Hari Ramachandra  1:12  

Great to be here, Preston, Stig.

Preston Pysh  1:14  

I’m kind of curious, Hari. There’s a lot of interesting things happening out there in Silicon Valley with all these IPOs blowing up. What’s the word on the street?

Hari Ramachandra  1:22  

Yeah, as we were talking just before we started the recording, the mood is changing among investors here, and also among professionals, but they are considering companies, who are promising high growth, but nonprofits.

Preston Pysh  1:37  

I mean, that’s been the model since the beginning, right? Just get it to the public markets and let them get it into oblivion. But yeah, I mean, it’s kind of interesting. And then, you had Jason Zweig [who] wrote the big article recently about…what are the limits of the difference between the private sector and the public markets, when they enter.

And I think it was a really good piece that he wrote that was kind of describing how you have these venture capitalists that just keep bidding these things, and then everything kind of is just dumped into the public sector. So some interesting thoughts going on. I’m curious, Toby, have you heard anything on your side down there in California? 

Tobias Carlisle  2:15  

Well, since Stig and I did the recording about four weeks ago now. I was at a conference. Just the one day that I wasn’t watching my screens, which is the best day for value in 10 years. And the worst day for momentum glamour touch stocks in 10 years. They said it was a five sigma move, which value, quantitative value nerds like me will tell you that the market doesn’t follow a normal distribution, so that’s that. It wasn’t quite as rare as that, but the point is that it was a very unusual move. 

And so, what happens when you have changes in regime as you have these very high volatility events like that, and so it’s very interesting. As a value guy, I’m always looking for values that had a really rough run. It’s been very weak, but when it turns, it can turn very violently. And we saw maybe an interesting kind of microcosm what can happen in one day. In 1999, 2000, after underperforming for about 5 years, it caught up. Value caught up to the market and caught up to the glamour stocks in seven months. 

So if you’re looking for a time to get some exposure to value, and you’ve been thinking about it now, it’s probably a good time. You should maybe listen to the last episode of this podcast that Stig and I did, where Stig was pitching a value ETF.

Preston Pysh  3:23  

I found that balance absolutely falls outside of the statistical norm of how value had been moving over the last call it 8 years. But the other thing that I’m kind of curious [about], and I have literally no evidence, it’s much more intuition on this than anything, I wonder how much correlation there might be between just quantitative easing and the performance of momentum investing. 

So, the Fed has been tightening. We see this slow down as far as the underperformance of value, and now, we see value just kind of spike. I wonder if, and this is a huge if, the US Central Bank turns back on the big spicket of quantitative easing if you’d see momentum start to come back into the performance realm.

Tobias Carlisle  4:07  

Well, in 2007, 2009, the market wasn’t quite as divergent as it is now. Value and glamour were quite a lot tighter. But as that market fell over, the Fed was easing the whole way through, and they started quantitative easing. It made no difference whatsoever. But the argument is that value and glamour or value and growth: the two ends of this duration trade. When someone says the duration trade, what they’re talking about is interest rates. 

What a growth stock is, it’s not earning very much now, but you think that in 10-years time. It’s going to be earning a lot of money. It’s earning money at the back end of your analysis. Value stocks [are] earning a lot of money now, but the thought is that they’re going to make less because they’re in declining businesses as you go through. 

Value stock earnings are front end loaded. Glamour stock earnings are back end loaded, and you think about if you drop interest rates, if any of you have done like an intro [to] finance type course, you’ll notice that the impact of lowering interest rates makes those backend cash flows much more valuable, which is why growth stocks do well, when interest rates go down. When interest rates go up, value stocks do a little bit better relative to growth. 

So it’s probably very low interest rates and a very long period of falling interest rates, [which] haven’t helped value. Sometimes it gets out of the control [with] the Fed. [We’ve] seen the [past] 10 years have been sort of gradually rising, gradually spiking. There’s been [a] little inversion of the twos and tens, which typically precedes a recession or depression. 

And often that precedes a big crash in the stock market, too. It’s never not predicted. It’s gone back out of that inversion. I don’t know what that means necessarily, but I would say that the smarter bit from here is probably for value over the longer term, even though in the short-term [no one] really knows what can happen. 

Stig Brodersen  5:42  

What is interesting is that we recently had the sixth worst period of value ever. And I’ve done a little digging into the empirical evidence. So value doesn’t follow the overall stock market, which a lot of our listeners would know. For instance, in the bear market from 2000 to 2003, value did exceptionally well, but fell together with the overall stock market in 2008. What we see looking back in history is that when interest rates are low for a long period of time, and whenever there’s a strong appetite for risk, value does very well. 

Today, we have low interest rates, and I guess you can also make the argument that the appetite for risk is not there yet for value to perform well. But I do think that we’re starting to see less risk aversion across the board, so I side with Toby on this one that now is likely the time to look into value investing. I’ll make sure to link in the show notes to the episode, where Toby and I recently discussed the current market condition, and we talked more about value investing. But guys, let’s jump right into the first stock pick. Who wants to go first?

Tobias Carlisle  6:52  

I’m always happy to put my head on the chopping block first. My pitch in the funds, in the Acquirers Fund long and short, and so, I’ve been pitching a lot of shorts on the show. And I’m doing that again just for the reason that I think that there’s a lot of stuff that’s very overvalued. I think long sort of little bit harder to come by than shorts, but there are lots and lots of shorts out there. And I’m just astonished at the valuations that some of these businesses attract. So, the pitch that I have today is for Vonage. The ticker is VG, and it’s a short. 

So you might remember Vonage. It used to be when you were maybe watching TV 10 years ago. There was a way that you could lower your phone bills, and that was by signing up to get Vonage, which is basically a voiceover internet. They gave you a much cheaper rate. I think for like 30 bucks a month. You could sign up, and you got, you got unlimited calls. So that consumer business is basically what drives Vonage these days and that consumer business is in terminal decline. It’s falling over at the rate of 10% or 15% a year. 

