The reason for buying two years ago was that it had this kind of stellar earnings growth that plateaued and the earnings have basically been falling since then. It looks like they’re going to continue to fall for another 12 months to 2 years. So basically to buy a pharmaceutical company, their specialty is antiviral drugs. That means they treat particularly Hepatitis B, Hepatitis C, flu, HIV. 

The problem for them has been that they’ve treated hepatitis C which was their big money makers so successfully that they’ve cured everybody who they’ve treated with it, rather than sort of drip feeding them this over a long period of time and building a really good business. That’s a great thing for the people who have received the treatment, but not so great for the shareholders in the company right now. 

My sympathies are with the people who are receiving the treatment, rather than the shareholders, but I’m a new shareholder, so they’re looking for new revenues for growth. The things that I like about this stock… It’s a $94 billion market capitalization as of today. The enterprise value is about $95 billion and net debt of about a billion dollars, but it’s got $40 billion in cash, kind of balancing that off. So it’s very, very liquid. 

It’s hugely cash flow positive, because they’ve got this drug that’s basically in runoff. They’re trying to find new sources of revenue, but they’re generating cash flow in the meantime so the chances of this going away as a business is very, very low. 

If I look at any of the statistical measures of distress, or any manipulation or fraud or any of those things, there’s nothing there. There’s no indication. The return on invested capital, which is not a measure that I think is particularly useful most of the time, but in something like this, where it’s got patents. It’s got various other protections. It is a kind of useful metric. It’s incredibly high. 

It sits around 73% return on invested capital, free cash flow yield around 15%. So when the return on invested capital Is that much higher than the free cash flow yield, that’s sort of an indication that the stock is probably way too cheap. 

I think, fair value for this stock is probably around $100 to $105, sort of at the low end. With the stock trading around $70, I think there’s a fairly wide margin of safety there. I think potentially, it could be worth more over the next few years, but the issue is going to be declining revenues for the sort of immediate future. So anybody who buys this in the next quarter, you’re going to see revenues a little bit lower. The quarter after that revenue is going to be a little bit lower. 

The only thing that you have going for you in this set, it’s incredibly cheap, and it’s generating huge amounts of cash flow. It’s generating this incredibly high return on invested capital. For me, this is exactly the kind of stock that I like. It might take a few years to work its way out, but by the time that the future is going to look a little bit brighter. It’s going to be a much more expensive stock.

Stig Brodersen  5:55  

Since you brought up this stock pick, Toby, I’ve been asked about this pick for at least a year so I want to say it’s been on my radar [for two years]… Or something like what you’re also saying, because it has been a very light stock, and then it became a very cheap stock. 

For me, I guess it always comes back to I don’t know how to value patents. For me, it’s too complicated whenever I read through the financial statements, and also when I look into the business model, in terms of figuring out how sustainable it is. 

So, Toby, could you talk to us about your process in terms of evaluating patents?

Tobias Carlisle  6:30  

Sometimes I take a slightly different approach to these sorts of stocks. The future is difficult for me to foresee. I think a lot of other people have much [of a] bit of crystal balls in it, but I have no idea what it looks like. 

For me, I sort of have to look at the immediate past and for this stock, it doesn’t look great. The revenues have been falling with it. There are a few things that I should have mentioned. One of them is that they’ve used some of their enormous cash pile to buy another company for about $12 billion. That’ll start generating earnings and income sometime next year I think. 

Then, it’s not going to replace the HIV income, but it’s going to come in at about a quarter of what the HIV income is. HIV is about $8 billion, this thing. I think it gets to one or two over the next few years and then it continues to grow. 

I think that it’s one of those things where the cash flow is very strong. The company’s got lots of cash on its balance sheet. It has bought back some stock. All those are things that indicate to me that it’s got longevity and the potential for something good to happen. I’m just sort of at this price. I think it’s so cheap that I’m prepared to sort of buy it and see if something good can happen.

Hari Ramachandra  7:35  

Falling upon Stig’s question about patents, what percentage of their revenue is from the HIV portfolio of their business? The reason I’m asking is their patents for HIV-related patents are supposed to start expiring starting 2017 to 2021. What are your concerns in that and how can they compensate for those explorations?

Tobias Carlisle  7:58  

The earnings are falling because they’re negotiating the contracts for the sales of this end of the future. For me, I don’t know what’s going to happen. I don’t know how they will replace it, but they are looking for ways to do it and they have the firepower there to do it. 

They’re generating lots of free cash flow already from the existing portfolio. So I sort of think it’s one of those things that revenues continue to fall but as a deep value guy, I don’t really mind that so much, because that balance sheet is pretty strong, free cash flows. They’re still learning what’s on its existing portfolio, and very, very cheap.

Preston Pysh  8:32  

Toby, I know nothing about technical analysis. So I’m just gonna throw that out there but when I’m looking at this, and I’m looking at the top line that we’re all talking about, and how it’s contracting and it’s going down, you kind of take a look at the chart and you’re seeing the price chart, which I think this is the first time I’ve ever talked about a price chart on the show in 165 episodes….

When you look at the price chart, I guess the pattern of the prices just keeps going down, and you’re not seeing much volume trying to stop that from happening. So when I’m looking at a business like this, that’s really big, and has to do a lot of R&D, a billion dollars in R&D to create a new product, and then they have to go through all the marketing, and then they have to go through everything to try to make it a successful drug to potentially start growing that top line again… 

I think they’ve got a tough road ahead of themselves before you’re going to see the price kind of normalize to start taking off again. There could be something. There could be a breakthrough in some type of R&D that they’re doing right now, that could make it pop on a whim. 

However for me, I guess I love the price and I love the valuation on this. I’m not gonna lie, when I did the intrinsic value on this, I got a very high number, double digit number. Though my concerns are more on the technical side of their performance on their income statement and my expectation of what it’s going to look like in a year from now. I think it’s going to continue to contract and I don’t see anything in the volume of people buying that’s going to maybe reverse that anytime soon. 

