable with management’s aggressive stance of acquisitive growth. XPO induced further unease when management expressed 2017 guidance?a dangerous move in our opinion-and we sold our shares. Through a handful of name changes and three management teams our XPO investment proved rewarding over our 7-year holding period, compounding at 28%.
Stay tuned for more from Allan Mecham’s letter