And what they’re trying to do is to transition to a more business offering, where they try and do all of text, and voice, and all these other things for business. They want to be able to embed into websites, and stuff like that. That little part of the business is growing pretty quickly, but here’s the problem for Vonage. I’m probably the only value investor left, who looks at the balance sheet, but I do. And I know it sounds quite [silly]…but I think that at some stage, the value of the business or the performance of the business should be reflected in the balance sheet. And if you see a balance sheet getting hollowed out, that tells you that all is not right on the business side. 

The main problem is that they’re [a] big business. The consumer side is in terminal decline, and the way that that turns up, so Vonage has a market cap of about $2.8 billion; enterprise value is $3.3 billion. So right off the bat, you can tell that there’s about $500 million in debt in there. So what do you get for $3.3 billion? You get a $100 million on EBITDA, so that’s about 35 times. 

And then, I look at all of my statistical measures, like, I look at Peter Trotsky S-score. I look at the Altman Z-score. I look at the Beneish M-score. And they tell you about whether the company’s a manipulator or not, whether the company’s in some financial distress, [and] how strong it is. All of those things are towards the worst end of the scale. 

So [put it] all together, it’s one of the uglier companies out there on that basis. So what they’re trying to do, they have to transition this expensive company carrying a lot of debt from its declining business into the sort of what it perceives to be a better business. The way they’re doing [this] is they’re acquiring. 

And so, for all of these acquisitions, that part of the business is growing a little bit faster, but they’re having to pay up money to do it. And the sum of all of that is that their return on equity is anemic. It’s 1.2%. Return on assets, 0.58%. So this is not a super high growth, super valuable, high quality, high return on investment company. It’s just a very, very expensive online company. 

If you look at the share price, and you see that it’s been going up pretty consistently over the last say, 10 years, 8 years, then you go in and have a look at the way that they’ve achieved that. It’s all multiple expansion. So the P/E right now is 383 times. That’s still expensive. Even in the current day, that’s considered expensive.

Book value, priced books like five times and price to cash flow about 35 times. Maybe these are prices you pay for a super high quality, high growth, high return on invested capital business with a big moat. That’s not what this business is. This is not a great business in a highly competitive industry. So I’m short in the Acquirers Fund. The ticker in the fund is ZIG; the ticker of this thing is VG.

Preston Pysh  10:25  

So Toby, you were saying that the business was declining by 10%. I’m looking at the top line revenue. I don’t have the I’m just looking at 2018 is my last number here. But it seems like the top line was pretty flat. This is a billion, yeah, billion dollars in 2017. It was a billion again in 2018. And then, over the last 24 months, it’s 1.1 billion. So I’m not seeing the 10% decline, at least not in their top line.

Tobias Carlisle  10:50  

They’ve got several business lines in that, right? They’ve got the consumer, which is in decline, so the consumer’s 2017 declined about 13%. Last year about 12%. Likely about 8% this year, probably about another 9% next year, and that’s their bigger business. That business is like $450 million, so the way that they’re keeping that top line growth is they’re acquiring. 

They’re trying to go into a business. They’re trying to enhance their business offering, and the way they’re doing that is by buying up this little, next mode talkbox, new voice. They’re trying to buy these little bolt-on businesses. That’s what’s keeping the top line looking better than it otherwise is. It’s kind of disguising what’s happening.

Preston Pysh  11:25  

I think this is important for people to understand as well. You’re talking about a company that if you buy one share, it’s going to cost around $11.50 today. And if you wanted to know how much profit that one share is going to give you on an annual basis, it’s around $0.15. So I’m with you, man. 

I’m not trying to [be a] sharpshooter at all. I just didn’t really understand that one metric, but the way that you’re describing it, it’s being masked by the debt that they’re accumulating, and I mean, the earnings are just a pittance for something that’s not growing for it to be capitalized that high.

Stig Brodersen  11:57  

Yeah, so I guess like you Preston, I’m not, whenever I look at this stock, I’m not super bull. I’m bull on very, very few things. I guess listeners would be able to tell it, but I’m looking at here, and I’m trying to think, “Hmm, I do see a little insider buying actually. Not a lot, but it’s not likely they’ve been running for the hills, and its value at multiple three times sales.” 

You have gross margins around 60%. What is it that we’re missing? I know all that is being eaten up right now with all the operating expenses. What could we potentially have missed here?

Tobias Carlisle  12:29  

The bull argument here is that the business lines are reasonably high growth and better business. And so, they have been growing and they have been doing a little better, and at some stage that will overtake the consumer side of the business. And then, this is going to be a high growth software as a service type business. 

The problem is that I have to transition to that point. The business market is a lot tougher on the consumer. I think that business makes it a lot more cyclical. Looking at it right now, at the best possible time in the cycle for it, it’s going to get worse as this cycle goes down. 

So, if you look at the share price of this thing, it looks like it’s been doing really well. But then, if you dig into the multiples, the only reason that looks like it’s been going up every year is that it’s just been purely mock multiple expansion to the point now, where it’s nosebleed expensive for not a great business.

Preston Pysh  13:17  

My question is for Hari on this one. So Hari, where you can get in trouble, [which] you obviously know with a short, is if somebody comes along, and they find your assets to be a strategic advantage to them, and then they start buying out the company. That’s going to really give you a hard time. So from a strategic standpoint, would you see a larger company that would find the assets on Vonage’s books to be advantageous for them from a strategic standpoint?

Hari Ramachandra  13:44  

That’s a good question, Preston. I’ve been a Vonage customer for a long, long time. Almost a decade now. And I can view it from a customer perspective, especially on the consumer section of their business. They’re going through a massive disruption, and that’s coming from WhatsApp. That’s coming from Skype that right now we’re [using]. 