So I guess for me, I wouldn’t buy this, even though it looks really juicy from a return standpoint, like from a value investing standpoint, it looks really juicy. But I guess I want to continue to watch it and if I feel like I see a large spike in the volume I might miss out on a little bit. However I think it has more to go. I think it has more to fall before you’re going to start to see the price return. That’s my personal opinion.

Tobias Carlisle  10:25  

Risks are definitely going to be lower this time next year. Almost certainly. The thing is that by the time this sort of gets when you can see the runway for this thing, the price is going to be a lot higher. It’s slower than it was a few months ago, but it’s higher than it was sort of six months ago. So I don’t know if that means anything to the technical guys. They can shoot me a tweet and tell me.

Preston Pysh  10:46  

I’m pretty sure no matter what, what comes out of the technical side, it probably won’t be… I just need to be quiet because I don’t know anything about technical [things].

Tobias Carlisle  10:53  

One of the reasons is you can have a look at the price chart from earlier this year. Johnny Hopkins, who writes for the Acquirer’s Multiple blog post, wrote a post about Gilead because he was excited about it. He said, “I want to post this up and I wanted to wait until the earnings data got populated into the spreadsheet from our data providers.”

In that sort of period of time it went, it can’t bounce really quickly from $64, where Johnny had founded kind of up to $67. Then it looked like it was going to get away. I felt really bad for Johnny because he had picked it really well and it didn’t look like it had taken off. As it happens, as so often happens with these stocks, you do get another chance to buy them. 

But it’s one of those things that I think I’ve just discovered a long time trying to buy and sell stocks that if you like the price today, you have to do it today because you might not get it tomorrow. They can take off really, really quickly.

Preston Pysh  11:46  

I agree with everything you just said. Let me ask you this then are you buying a small volume at this point and slowly working your way into it or are you just taking a decent sized position right now?

Tobias Carlisle  11:57  

I bought a chunk of it, and I bought some leaps like six months ago or so. It wasn’t the bottom, but it was in the high 60s, I think at the time that I did it. Then it got a little bit cheaper after that and it’s sort of taken off since. I have had a pretty full portfolio until today. So I’m going to revisit it again. It’s probably something I’ll buy some more of.

Hari Ramachandra  12:17  

I guess what I’m getting from Toby’s point of view is that the price is so low that there are a lot of upside, including acquisitions, which we didn’t talk about, but they can be a potential target for acquisition and a quick payoff from that aspect as well. 

Preston Pysh  12:33  

That’s a good point.

Stig Brodersen  12:34  

All right, so I think that concludes Toby’s stock pick. The stock ticker is GILD, and we’re just going to go around the horn here. So Hari, do you want to go next? Hari, you’re up.

Hari Ramachandra  12:49  

Always fun to sit around and chat with you guys. I’m ready to be beaten up. My pick today is Union Pacific, which is a railroad company. There is a lot of talk about tariffs and restrictions on imports from Mexico and whatnot. 

Union Pacific does a lot of business with Mexico in the sense that a lot of companies, especially automobile manufacturers, transport a lot of their parts through railroads. Union Pacific and BNSF are the two big railroads in the west. 

For those of you who are not familiar with railroads in the US, there are different classes of railroads. Back in the days, that is before 1980, there were many railroads because of a lot of regulations against consolidation. 

However, things changed, and from then on, it’s called the Status Act. From then on, the consolidation started happening, and a lot of synergies were realized, and the number of railroads also started reducing. 

So today, there are only a handful of class one railroads. On the west, we have Union Pacific and BNSF, which is now a wholly owned subsidiary of Berkshire Hathaway. On the east, it is CSX and Norfolk Southern. Of course, there is the Kansas City Railroad as well, which is a small player. 

Some of the interesting facts about railroads is that about 40% of all the intercity freight volume or transported by rail today. Railroad today employs around 185,000 jobs. It used to be 1.5 million 100 years back, so they definitely work a lot on productivity and efficiency. One train replaces around 250 trucks on the highway.

Also some of the other interesting facts about railroads, in terms of their efficiency, is the freight can be moved 479 miles on one gallon of fuel. That’s much more efficient, and also safer way to transport freight than trucks. In terms of what they carry, around 19% is coal. So coal is a major contributor to the revenue. Then chemicals, grains, and wood, and then assembly parts, motor vehicles. Then finished goods and miscellaneous. So that’s kind of the overall contributors to revenue. 

Union Pacific specifically operates mostly in the western region. As I said, most of their volume comes from the ports of entry, which are on Los Angeles, Long Beach on the West Coast. Then BNSF pretty much are neck to neck. If you look at their revenue, number of miles of tracks, BNSF and UNP have a duopoly on the West Coast. 

One of the interesting facts of railroads is obviously their moat. It’s really hard to create another railroad because of all the regulations in terms of land acquisitions and building out the infrastructure is concerned.  UNP has been expanding quite a bit in the last couple of years. Also it has increased its overall efficiency and productivity. 

The reason I picked it is there are some uncertainties going ahead in the next couple of months. Based on how the policies on imports are shaped, it might impact railroads, specifically Union Pacific and BNSF. So this will be a stock to watch. It would be good for us to understand what are the different sources of revenue for this railroad. If there is a panic about this particular stock and if people are ready to throw the baby with the bathtub, it might be interesting for some of us.

Preston Pysh  16:57  

Hari, for me, when I’m looking through this, I go straight to the numbers. Although I think that the competitive advantage piece of it, I completely agree with everything that you said. I don’t see the revenues are really contracting at all. I think they’re going to continue to be able to produce decent cash flow.