What used to happen earlier is that a lot of countries in the world didn’t have cheap data plans. And one edge was this bridge, where we could call landlines back in India or any other country. So that was their unique selling point. Our valuation. Whatsapp and data becoming cheap, both companies and customers or consumers are shifting to these new technologies that have transformed this voice calling. Voice or data as they call it. And Vonage, I don’t think they were able to adapt in time and their value prop has become very weak. It does look like it’s the technology of the past not of the future.

Preston Pysh  14:42  

I’m on board with you. Looking at it from the outside, I definitely don’t have the technical background that you have in a lot of these areas. But I mean, it just doesn’t seem like this is something that’s going to perform too well moving forward. So I’m not one that really likes short individual companies because of the risk of somebody that you just don’t understand what their strategic interests are coming in and sweeping it up, and buying it at a premium, then you just get wrecked. But I’m with you, Toby. I think it’s a pretty ugly, highly capitalized company that doesn’t show any prospects for the future.

Tobias Carlisle  15:11  

On the acquisition front, they have this old technology, but it’s the consumer side. The value of that, I think is declining and debatable. the business side they’ve been acquiring. They’ve been buying things to get it to this point, and what they’ve been paying, so they bought Tokbox. They paid $35 million for TokBox. So that’s 1% of the enterprise value of this thing. So I don’t see the TokBox being the thing that people come hunting for. 

Next Mode, they paid $230 million for, and this is in the context of a $3.5 billion company. NewVoiceMedia is their biggest acquisition ever. They paid $350 million for that. Someone’s going to come along and pay like a ten times for their biggest acquisition ever to even get to the value of this company. And I just don’t see it happening. 

Preston Pysh  15:55  

Let’s go on to the next one. Stig, I hate to put you on the spot, but I kind of want to talk about yours. I like your pick.

Stig Brodersen  16:01  

Yeah, so talking about old technology and perhaps not being fit for the future. Let’s talk about my pick, which is AT&T. I guess that most of our listeners are already familiar with AT&T, but is an American, international conglomerate, and it’s the world’s largest telecommunication company. Since June 2018, it’s also the parent company of the mass media conglomerate, WarnerMedia, and that’s also made it the world’s largest media entertainment company in terms of revenue. Actually, if you’re looking at 2018 numbers, AT&T is number 9 in terms of the biggest American corporation by total revenue. 

There are a few reasons why I have AT&T on my radar. One is that it’s very difficult to find the stable yield these days; stable high yield that is, at 5.4% with an excellent dividend history, and very stable numbers in general. It’s an interesting stock just for that reason. Dividend has grown every year for 36 years. So if you are a dividend investor, it might be a stock you want to take a closer look at. Another reason is that Elliott Management Corporation announced earlier this month that it’s taking a 1% stake in AT&T as an activist investor, and they said that the stock price could go up as high as $65. 

Right now, it’s trading at 37. I’m not as optimistic as they are, and I will elaborate more on that later. But I do think that they have quite a few good points on where AT&T could go here, and perhaps be soon trading at a more attractive valuation, especially given the current market conditions. If you look at the performance over the past 10 years, AT&T stocks underperformed the S&P 500 with more than 150%. So they only returned for the 2% compared to the broader market that’s delivered 193% return. 

And it was actually so severe that Dow Jones cut them off. They actually used to be [highly profitable], including predecessors, since 1939. So that was something that sort of surprised the market despite their current underperformance. So if you look at the industry in recent years, they have been very aggressive in their mergers and acquisitions strategy. And they had a series of deals totaling almost $200 billion. 

And the intention for AT&T was to become a diversified conglomerate by pushing into new markets. You can kind of like see it as this [company that] started the decade by being a pure play telecom company with leading wireless and wireless franchises. And now, they are more a collection of businesses, new markets with the different regulations, and include some more special franchises and before. 

So let me give you a few examples. They bought T-Mobile, $39 billion; DIRECTV, $67 billion; and thereby, they also became the largest paid TV operator in the country like [I] mentioned before. They also bought Time Warner of WarnerMedia valued at $109 billion back in 2016. 

That was completed here in 2018, so very, very interesting company right now. If we look at the valuation, we can talk more later about some of the catalysts and why it can happen. If you look at the valuation, I’m looking at a TIP multiple of 15. So that’s the EV, the enterprise value compared to the operating margin, and at the face of it, it doesn’t look super cheap. But it’s not also very expensive, I’d say given the quality of the company in the future prospects. 

They have a positive momentum, and in my valuation, I used a 3% as my most likely growth rate and allocated 50% as my most likely scenario. It probably seems very low, whenever you look at the historical growth in revenue, but keep in mind that this has happened by leveraged acquisitions. 

So whenever you have a top line, that’s fueled by debt, you simply don’t want that to continue for too long. Also, I allocated a 25% probability of 10% growth happening. And that could happen if they would become the leader in 5G, which is probably something we can talk about more, and thereby reclaim the market leader position in the industry, where they already make half of their profit. And then, as a conservative estimate, up to 25% probability of a zero percent growth. 

So whenever I do that, I use a normalized free cash flow of $22 billion, which is probably a lot less than will be this year. I think they are on target to get closer to 29 billion, but if you use $22 billion, given those assumptions, I’m going to be close to 11% return. So guys, this was sort of an obvious stock, so I’m curious to hear what you had to say; talking about old technology. 

Preston Pysh  20:55  

So Stig, you had mentioned there was a figure thrown out by some analyst that put the price at $65. Is that what you said? 

Stig Brodersen  21:02  

Yes. 

Preston Pysh  21:03  

So, whenever I did this, like you, I mean, we’re using kind of the same tool here as far as calculating the intrinsic value on it. I had a little bit more pessimistic numbers for the future free cash flows. I was just probably me being conservative with it because I hadn’t done as much research as you had. And whenever I did that, I came up with an excess of an 8% return based on the current price. But what was interesting is when I plugged…let’s say the price went to $65. What was interesting is the IRR became around three and a half percent, which is where the rest of the market, the S&P 500 is priced. 

I found that interesting that they’re saying that that’s their price target. Looking at the top line, it looks super healthy. The fact that you said that you’re expecting the free cash flows to be that much higher than they were last year, I think is just really exciting. From a momentum standpoint, on our TIP Finance Page, the momentum is green. It turned green fairly recently, actually. 

September second timeframe, this turned green on our momentum tool. So, for me, I’m pretty excited about this. I think this is a nice, stable, large company that’s kicking off a lot of cash flow for the price, and it’s got good momentum indicators. I like it. 

Stig Brodersen  22:14  

Whenever it turned green that coincided with Elliott Management going in, and saying, “Hey! By the way, management, you should change a few things here. And we think that the price tag is a lot higher than it is right now.” The market definitely appreciated that. And I actually like to talk about some of the things that they highlighted, kind of like as a basis of saying where it could go. 

So first of all, they talked about selling off assets. And it’s very difficult to find, I guess, any activist, who are looking at conglomerates without saying, “Hey, let’s focus on what we’re good at, and then use that excess cash to buy back stock, and focus more on the most profitable business units.” There is no difference. 

For instance, they would really like to sell TV. It has not panned out as well as I guess, as AT&T would hope. It’s been in decline ever since they bought the company. And it’s one of those things where you would say, “It would probably be a good thing.” This is not really what they do. 

Again, they are a conglomerate, but this is probably not what they do. This is not where they make the most of the money. They already have a lot of debt. Perhaps that’s already trading an attractive valuation, at least you would say that by definition as an activist, so perhaps we could apply that cash better. 

I don’t know if they can get the $67 billion back, and they also need to find a buyer, who can swing. Something like that, but I sort of do agree that it might be a better option for them. The interesting thing is that…the CEO has been out saying, “No, that’s not what we’re going to do. That’s not the strategy,” and I wonder why. Like most CEOs, especially for conglomerates, they do not buy into the activist argument that we should be more focused. That’s not where they’re saying at all. 

Another example, and one of the reasons why I might be slightly more optimistic than Preston, but not as optimistic as Elliott Management is that they are calling out for cost cutting and more efficiency in operations. And it’s just one of those, whenever I read that, I said, “Yeah, I mean, it’s not like I disagree, but show me this top 10 conglomerates in the world that can’t be more efficient and where you can’t play around with your Excel sheet and say, ‘We should increase our margins by 3% because right now. There’s too much red wine, private jets, and PAs running around. Is that really going to to happen?'” 

And the other thing is also that so much cash is already spent on dividend payments. And yes, you might say, “Oh, let’s be better capital allocators.” Keep in mind, I mentioned before, this is a company, who had high dividends for 36 years straight, and they have healthy cash flows. You are not the CEO who’s going to be like, “No, no, I don’t want to do that. I like that activist, who was saying, “I should stop paying the dividends. I should sell my assets that give me all this influence, all these employees, and then start making a special dividend or allocate differently than we’ve done before. We don’t want to be this conglomerate having everything.” 

So I think that’s one of these concerns, where I’m like, “In theory, it would be fantastic. In practice, that’s probably not what’s going to happen.” So, I don’t think you can be as optimistic about the future. Yeah, I didn’t realize the payout ratio was 70%. That’s pretty high. I mean, it’s trading at $37, and it pays a $2 dividend that’s really high.

Hari Ramachandra  25:47  

I think, Stig, the way I think about AT&T is that they have a very stable revenue source. I don’t see a disruption coming in terms of their main cash cow. However, what I’m worried about is their investment discipline. The assets they bought, whether it is Time Warner or…there is no network effect for them, so it’s not helping them grow. If we are thinking it more like a bond, yeah, maybe fine. But I’m also worried about the payout ratio as Preston just mentioned.

Tobias Carlisle  26:17  

From my perspective, it’s, I think it is a little bit undervalued. But I don’t think it’s undervalued for a slow, stable growing business, growing at the rate that it is. Pretty anemic, returns on equity. And returns on equity is about 9 1/2%. Return on assets is about 3%. And the reason that there’s a big differential there is it’s carrying a couple of hundred billion dollars in debt. So market cap, $275 billion; EV, $470 billion. 

That means a couple of hundred billion in debt, which is pretty chunky, but haven’t been a great [investment], haven’t been great at buying back shares, and they’ve been paying out most of their money. I think that the most interesting thing about this is that Elliott is in there, and maybe Elliott can do something with a capital structure, and with the way that they allocate capital. 

As it stands, I don’t think it’s particularly interesting. But Elliott is a very smart activist firm, and a very aggressive [one], too. Very tenacious. So if Elliot has seen something in there, then I think it would be worth taking a little position, just to see what Elliot can do.

Stig Brodersen  27:20  

Yeah. And it’s interesting because it also really depends on how much they want to do. For instance, Elliot or the activist. It’s a massive company. It takes billions and billions of dollars to have any say, and keep in mind, they only just bought a bit more than 1%. So far, the way I read the year management statements is that they don’t really care. If you read what they say, they say, “Yeah, we’re already doing what they’re saying that we should do. And we already paid off $9 billion in debt this year. It’s not a lot of debt.” 

And they’re also saying, “Yeah, we should probably start looking into share buyback because there’s close to no cost to debt right now,” which in itself is a sort of disturbing statement, I guess. I do think that where there is a really interesting game-changer for the future of the company and for the future free cash flows that’s already on showing it a positive directory is that if they indeed become the leading provider in 5G, so right now it’s Verizon. And it’s sort of like too early to say who will become the best in 5G. They all have a fantastic distribution system. And just to give you sort of like an idea of what we’re talking about, it’s like, “Oh, 5G. What is that?” 