However, the premium that people are paying to own it today, for me, is not a buy. I’m kind of curious what you think the intrinsic value like an IRR is, but for me, I’m coming up with…. And I think I’m being very liberal in my assessment as to what I think they’re able to do into the future, basically saying, I’m giving them much more a benefit of the doubt than being conservative with my numbers. I’m still coming up with like about a 3.5% return at the current price, basically saying what they’ve got today, they can continue to sustain into the future. That’s my worst case. 

My best case is saying that they’re going to grow at 7%, and those are the numbers that I’m using as my projections into the future and I’m still coming up with 3.5%. So I guess my question back to you is if that’s a true statement, let’s just assume that that’s a true thing at 3.5%, why not just buy an S&P 500 because I think you’re gonna get the same return and you’re gonna have less risk?

Hari Ramachandra  18:07  

That’s a good point. I’m not recommending a buy at these levels. My assumptions are also that this is not a stock that I will buy, hoping that they will grow their revenue at a faster pace from here. In fact, I’m not even assuming any growth in revenue. I am looking at them as a place to park my cash and earn some dividend. It’s more like an income generating opportunity, but not at this price. I would be interested in the stock when it is in the lower 70s. That’s when it becomes much more compelling and interesting. 

However, it’s good to study this now because I’m expecting that there will be a lot of rumors and news around banning Mexican imports or tariffs on Mexican imports that can drastically impact the revenue of Union Pacific, because they’re already low on their revenues from coal, which is slowly dwindling. That is being compensated by the revenue from imports from Mexico. So there are definitely some headwinds.

Preston Pysh  19:14  

So it’s your number that you quoted there, you’re looking for something in the $70 price range, and when I put that number into my intrinsic value assessment, I get around an 8% return, if you can buy it for like 70 bucks. 

The problem is, it’s not $70, it’s $115 right now. So I’m with you, Hari, as far as waiting until around that price range, but by the time it gets to $70, there might be some other deals in the market that are way better than an 8% or 9% return. 

I also want the audience to know that right now, the dividend on this has given you a 2% yield at the current price. So that’s not a bad dividend and I think that all the money that you’re going to make on this from now, moving forward at that price is really going to be the dividend.

Tobias Carlisle  19:57  

I was just going to throw some thoughts at you on this one. If I look at it on a Petroski Altman Beneish, which are my statistical measures to determine if it’s in any financial distress, if it’s financially strong if there’s any sort of earnings manipulation, so there’s none of that, which is always a good sign. Market cap is around $91 billion enterprise value is about $106 billion, which means that it’s carrying sort of $15 billion in net debt, net obligations, which I don’t typically love. 

If I look at an Acquirer’s Multiple basis, it’s trading a little bit over 13 times, which for a really good business that could be about fair value. I think for this business, I think it’s either just at fair value, it’s just a little bit below fair value, the way that I would calculate it, returning on invested capital around 9%. The return that’s available is about 3%. So it’s a little bit overvalued for me.

However, there are some things that are nice. One of them, it’s got a very stable earnings trajectory and so it is one of those things that if you could get it at the right price, which is $70 is probably the upper limit of the right price. Though that’s well within the possibility of something you would do. It’s probably something that you can buy there and then let it sit for a long time in an account just to sort of accumulate and grow. 

So I think it’s a really nice fundamental stock. I;m a little bit worried about the level of debt that it’s carrying. Just not something that I love. I’m sorry, I shouldn’t say I’m worried about it. It’s just not something that I like to see. Otherwise, I think it’s a good fundamental business, just a little bit expensive.

Stig Brodersen  21:27  

For me, I don’t have too many things to add. I also ran it through our intrinsic value calculator. Whenever I look at it, we are probably around 3% or 4%. So I have similar results as Preston.

In terms of debt that Toby just mentioned, I don’t think I’m as concerned. So you can have different types of obligations that might be more burdensome for the company than others. If a little bit, at least interest bearing debt, it’s not too bad. 

You still have a coverage ratio above 10, which basically just means that you can pay the interest expenses but your operating income at least 10 times. Even though the debt has slightly increased, I don’t think it’s a huge issue. 

Therefore, I think, Hari, that the feedback, to really sum it up as a great business, not a lot to say about that, to bring out a lot of great points about local monopoly, and perhaps pricing power to some extent, even though it’s regulated. But really, the valuation is really the big red flag here.

Hari Ramachandra  22:25  

Yeah, I think I definitely agree with you. One piece of information for the audience is that the previous month in October, US class one railroads together are more intermodal containers in October, than during any previous month in the history of railroads. 

So, obviously, the valuations are basically reflecting the recent trends and the recent numbers that are coming out of all the railroads of today, valued either fairly as Toby was alluding to, are  a little bit higher than fair value. It’s definitely not something that I will buy right now, but I will definitely watch them.

Stig Brodersen  23:08  

When I look at the revenue, and I guess you can say that about a lot of utility companies, you’ll see that it’s more or less flat. You also said before that you don’t expect perhaps growth at all. Is it even possible in this business to grow your top line being as a local monopoly as a Union Pacific operation?

Hari Ramachandra  23:32  

If you look at their revenue growth, it pretty much tracks the GDP. Also it tracks the import and export dynamics between US and Mexico. In fact, I have a chart in my analysis, which essentially tracks the dollar amount of US and Mexico import export and the volumes of freight volumes that UNP is hauling and their revenue from that particular part.

Another interesting aspect of UNP is they own a significant percentage in Mexico’s biggest railroad. So they have some growth coming in from Mexico as well. But again, right now, I think everybody recognizes these facts… Whatever I’m saying… So everything is baked into the stock price.

Preston Pysh  24:22  

Stig, go ahead and talk about your pick because I didn’t know what your picl was until just a couple minutes before when I was doing a little bit of research on your pick and I had the smile because we almost have identical picks. This was not planned in any way but go ahead let’s hear yours first.