So if you go back in the day, back to 1G that was sort of like a voice only service or an analog network. 2G, I think [was] text messaging. That was sort of like. That was what you could do with that technology, but still it was pretty huge! 3G web browsing video call. 4G, that’s sort of like where we are now. It allows us to stream all our Netflix. Ride sharing with Lift and Uber. 

And now, 5G is just so much faster. It’s approximately 10 times as fast. And it’s, I’m sure Hari can laugh at my explanation of the difference between these technologies here. But it’s something called latency. So it’s kind of like a packet of data that is traveling to a receiver or a network. And it just allows for almost a real time experience that you can’t do now with 4G, but you have that with 5G, so that would be like multiplayer gaming, and very video intensive services. It can potentially be a game-changer. That’s already where they’re making 49% of all their profits. 

Tobias Carlisle  29:41  

I love these rebranding exercises for the technology, but it’s going to stick another number in front and charge you twice as much. Here you go now, 5G! Enjoy it twice as much. 

Preston Pysh  29:51  

I’m going to go ahead and pitch mine if you guys don’t mind. Okay, so I just want to put a quick plug out there for one of the services that Stig and I have on our website. We have these intrinsic value assessments that we do. The one I’m getting ready to talk about is one that we published on the seventh of July for a company called stamps.com. These are completely free on our website. We publish about two of these per month. And we have a kind of a systematic way of analyzing a particular pick, where we go through; we talk a little bit about what the company is. We then show our math of how we’re coming up with our intrinsic value of the business. 

And then, we talk about opportunity costs. We talk about the competitive advantage of the business. We talk about risk factors of potentially owning it, and then just an overall summary. Again, these are completely free on our website. We publish about two of these per month. So if you guys want to get access to this, or you want these sent out to you, you can go to tipemail.com. That’s tipemail.com, and you can get a bunch more information on it there. 

Anyway, so when we first published this article, and I got to give a huge shout out to Christoph Wolf because he’s the one who kind of gave us the hand off on this. When Christoph handed this off to us, it was at $46.33. And today, we’re already at $74.26. So we’ve already had a, a significant move on this one, since the time we published this. But with that said, even though we’ve had a huge jump in the price, I still think that there’s quite a bit of value here. 

A little bit of context for people, so stamps.com, I think everyone’s pretty familiar with it. [It’s] where you can basically print your postage, stick it on an envelope, and mail it out straight from your house without having to go to the UPS. Super convenient. This stock was trading at a huge price just in July of 2018. 

So a little bit over a year ago, this was at $283 when it peaked. It had gone down to $37. Now $34 back in May. One of the reasons that this went through this significant decline is due to this negotiated service agreement that stamps.com had with the US Postal Service, and that contract that was pre negotiated that got them the rates that they had been severed. 

And then, they went into different agreements afterwards, which ended up giving stamps.com more flexibility. And I think this is another misnomer that a lot of people don’t understand is that stamps.com was the one that initiated the termination of that negotiated service agreement. I think a lot of people on the surface might have viewed that as USPS severing that relationship, but it was actually stamps.com that severed it. 

Now, it went through two significant price declines down to the really low price that I was telling you guys earlier. But where I think this one gets really interesting is in the numbers, when you start calculating the intrinsic value on this. So when I go into our intrinsic value tool here, and I’m punching in the numbers, the free cash flow right now is around $273 million a year. It’s the free cash flow on the business. When you interpolate that out in the free cash flow has aggressively been going up in the past, I would say, 3 to 4 years. So, I have a little bit of a concern as to how well they’re going to be able to sustain that. 

And so, whenever I was interpolating those free cash flows out into the future, I was pretty pessimistic by basically saying that there’s not going to be any future growth in the free cash flows. In fact, I think I even incorporated maybe like a negative 1% decline overall across the whole array of potential outcomes. 

Whenever I did that, and I looked at the number of shares outstanding, the current price at $74 a share, I’m getting an IRR in excess of 15%, even with the free cash flow is kind of descending into the future. By descending, I’d say like one, negative 1%. So that’s, for me, really, really exciting, especially when you look at your other opportunities in the market. The S&P 500, you buy that today, you’re going to get 2% or 3% return assuming everything can remain stable with everything that’s going on from a macro standpoint. 

So something like this, I think is going to do quite well, mostly because it’s had so much just punishment in the open market on the market cap. And I’m pretty excited about it. There is no dividend that’s paid, so all the money that you’re going to make is going to be recouped through the price appreciation or the market cap growth. But I see it pretty solid. I’m kind of curious to hear what the group thinks.

Stig Brodersen  34:21  

Preston, it’s interesting, what you would say there with the US Postal, and that agreement being severed. And when I was looking at it, and you’re reading the statements there for stamps.com, [which] they were talking about. They’re betting big on Amazon. I have a really hard time seeing the future. I’m not just talking about next few years, but it seems like Amazon is the reason why they’re so successful or potential is so big, but it’s also the threat that it can go over and just basically cut out stamps.com. I guess my question to you is: Why would Amazon.com, with everything they’ve been doing in terms of deliveries, ever need stamps.com? I’m not talking about tomorrow. I’m talking 5 years, 10 years. Why would they need them? 

Preston Pysh  35:04  

Well, I guess I looked at it from [the point of view of] our own business. If I need to mail something out, I go to stamps.com. I print the labeling, and I send it out. So I think maybe you’re dealing with small businesses that are heavily using this service. I think one of the biggest assets that they possess. [It’s] just their domain and their brand. I think that their brand is so easy to understand. And it’s something that people just immediately think, at least here in the United States, [we] are just like, “Oh, well, if I need to send something, and I want to send it from my house, and I want to print the labeling off of my own home printer, [I just] go to stamps.com.” I mean, it’s just pretty straightforward.

I think that’s a huge asset for them. I think if anything, if they are going to be taken out of the market or somebody else is going to eat away at their market share, they’re probably going to go after them just to buy them is what I would suspect because of that brand power.