Stig Brodersen  24:42  

My pick is Southwest Airlines and the stock ticker is LUV. So what’s not to like about that? It’s a major airline and together with Delta, United, and American, they control 70% of the US market. They’re the biggest at least in measured *inaudible*, and they provide scheduled air transportation throughout the US and also in the international markets. 

One thing to mention just before we talk about the industry is that they have 44 consecutive years of visibility and that’s almost unheard of, especially if you’re talking about an industry like the airline industry. 

Some of the key industry ratios to look at, first of all the load factor. So the load factor, that’s basically the how they fill their seats per mile. If we look across the board, we’re looking at something slightly above 80% in North America, 8.7 to be exact. LUV is one of the best airlines out there with 83.6. Unfortunately, the very best company is Delta. I don’t know if I’m allowed to say that Preston, your pick?

It said 86, the top of the class where Southwest Airlines really makes its mark is on customer satisfaction. If you look at the airlines, that’s its top ranked in all the major airlines. Number two and three, JetBlue and Alaska and then Delta is number four. But [it is] very interesting and people are probably not surprised when I say that United Airlines, they’re not doing that great in their customer satisfaction survey here. 

The oil price is very important, and it’s a high percentage of the operating expenses. It fluctuates a lot. If you look at the past 15 years for Southwest, it has been everything from 16.5 back in 2003 and up almost 38% of operating expenses in 2011. 

Today, it’s hovering around the low 20s because of the relatively low oil price that we see. That’s another interesting factor to consider. So if you think the oil price was still down for a long time, it might be a more appealing pick. If you have a different opinion, you might come up with a different expected yield. 

The rotation for the industry is really not good. I don’t know if people remember Warren Buffett buying into airlines a few decades ago, and he has continuously set almost ever since, I did say almost because he actually just bought into airlines. However, he used to say that he has an 800 number that he used to call and, and say, “Hi, my name is Warren and I’m an air-a-holic,” because he just loves buying into airlines, at least at that time. It didn’t pan out for him as well in the 80s as he had hoped. 

Typically, it’s also a hated industry, because the labor is unionized. So it’s a tricky business to be and definitely to put that out there. There’s been quite a few changes in the airline industry over the few decades, though, which is probably also one of the reasons why you see investors like Warren Buffett and other investors going into the industry. 

Why? It’s still a very competitive business. There are fewer airlines today than they used to be. It typically provides more monopoly and thereby also pricing power in different regions. Like if you are in the Dallas area, you might primarily be flying American ,or if you’re in New Jersey, you might be flying United. So you do have some pricing power. 

Even more importantly, the load patch over the past 15 years has gone from 70% above 80%. It has been very important that you’ve seen this consolidation in the industry. If I look specifically at LUV, I see almost no death, almost no dividend either, but that’s really not that important. I think that the way they allocate the capital is really good. You see a share buyback around 5%. 

However, perhaps the thing I really like to highlight is the moat. If you look at the competitive advantages of LUV, I think it is the culture. Even though it’s very hard to quantify the importance of culture, I think that is one of the very reasons why you see this customer satisfaction being so high for this company. 

This is probably an anecdote more than anything, but the company does not allow any type of art on the walls of the headquarters. Instead, they only allow pictures of employees, friends and family. We spoke to Mohnish Pabrai months ago about this pick and he talked about how the annual meeting people would give each other *inaudible* with this to be something you don’t see unless you a team up with our crew in *inaudible*. 

It’s a very appealing company, both from a mental standpoint, but also for the future prospects, but I’m curious to hear what the group has to say before we talk about the potential growth and the catalyst for the stock.

Tobias Carlisle  29:52  

I’m a big fan of the airlines. They’ve all come in to the Acquirer’s Multiple screener. Delta both and LUV. LUV is just sitting slightly outside of the screen at the moment. I’ll tell you if you think that the reason that I like it, market cap is $32 billion enterprise value. So almost no debt on Acquirer’s Multiple of 9.6 times, so that the most expensive stock in the screen at the moment is 9.2 times. So that tells you how close it is to appearing in the screener.

Of all the airlines, it is probably the best run airline. That’s reflected in a few things. It’s got excellent return on invested capital, it’s among the best companies out there on that basis. I think the price is excellent to where it is. 

The only two concerns that I have is free cash flow yield is very low. So it’s generating a little bit under 5%, our free cash flow basis. If I look at my statistical measures, if I look at my Petroski Altman Beneish, which are financial distress, financial strength, and it’s manipulation, fraud, etc. It’s fine on financial distress. Fine, it’s not a manipulator. 

But [the] Petroski score is 4 out of a possible 9. So that’s sort of towards the low end. I’d have to dig into that and find out exactly why that is but it’s just an observation. Otherwise, I think it’s a good pick.

Preston Pysh  31:13  

Stig, this one also, I agree, I think it’s a decent pick but I’m curious what you got for the intrinsic value as far as what you think the yield is based off the current price?

Stig Brodersen  31:25  

Yeah. So when I did that, I thought it was conservative. Now, we haven’t talked too much about the growth opportunities. I put 7% as my upper band, or with a 25% probability. 3% as my most likely growth rate, 60%… 

The reason why I came up with 3% is because the expectations I think [were] 2034. That’s around 3.3 which is… It is hard to predict and yet it’s not. It has to do with immigration. It has to do with GDP growth and it would not be unreasonable to expect 3%, whether or not Southwest could capture that. That’s always off discussion. 

Then I have a minus two in my lower band, because I’m just very pessimistic, I guess. I came up with an internal rate of return or expected rate of return of 7.2%, which is not great. It’s not something I’m super excited about but I think a 7.2% in times like this, I think that might be if you have some sort of certainty for that, it might not be too bad. 

Luckily, I had a chance to speak with my good friend Toby about this. Just last week, we talked about whether or not actually 7% was the upper limit, given how the market is right now. I don’t know if it is very modernist, but it seems to me to be good if you’re paying the opportunity cost of the market. I’m curious to hear your thoughts about your intrinsic value calculation, Preston.

Preston Pysh  32:57  

I had very similar numbers to you as far as the bands and adjustment that I made, I think that their free cash flow that they had for this past year coming in at 2 billion is what I had for this past year seemed like it was a little uncharacteristic of the previous period of time. So I felt like that was a little high so I adjusted that down, and when I did that, I ended up getting around a 5% to 6% return for the IRR on the company. 

If we split the difference, we just say it’s somewhere in between 5% and your 7%, we’re at 6%. If the market is priced at 3%, and we think we can get 6% with this, double the return of the S&P 500, that becomes a hard decision to go into an individual stock pick, especially something that’s highly regulated, highly unionized, very susceptible to commodity prices as they fluctuate and change. I don’t know. I would probably buy a little bit of it, but it would not be a big position

Tobias Carlisle  33:56  

You’re the abominable *inaudible*.

Preston Pysh  33:59  

I’m not. I’m just a little hesitant because the returns aren’t really extremely fat, and it is a great business. I’m not going to lie. This is probably the best airline company out there. 

Stig Brodersen  34:11  

It all comes down to the valuation. That’s basically what you’re saying, Preston.

Just to provide a few comments to the discussion about free cash flow. I actually think I was conservative when I used the current number as the benchmark. I don’t think it’s necessarily a low number when I see the possibilities moving ahead. 

We can talk about more of that later but the reason why I also want to say that is if you look at the age of the fleets of Southwest, they’ve done massive capital investments, and the average age is 11.8 years. Whereas for say, Delta, of all the four major airlines, they have the oldest fleet of 17.2. 

Now, it is actually part of Delta’s strength, often to have an older fleet and then pay more maintenance costs and then not as much in terms of the cost of some of the acquisitions, but it’s something that I guess it’s my way of saying that if I look at numbers. I don’t think that the current level we’re seeing now is high.

Hari Ramachandra  35:08  

I just wanted to bring up the point there. What’s the downside from here? I was just looking at how they did during the 2007-2008 recession. I don’t see any dip in their revenue during that time.

Preston Pysh  35:19  

Yeah, it’s really hard to believe that the airline industry is recession proof. So it’s counterintuitive. The data at least is counterintuitive to me. When you look at the numbers, I know, at least for the Delta numbers, when you go back and you look at 2008-2009, the revenues were not impacted at all. In fact, the revenues went up from 2007 to 2008 and they went up again from 2008 to 2009, which I was blown away by that. 

However, their bottom line suffered tremendously and most of that was because of the oil prices [that] went up to $150 a barrel during the 2008 period of time. I’m with you. I thought the exact same thing, Hari, but the numbers were telling me a different story. I guess the expectation moving forward is that if you have another credit contraction that the revenues probably wouldn’t be impacted too much with the airlines, which is surprising, but who knows? We’ll see what happens.

Stig Brodersen  36:06  

Yeah, and the thing is I’m very excited to see what’s going to happen next year.  Southwest only just started to grow outside of the US a few years ago. It still only counts for 4% of their top line, and that’s really the focus now.

Typically, the margins are not as good also, because the load factor is not as high for international flights but there is much more room to grow for Southwest than for the other airlines. So even though I always like to be conservative in terms of my estimates, that’s something I do put an emphasis on. Now, keep in mind that I did say that my upper band was just 7%. I want to give that 25% probability… The analysts at Wall Street expect consensus around 10% growth for this company.

Tobias Carlisle  36:54  

The growth rate is pretty strong in the last 10 years. If I look at the data here, I think it was like it’s more than 20%, which is another thing that I found difficult to believe *inaudible*.

Preston Pysh  37:06  

On an annual basis, it wasn’t growing at 20. So that was it? I guess for me when I’m just looking because on our tool here, we plot the free cash flow. We can see graphically what they look like and then we kind of interpolate that line into the future with another line that we can graphically see. I mean, if I put in 10%, if you put in 20%, it’d be… it would not look right. I can tell you that much.

Stig Brodersen  37:31  

Well, if you look at the 10-year average here, revenue, just last year, would be around 8.5%, but then the operating income, we’re around like 15%. I mean, so it might not be 20%, but it’s definitely, I guess a lot more than most people would give you credit for. Again, yes, it does come down to the valuation. Is this a great airline company? It is and we should probably have bought when Warren Buffett did, and he acquired his thing [at] 7% or 8% stake in both Delta and Southwest, if I might add.

Preston Pysh  38:04  

However, the price isn’t too much different from when he got in. I mean, it’s a little bit… It’s definitely higher than when he got it, but it’s not a lot higher. In the summer, both of these picks went way higher, and they’ve come back quite a bit. I know for mine for Delta, it was as high as $55. Now, it’s back down to $48. I mean, it’s contracted quite a bit. I think the opportunity is there.

I’m curious, let’s transition over to my airline. I promise you I had no idea Stig was coming to the table with an airline tonight. I really laughed when I saw that and I was actually coming with an airline as well. So Stig, I’m curious, what did you get for your intrinsic value for Delta? Before I even start my pitch, I want to hear what you got.

Stig Brodersen  38:48  

Yeah, so I didn’t know that you would pick Delta. If I picked LUV… it actually came in a little higher for Delta than when I did with LUV. I think I came around 8% or 8.5%, something like that. I don’t think the airline is as good, but the valuation is definitely more interesting.

Preston Pysh  39:06  

I’m getting a higher valuation than you and I think I’m looking at it with the same conservative eye, as when I was looking at the last one, and I’m getting 10% on this. So when you go from 6% to 10%, think that’s a significant jump in the return. 