Tobias Carlisle  35:56  

I really like this one. I think it’s rare that you get a chance to buy something that’s growing as rapidly as this; that’s generating the returns on investment that it is at a price like this. The market caps 1.27 on my numbers; enterprise value is 1.24. So no net debt to speak of. If I look at all of the risk metrics, it’s safe on Altman Z. It’s not a manipulator on Beneish M. EV/EBIT Acquirer’s Multiple’s site, 8.7, so that’s pretty cheap. And it’s growing really, really rapidly. They’ve been paying down their debt, operating cash flow, [and] free cash flow exploiting.

Preston Pysh 36:31  

Hari, any comments from a tech standpoint on this?

Hari Ramachandra  36:31  

I feel what you said Preston is correct. Like once you have a brand name, it’s not easy for somebody to just replace them like how Amazon bought over diapers.com for example. They might force them to sell it to them, but I think Amazon is much more under scrutiny now. So it’s not going to be easy for them to do something like that.

Preston Pysh  36:53  

I mean, I think you could make the case that it’s a great, I don’t know [if]] “buyouts” the right word, but for an Amazon-type company to start coming in and taking a large chunk of the equity in the open markets, and then using that for their own influence or whatever, I don’t know. But I just think that the price right now [is good], even after [setbacks]. I wish we could have recorded this, when we published this on our site. 

[It’s], I mean, it’s…big from when we wrote this, and put this on our site. And I still think there’s a lot more to go. So I’m pretty excited about it. And it’s a recognizable brand that I think a lot of people can just understand inherently, as well. So all right, well, let’s go head over to Hari! Hari, look, what do you [have]?

Hari Ramachandra  37:33  

This somehow *inaudible* company from India, it’s called Reliance Industries. It is the largest company in Indian stock extended by market cap. That’s $120 billion, so think India market cap. So the interesting thing about this company is that they started out as a textile company, but expanded it to petrochemicals. 

Now, they do everything like oil exploration refineries and petrochemicals as well. That used to be their main source of revenue. However, in the last couple of years, probably four years, they started expanding into mobile with their new brand that they launched called Jio. And within three years, they became India’s number one mobile carrier, and world’s number two largest in terms of subscribers. 

To view a comparison AT&T, which Stig has pitched, has 158, correct me if I’m wrong, Stig, subscribers. Today, Jio, which is Reliance’s mobile carrier has 314 million subscribers. The next four competitors put together are still smaller than the Jio brand, so that’s a huge growth potential for them. They have been blowing a lot of money into it. In fact, I believe they invested almost $50 billion in the last 3 to 4 years in laying out all the fiber [and] the wireless towers that were needed to roll out this plan. 

So recently, this month, they launched JioFiber, which is like home broadband. Now, their base rate will be 100 Mbps. And to give you a comparison with average internet speed in the US is 90 Mbps; base rate of 100 Mbps, and go all the way to one gig. What they’re doing is pretty interesting, and that’s the bet they’re placing, and we’ll have to see how it will play out. That’s starting with mobile, wireless, and internet for homes. They provided for cheap, but then they offer other services like they have their own Netflix for India. That’s called JioCinema, which basically is Netflix’s competitor. 

They have their own PayPal kind of a thing, wherein you can transfer money online through mobile. And in India, mobile payments are very popular, so they’re going to be capitalizing on that. Charging per transaction. Apart from that, they also have the largest TV network, including, it’s called, Network 18 that owns both CNBC India, and Nickelodeon, and CNN India. 

Also, they also have print media. They have Forbes India. [It] is owned by them. They started out [in] textile, oil and gas, and [then] refinery business. They’re still being seen as one. For example, Jio was not even there 4 or 5 years back. Now it is 22% or 23% of their revenue. 

One other thing that is interesting is they’re one of the fastest growing retail brands, so they have Reliance Retail, which contributes shares on 10% of their revenue. And they have more than 10,000 stores, and they’re opening almost 10 stores every day. In retail, they’re into grocery. Let’s call it, Reliance Fresh. They have Reliance Smart, which is basically electronics. 

And they also have their own mobile phone, Jio brand phone. [A] branded phone, which they sell through their outlets. And then they have Reliance Trends, which is selling clothes. They have their own popular textile brand called Only Vimal, but they also sell other brands, so the retail is growing very fast. 

And on top of that now what they’re doing is they’re growing on a e-commerce platform for all small businesses very similar to Alibaba, where they can sell online. So I see a business that is in transformation to becoming a digital services company. However, if you look at their P/E ratio, it’s around 19, 20. They’re still being valued as an all-time traditional business, so their total assets are $142 billion, but they have debt of around $40 billion, and their total liabilities are around $86 billion. 

One of the companies is taking some steps to reduce this debt burden, and they needed to take on this debt in order to lay out the infrastructure for Jio. That cycle is now complete. So, they’re now investing 15 billion or basically paying them $15 billion for a stake of 20% in their oil and gas business. So my guess here is that it’s a, it’s a business in transformation. The market doesn’t see it that way yet. It’s India’s sector growth in the next decade. 

My pitch for Reliance is that it’s a business in transformation, getting into digital services. One of the best companies to take advantage of the growth in India. However, because of the perception of the market about the company in terms of them being an oil and gas company, and also some concerns about the debt they have on their balance sheet. They’re not being valued as such.

Tobias Carlisle  42:44  

I think this is a really interesting idea because they’re transitioning from a refining business to this telecommunications business. [They] have spent $50 billion, and it’s all in debt, which is why the balance sheet looks so bananas. 

However, Ambani now says that they’re going to start paying down the debt, making it look to free up some of the real estate and various other things that they have to pay that down. It’s an interesting position to watch. It’s hard to kind of see at the moment. I think you’re paying a slight premium for the retailing business [and] for a telecommunications business that really has yet to prove itself. For me, it’s not a long just yet, but I think it’s definitely worth watching.

Stig Brodersen  43:25  

So I really like this pick, Hari. And I know you briefly said this is not Alibaba, and still it is…you are thinking a tech giant that’s just ages behind Alibaba. You’re thinking something like that. Catch it right now before it explodes. If you can even say that for a company that’s valued more than 8 trillion rupees. One dollar is around 70 rupees, so it’s already a massive company. But where I do see some resemblance with…for instance, Alibaba, you can even say Tencent, that they are betting big on GDP, and I know that’s kind of like a very simplistic way of saying it. 

But they are betting big on the economy going well, which I guess most people have a consensus about. This is what we will see in India. And they have a lot of advantages, not just because it’s so difficult to enter India, and it’s super, super difficult. So they are building the infrastructure for the consumers to consume. 

And not even just that, they looked around and said, “Let’s have access to the wallet. Let me do Alipay. Let me do Wepay and just have access not just to the infrastructure, but to the very wallet of people before they start spending [their] money on our goods. By the way, and have everything in a close loop?” 

And I think that it probably doesn’t seem advanced, or it probably doesn’t seem like, “Oh, that’s so unique,” but it’s just so difficult to do. And they seem so well positioned to do that. Makes a lot of sense what they’re doing here with the Saudi Aramco deal that you talked about with a 20% stake for as much as $15 billion. 

I do think there are a few red flags. As far as I can tell, reading through some of the things that management have said, and the way it’s been managed. They haven’t really been that open about debt load before. We already have a coverage ratio at less than four. And I know that might come off as a bit cynical, whenever I would point that out, just having pitched AT&T with all that’s debt. 

But I do think that the stability of the cash flows are very different. I also think one thing that concerns me is that you have a lot of people, who are saying that what’s reporting on the balance sheet is actually not the type of debt that they have, like the real debt they have is actually a lot more. And the reason for that the management is saying, “Well, it’s interest bearing debt, and that’s the only thing we need to report.” 

With this, [it] can be sort of argued that’s the case. They have given so much credit that it’s almost like they’re doing it like an internal financing those years [and] years of credit, where I’m like, “Hmm, yeah, it might be true that you’re not supposed to include that in your calculation of your coverage ratio or however you want to put it, but in terms of how you’re managing the company, it’s sort of like an interesting number to…let’s call, ‘adjust.’” That’s the positive phrasing of that word. 

So I guess that would be some of the concerns I have with the company. Perhaps they’ve been a bit too focused on their growth in the short-term, and it might not be good here in the next phase that they’re entering.

Hari Ramachandra  46:32  

I agree with you, Stig. I think the way I’m seeing is also, it’s an option *inaudible* as I said. Catching some companies like Alibaba at the beginning. And as you know, Alibaba went through its own bumps on the way, and I’m sure Reliance will also have its own bumps. It’s going to be a bumpy ride. But thank you, I think those are really good points, and we have to be cautious while we are looking at its balance sheet.

Preston Pysh  46:55  

So for me, I’m looking at it. It’s a huge company. I’m looking at the top line, and it’s definitely moving in the right direction. But it’s not this perfect, just steady growth stream that you see with Alibaba. And you see with Amazon. I think if somebody is trying to make that comparison saying that, “Oh, we’ve got the Indian version of one of those companies.” I don’t necessarily see it off the top line like you did with some of those companies. 

I think it’s also important to look just at the free cash flow of the business, and…you can see in the numbers that they’re capital intensive in a major way. Out of the last 10 years, I’m looking across the free cash flow, and it was positive only 2 of the last 10 years. So, I think it’s an interesting pick. 

I’d have to do a whole lot more research on it to understand the valuation, and I guess I just have a little bit of reserve with it based on a few of the things that I’m seeing in the numbers, but it definitely seems like something that one other thing that I found interesting was on the current ratio for the business. 

It’s less than one, which typically [sticks], if somebody can sustain that, which they have, or a business can sustain that. They’ve sustained that for the past 5 years, where[in] their current ratio has been less than one. That tells you that they’re a force to be reckoned with, [especially] with their subcontractors and their counterparts. 

The vendors that they’re dealing with or having to put up with their price demands or their payment demands, because that’s very rare that you see that. We’ve covered companies like Walmart and some others that can do that kind of pricing. Or I shouldn’t say pricing, but that repayment or that trade off with their vendors that they basically give them money a whole lot slower than the vendor has to give it to them. 

So I think that that’s kind of a unique characteristic of the business that shows that they do have a lot of power and a lot of force in the business sector. And it’s probably a good indicator to show that they have some room for growth moving forward, but I’m just kind of a little skeptical on some of the top line growth and some of the other factors that I mentioned earlier.

Stig Brodersen  49:00  

We talk about the top line. We talk about a lot of numbers and the way it’s been displayed. You can buy this as in so-called ADR in the States. It’s RLNIY, but just keep in mind, whenever you’re looking at this, this isn’t rupees, and definitely we’ve seen a lot of stabilization with the inflation rate. 

It’s just below 4% now. You would have to go back to more than early 2016. [It] just was a slightly higher than 6%. And then, it was 12% back in 2013. So that’s just something to keep in mind, whenever you look at something that triples or doubles or whatever it’s about to do. You have to discount it if you come from a country, where you’ll have as much inflation because that would be reflected in the exchange rate. Not going into a long discussion about demonetization and monetary policy in India, but it is something that you should, where you should allow yourself for a margin of safety of something like that happening.

Preston Pysh  49:57  

Well, I think that concludes our discussion here, guys. As always, this is just such a blast to hear some of these different ideas and to kind of pick through each other’s thoughts, but Hari, Toby, tell the audience a little bit more about yourself, where they can learn more about you. Go ahead, Toby, you take it away first.

Tobias Carlisle  50:14  

If anybody wants to see a list of free stock picks on acquirers, acquirersmultiple.com. You can find me on Twitter: @greenbackd. It’s a funny spelling: G-R-E-E-N-B-A-C-K-D. Or you can see my portfolio, which includes the longs and the shorts; the stocks that I actually hold. Go to acquirersfund.com. 