When I’m thinking about a person that’s booking their airline, I don’t think that a person, if they can save 100 bucks by going on Delta, as opposed to going on Southwest, I think they’re going to go on Delta every day of the week, for the most part, especially when you get into some of the more expensive tickets. I think people are looking to save money way over the brand of the airline. 

I might be wrong. So for me when I’m thinking through that, the competitive advantage of the brand and all the quality that we talked about what Southwest is I don’t know that I’m necessarily willing to take a cut in the yield that I expect to get for that to happen, simply because I don’t think that it’s a competitive advantage. I mean, it’s definitely a competitive advantage. Don’t let me go to the extreme here. But I don’t think it’s as strong of a competitive advantage as what some people might give to some other type of industry. 

That’s why I think this is probably a better pick than yours. A lot better. Just joking. 

However, I do think that the return is a little bit fatter. I could get into some of the numbers, something that I think has caused the airlines to maybe pull back a little bit from where they were at in the summer, is when you start looking at the revenue. When you look at the revenue for Delta from 2001, up until the year 2016, the revenues had increased every single year during that period of time, which I find just amazing. 

2016 was the first year that you had the revenues actually contract, just a touch. Looking at the trend for this year in 2017, it looks like the revenues are going to go higher than they were last year, which I think is good. However, I think that maybe that’s why you’ve been seeing the price maybe not pop as much as what we probably expected a year ago, just to kind of put some context on this for people. 

So the price of Delta right now is $49 a share, the earnings or the profit that you get for each one of those shares is $5.79 cents. So good luck finding anything like that on the US stock market. 

As far as I’m concerned, I think that you’re going to have a very challenging time trying to find a company that’s giving you that much profit for the price that you’re paying, especially for something that’s this large, and this stable. The debt to equity on Delta is a .5, when the rest of the industry is a 1.3. So their competitors are more than double the leverage than Delta. 

In general, I think that those are all positives. This is something that I’m definitely taking a position in. It’s not a very sizable position, but it’s a position. I think that the negatives here, the free cash flow seems to be holding pretty strong. It’s growing, but it’s not growing at a rapid clip. 

I think already mentioned when Stig was talking, I’m not a real big fan of how regulated this industry is, but I am a fan of how much it’s been consolidating recently. I think that that’s one of the reasons why you’re seeing it as a decent place to be based on the prices and in the profits that you’re seeing. That’s my pitch. I’m curious what everyone else thinks.

Tobias Carlisle  42:27  

I was just going to run through the numbers very quickly as I saw the market cap $35 billion, enterprise value 41.5, so it’s carrying a little bit of net debt. However, as Preston points, there is still very low debt to equity. I’ve calculated 2.6 but Acquirer’s Multiple under 7 times, so it’s slightly cheaper than Southwest, which was Stig’s pick. So I think on a valuation basis might be a little bit weaker. I still think it’s too cheap. 

I picked the DCF around $60-65. Though growth hasn’t been as strong as Southwest but I think that the cheapness makes it a slightly more interesting pick. Petroski’s score is around 5 out of 9, which is slightly better than average. That’s not too bad. 

One thing that’s worth raising the Altman Z-score, which is the measure of financial distress, it has it in a distressed zone. That could be sometimes it’s just that the nature of the business model slightly confounds the statistical models. It’s not something that’s necessarily a concern. 

It’s just when I see something like that, it just tells me that I have to dig into a little bit more. I haven’t had the time to do that at the moment. It’s just something to bear in mind and if it continues to deteriorate, to understand why. However, when I look at the other metrics, it doesn’t bother me that a pretty good return on invested capital is doing much better than its free cash flow yield. So it’s undervalued.

Stig Brodersen  43:47  

So just to sum up, Toby, if I put you in this ungrateful situation of deciding what to invest in, given the current valuation. Would you pick Delta in that case?

Tobias Carlisle  43:58  

Warren Buffett, greatest investor alive, probably greatest investor of the last four or five generations. I don’t know as far back as anybody can tell, he took a pass on that and he bought a basket of them. So there’s no chance that I’m going to pick one over the other.

Stig Brodersen  44:16  

How about you, Hari? Now you heard our pitches. 

Preston Pysh  44:18  

What a squirmy way to get out of that question.

Hari Ramachandra  44:24  

Hiding behind Buffett. 

But I had a question actually, like we are talking about the consolidation, everything growing. Why is the market not seeing it? Is it something that folks are seeing in the sense that it has been historically prone to competition and irrational participants? What are the odds that will not happen again?

Preston Pysh  44:50  

I think it’s just been known as such a hated sector. I think everyone latches on to the narratives that were saying about the unions, about the government regulation, and all that stuff that even as the price becomes attractive, a lot of people are like, “Yeah, but no one ever makes money on airlines.” Then they just stop their analysis there. That’s what I think it is, but who knows? I don’t know.

Tobias Carlisle  45:12  

Part of the problem is that they have this massive operating leverage in it. They leave it to the oil price, which is currently low. I’m surprised that they’re not as *inaudible* to the economy as… Maybe that’s another bias of mine but I do think that if oil moves up, it might be a different complexion, but I think you can see when… I fly a lot. When I fly, the plane is full every single time I fly. So business is good.

Stig Brodersen  45:37  

One thing about the culture that I do want to point out and also just to make sure that it’s not, I guess misinterpreted is that I think that the culture is the most important thing to any organization. Preston had a good point when he was saying, “If I can save, call it, $100 or whatever on Delta. Why wouldn’t I fly with them?” 

And obviously, it’s worse. I don’t see culture like that. I mean, it’s kind of like the same reasons why Bridgewater is successful. I don’t think people are necessarily willing to pay higher fees, to have Bridgewater handle the money because the culture is strong. I think it’s the other way around. I think you are building a stronger company, whether it’s in how you train your company, that’s how efficient you grow if you have the right culture in place. It’s more likely trickled down to the customer rather than the other way around. I think that’s something I want to pay a premium for. 