Hari Ramachandra  50:35  

You can find me on Twitter. My handle is @HariRama; on my blog, bitsbusiness.com. And I look forward to engaging with you all.

Preston Pysh  50:46  

Stig and I both just want to thank you because you guys always make time for both of us. You come on once a quarter to have these discussions. And it just really means a lot to us, so I just want to personally thank you guys because we don’t do that enough.

Tobias Carlisle  50:58  

We absolutely love it. Thanks very much for having me on. I love chatting to you guys once a quarter. 

Hari Ramachandra  51:03  

Same here.

Preston Pysh  51:04  

All right, so real fast, guys! Now that we gave you that praise and the thank you, I got a question for you. Can we get you guys to commit to the 2020 Berkshire Hathaway shareholders meeting?

Tobias Carlisle  51:15  

Yeah, I’ll be there. I’ll be running around in my ZIG hat pushing my ETF if anyone will talk to me. 

Preston Pysh  51:22  

Hari?

Hari Ramachandra  51:22  

I’ll be there with a probability of 90% right now.

Stig Brodersen  51:26  

Fantastic. We’ll make sure to post a link to how to get your credentials, [how] you can get in, and where to meet up with the entire Mastermind Group or at least 90%. Hari [won’t be there], but Preston and I and Toby are coming for sure. And we are going to invite a lot of the guests starting from now on until the Berkshire Hathaway event. So a lot of the guests that we have here in the show, we’re going to ask them if they want to come out and hang out with us. So we’ll make sure to put all that information on the site that we’re going to link to there in the show notes.

Preston Pysh  51:54  

And if anybody listening to this wants to have us invite a guest to Berkshire, send us the name on Twitter, and we’ll reach out to whoever that is, and hopefully try to convince them to come out to the meeting because it’s going to be really fun this year.

Stig Brodersen  52:09  

All right guys, so [at] this point in time in the show, we’ll play a question from the audience. And this question comes from Rachel.

Rachel  52:16  

Hi, Preston and Stig. My question for you is in regards to Berkshire Hathaway earnings. It’s difficult to tell, at least for me, who I’m not very fluent in accounting, whereas I think you guys are, especially when it comes to Berkshire Hathaway. 

Does a Berkshire Hathaway income statement include income from their subsidiaries that they own 100% of, or let’s say for Geico, or I think Dairy Queen is another 100% subsidiary. Do they report income from those two companies? Or do they keep maybe Geico, Dairy Queen, all the other subsidiaries that they own 100% of, do they keep those separate? And if they do, what exactly goes into Berkshire Hathaway earnings? Is it realized gains, unrealized gains from their investing activities? Do they ever report income for a game that’s not necessarily realized, but just appreciated over the past quarter? Thank you.

Stig Brodersen  53:20  

That is a great question, Rachel. And it’s surely a question that I asked myself multiple times before given that Berkshire Hathaway currently is the biggest equity position I hold. So to answer the first part of your question about the earnings for the subsidiaries, yes, they are all included in the earnings for Berkshire Hathaway. They’re not disclosed separately. 

And Warren Buffett has several times explained why, since he’s not required to do so, he really finds that there’s no reason to give that confidential information to his competitors. So yes, all the earnings from the subsidiaries are simply added together. It is what accountants typically refer to as consolidation, and also, included in the earnings of Berkshire Hathaway is the second item you mentioned in your question. Both realized and unrealized gains are included in the earnings. 

So for example, if Berkshire Hathaway has $100 in equities, and the value of that portfolio appreciates 10% over the past quarter, the $10 appreciation would still be recorded as earnings, regardless of Berkshire Hathaway selling that position or not, whenever the next quarterly income statement is being disclosed, and this is a very recent chain. And if you think that it makes no sense because it makes the earnings very volatile, and you can’t use it for valuations, you’re definitely right. 

Keep in mind that Berkshire Hathaway’s portfolio is currently valued at more than $200 billion. So a 10% change and that would result in a $20 billion reported earnings or loss, which completely distorts the picture of the fundamental value of Berkshire Hathaway. That’s a company that has a solid stock portfolio, where the price might change 10% quarter over quarter. But that doesn’t change the fundamental value at all at the same speed. 

And also, in the earnings, you have the close [at] 100 subsidiaries that Berkshire Hathaway owns. [It] was steadily appreciating in value, but they’re not listed separately. Now, there’s also a third component that you didn’t include in your question, then I would briefly like to touch upon. 

Consider Berkshire Hathaway’s 5.4% stake in Apple. So in 2018, Berkshire Hathaway recorded $745 million dividends in their earnings, but they shared the return earnings were $2.5 billion. And of course, you can argue that continued performance will eventually turn into a higher share price, and then indirectly be recorded in the earnings statement, but it doesn’t happen in lockstep with the share price. That’s another argument that while I do suggest that you read the earning statement, please do not use it as a valid input for evaluation.

Preston Pysh  56:00  

Hey, Rachel, this was a great question and probably one of the best questions you could ask to understand accounting and financial statements. As a token of our appreciation, we’re going to give you a free subscription to our Intrinsic Value Course, where we teach this kind of stuff in much more detail. 

Additionally, we have a filtering and momentum tool, which we call TIP Finance. We’re going to give you a year-long subscription to TIP Finance completely for free. Leave us a question at askthetinvestors.com. That’s asktheinvestors.com. If you’re interested in these tools, simply go to our website, theinvestorspodcast.com, and you can see right there in our top level navigation, there’s links to TIP Finance and also the TIP Academy, where you’d find the Intrinsic Value Course.

Stig Brodersen  56:41  

All right, guys! That was all that Preston and I had for this week’s episode of The Investor’s Podcast. We see each other again next week. 

Outro  56:49  

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