I know this probably, I don’t know if that makes sense whenever we talked about the calculator, and we talked about whether or not we should adjust our growth rates and if you have high growth, you’d have a stronger culture. I just think at the end of the day, given that we know how important it is with taxes and moving around in your portfolio, that if you want to hold something for the long run, it’s very, very difficult not to hold a company like a LUV or Bridgewater… Whatever you want to call it because the culture is so strong. 

Hari, I see you have a point.

Hari Ramachandra  47:02  

Stig, to follow on your point about culture and the service they provide, I think it can have a tangible benefit, if it reduces the surge cost for customers. Based on my experience and a lot of folks I interact with here in the West Coast, especially in the Northern California, most of us don’t even think about other airlines when we are buying tickets to LA, for example, or any place that is nearby, because we have got enough trust that the prices are usually fair or competitive. 

So, that goes to the fact what Stig was mentioning that culture in itself, the service in itself will not win customers, but the price point is also important. So the customers in the airline industry are very price sensitive. Whatever you do should be on top of the price. You cannot compromise the price. So the culture will not give you pricing power. I don’t think any of the airlines have pricing power.

Preston Pysh  48:04  

All right, so did you guys have anything else you want to talk about? Current event or anything like that that’s just pressing?

Hari, you have something good? Throw it out there.

Hari Ramachandra  48:12  

I wanted to throw at you a couple of points so to just get your reaction. Number one, Bitcoin cash is making a lot of news nowadays. I see a lot of folks in the valley are very excited about Bitcoin cash. 

The second thing I also wanted to throw at you is Ray Dalio, since we are talking about him. He recently made a huge purchase in gold, which was a 573% increase in the state or something like that. What do you guys make of this?

Preston Pysh  48:43  

Hari, you just turned this into another hour episode.

Well, I’ve got some hardcore opinions about the first one. So Bitcoin cash versus Bitcoin. So let’s just give a little context of people if they’re not familiar with this, so we’re obviously talking about cryptocurrency. Back in August, there was a hard fork that occurred between Bitcoin cash and Bitcoin and a gentleman by the name of Roger  Ver was behind the Bitcoin cash fork. 

The big debate goes down to why it ended up working is because there’s one camp of people that think that Bitcoin should be for everyday purchases so that you should be able to go out and buy a cup of coffee with Bitcoin with your smartphone. 

There’s another camp of people that say Bitcoin should replace gold, and it should be what central banks ultimately store instead of gold itself, and it should be the new monetary baseline on a global level. 

I fall into the latter camp. I think that when you think about what Bitcoin is trying to do is trying to fix the monetary baseline so that the central banks cannot continue to print. So I guess this is the question I often ask people, what is Bitcoin? What’s the purpose or what’s the problem that it’s trying to solve? 

I don’t think that it’s necessarily trying to solve everyday coffee purchases. I don’t think that most people would say that there’s an issue there, as far as they’re being taxed too much on the purchase through the currency itself. I don’t see a fundamental issue there.

Where I do see a fundamental issue is that right now, every developed country around the world has a fiat currency that’s pegged to nothing. These governments can continue to print at ridiculous levels, and since the currency is not pegged to anything, Bitcoin solves that fundamental problem. 

We could go into this a whole lot more, but we’ll get into block sizes and when you’re talking Bitcoin cash and the way that they’re scaling this with an eight megabit block, that in the end creates a very big and chunky block chain, 10 to 30 years from now. 

If their solution to scaling is to just increase the size of the blocks that are produced every 10 minutes, in the end, individual people can’t mind that or can’t keep the actual blockchain on their computer. So then that becomes a security concern because now you’re not having something that’s going to be decentralized. In the end, you’ll have something that’s centralized, which actually doesn’t solve the initial problem with the central banking part that I’m talking about. 

So I’m a Bitcoin fan, but I am not a Bitcoin cash fan at all. So I’m curious what you’re hearing out in the valley, Hari, on this one?

Hari Ramachandra  51:22  

One of the speculations in the valley is folks in Asia are behind Bitcoin cash. It’s almost like a cryptocurrency for Asia, and Bitcoin is the cryptocurrency for Europe or the West.

Preston Pysh  51:36  

Well, what it’s really coming down to is miners versus the individual people and a money that’ll fix the monetary baseline. So think about it. All these mining pools that are over in China, what do they want? They want more power and control over the currency. So what they’re trying to do, and you look at one of the guys who’s behind this, he has one of the biggest mining operations there in the world. That’s why he’s trying to make it bigger blocks because what does that do? That centralizes the power into his hands and not into the greater good of people.

Something that Stig and I read about in the Dalio book, and there’s another book that I read called “The Selfish Gene.” It talks about how when something is good for the masses, for everybody, that’s the direction that things will move naturally. That whenever things are only good for the individual, the universe works in ways to always destroy that initiative. 

So whenever I’m looking at this debate, through centralization, through greater power for the miners versus distributed power for everybody, and for the greater good of the world, I think that they’re swimming against the current with Bitcoin cash and I think that the regular blockchain Bitcoin is actually swimming with the current, but that’s my that’s my opinion. 

Just as a word of caution to anybody hearing this stuff, I think cryptocurrencies are extremely dangerous, and we have no idea what this stuff is or what this is going to become. And if you’re actually investing in this stuff, I hope you’re not allocating a large portion of your cash flow to it because there’s just ridiculous amounts of inherent risk associated with it. However, I also believe that with that inherent risk, there are potentially enormous upsides with the market cap, so that a global currency could potentially arise to.

Tobias Carlisle  53:21  

Look a little bit gold. I don’t have any particular view on it other than I think it’s a little bit of a hedge. I don’t have any Bitcoin, I just don’t have the psyche to kind of figure it out. I wish I’d bought some a few years ago. 

I had a client who put $10,000 into the ICO of Ethereum because he liked Bitcoin and he met the kid. He was in San Francisco, he met the kid who came up with a theory.. I shouldn’t call him a kid. But the young guy came up with a theorem. 

He put $10,000 in the Kickstarter, which is what they described it as this is before it was kind of called an initial coin offering. That was worth like $10 million dollars a few months ago, and he was at that stage where he was thinking about the influence of the moon on the tides and how he was going to try it, so I figured he’d sort of lost his mind. So he sold out the $10,000 into $10 million. That actually happened.

Preston Pysh  54:06  

Yeah, there’s a lot of stories. I mean, there’s a ton of stories out there like that. In fact, Trace Mayer is a guy that I follow very closely in this space, because I think that he has some of the best information out there on it. 

Trace was an early adopter, 2010 kind of guy. I think he was buying it at a quarter and I saw some crazy stuff on Twitter where this guy, they were talking about this *inaudible* that didn’t happen, by the way.

But Trace Mayer said something like, “Hey, Roger, I’ll bet you something like 30,000 bitcoins…”Whatever it was, I can’t remember what the number of Bitcoins were that he had that he wanted to bet him. This is just what he was willing to bet so I don’t know what else he had on the side, but the amount came out to be $100 million.

Some of these early adopters and these guys that have bought this back whenever it was a couple pennies, and under $1, and now it’s trading at $72 to $100, they are extraordinarily wealthy. I can only imagine if we’re talking about when you look at the market cap on this thing and this is so crazy when you’re looking at the market cap on Bitcoin right now. It’s around I think $120 billion or something like that. 

If this thing actually becomes a real currency, the global currency, we’re talking trillions of dollars here for the market cap, because you look at what gold is, as far as market cap, I want to say it’s around $4-6 trillion in market cap for gold alone. 

You start talking about derivatives markets, there is $1600 trillion in derivatives, just to kind of give you an idea of how big this is, and Bitcoin is just at $120 billion. So if this thing actually matures and goes to some of these levels, these guys that have those kinds of positions today, and they’re already worth $100 million plus, there will be some pretty wealthy people in the world.

Stig Brodersen  56:01  

They won’t be excited about your Delta pick. You’d be like, it’s not 6%. It’s 10. Well, they’ll be, “Yeah, I just made a thousand X year over the past few years.”

Preston Pysh  56:13  

So I’m looking at the price of Bitcoin. It did 10% today, like literally, now it might do negative 30% tomorrow, but it did 10% today, which is what we were talking about the whole time about Delta potentially giving us on an annual basis. So completely different. 

Like I said, if you want to invest some money in this stuff, go ahead and do it but I wouldn’t use a large substantial portion of your free cash flow. But if this thing turns out to be something, you might be able to pay for your house with a very small sum of money invested.

Tobias Carlisle  56:43  

*inaudible*, dot-com bubble, housing bubble, Bitcoin bubble…

Preston Pysh  56:50  

I might go down in the books as being criticized heavily for this comment, but I don’t see Bitcoin as being anything remotely close to the Tulip mania whatsoever. I think there’s actually something here. I think it’s yet to be seen which blockchain might emerge as the currency right now, it sure looks like it’s gonna be Bitcoin.

Hari Ramachandra  57:09  

Yeah. My last comment is I believe blockchain technology and cryptocurrency are very interesting. However, it’s very similar to the early 1900s when there were many automobile companies coming up at that point of time, if we had to bet it would have been very hard. 

So that makes it very hard to bet on any cryptocurrency right now and I’ve been trying to understand this technology and this market, but I’m still not at a place where I’m confident enough to invest in it.

Tobias Carlisle  57:43  

I love Buffett’s line where he says he didn’t have to know which car company was going to win. It’s known that you wanted to short the horse.

Preston Pysh  57:53  

Yeah, but he doesn’t short anything. That’s a catchy quote though. I guess my point for you, Hari. First of all would be I don’t necessarily buy into that narrative, comparing it to car companies because when you’re dealing with this, I think there’s really strong network effects that take hold when you’re dealing with a cryptocurrency that don’t exist, when you’re dealing with like an individual business with cars.

[It’s] like there’s no major… I don’t want to say there’s some network effects associated with cars. But as far as picking the right brand of car, I don’t see there being network effects associated with that. 

When you’re dealing with a currency on a global scale, I think you start getting into some of these network effects. You know, I could name some of them off like speculation, origin adoption, consumer adoption, security, developer mindshare, where you’re getting the smartest people involved in some of this stuff, and there’s plenty more. 

So I think that that’s a consideration to maybe move away from that narrative and think of it maybe a little bit differently just because of the influence of those network effects that can take place anyway.

Stig Brodersen  59:00  

All right, so, guys. I think that concludes our mastermind discussion about stock picks-slash-Bitcoin cash. If you want to go first, Hari, where can people learn more about what you’re currently up to?

Hari Ramachandra  59:14  

Same blog: bitsbusines.com

Preston Pysh  59:16  

All right, we’ll have a link for that in the show notes.

How about you, Toby? Where can people find out more about you?

Tobias Carlisle  59:21  

acquirersmultiple.com, and on Twitter @Greenbackd, which has a funny spelling and I’ll put it in the show notes. And Ray Dalio, his favorite book, I’ve just got it out now. It’s called the Acquirer’s Multiple, out on Amazon. It’s not his favorite book. It’s on his top five, max.

Preston Pysh  59:42  

Hey, we got just as a side note, we got a note from Ray this week. He listened to our episode that we did as a review of his book, he actually sent us a note on Twitter that he listened to our show. So we were yeah, we were super pumped. So Ray, if you’re listening to this we’re joking. We’re just having a little bit of fun.

Stig Brodersen  1:00:01  

All right, guys, that was all that we had for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro  1:00:08  

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