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Graham Doddsville - Issue 23 - Final PDF
Graham Doddsville - Issue 23 - Final PDF
Corsair Capital —
Editors:
Investing on Change
Matt Ford
MBA 2015 Jay Petschek and Steve Major ’94
are the co-portfolio managers of
Peter Pan
Corsair Capital Management, a
MBA 2015 value-oriented, event-driven, long/
Tom Schweitzer, CFA short equity investment firm with
MBA 2015 $1.4 billion in assets under
management. The firm’s strategy
Brendan Dawson Jay Petschek Steve Major ’94 focuses on small to mid-cap
MBA 2016 companies predominantly in the US
and Canada going through strategic and/or structural change with impending
Scott DeBenedett catalysts. Corsair Capital Partners, L.P., the firm’s flagship fund, was founded in
MBA 2016 (Continued on page 13)
Michael Herman
MBA 2016 Andrew Wellington —
Working Hard to Find Easy Investments
Visit us at:
Andrew Wellington co-founded Lyrical Asset Management
www.grahamanddodd.com
(LAM), a New York-based boutique investment manage-
www.csima.org
ment firm, where he serves as the firm’s Chief Investment
Officer and Managing Partner. Lyrical began investing client
capital at the start of 2009. Over the six years ended De-
cember 31, 2014, LAM’s U.S. Value Equity-EQ strategy re-
Andrew turned 323.7%, net of fees, more than doubling the S&P 500
total return of 159.4%.
Wellington
Mr. Wellington has been involved with active portfolio
management for almost twenty years. He was a founding member of Pzena Invest-
ment Management, where he was the original equity research analyst, and later
(Continued on page 21)
Page 2
Professor Bruce Greenwald and Louisa Jon Salinas ’08, Founder and Managing
Serene Schneider ’06 at the October, Member of Plymouth Lane Capital, served
2014 Graham & Dodd Breakfast. as a panelist during this year’s Graham &
Dodd Breakfast.
Volume I, Issue 2 Page 3
Panelists included Professor Bruce Greenwald, Mario Tom Russo of Gardner Russo & Gardner speaking with
Gabelli ’67, Bruce Berkowitz, and Jon Salinas ’08. Dean Glenn Hubbard.
Henry Arnhold with Jean-Marie Eveillard of First Eagle. The panelists speaking with Dean Hubbard.
Page 4
Bill Ackman
(Continued from page 1)
Harvard Business School BA: I had very few actual think about mentorship within
and a Bachelor of Arts mentors in this business Pershing and about developing
magna cum laude from because I didn't really know your team on the investment
Harvard College. anyone. I bought Seth side over time?
Klarman's book, Margin of
Graham & Doddsville Safety, which was published my BA: I don't think we have any
(G&D): If we were to go back first year of business school. I particular programmatic way
to the period before launching called him up and said, "Hey, to develop people. The
Gotham, how did you get your I’m a business school student Goldman Sachs' of the world
start in investing? and bought a copy of your have real training programs. At
book.” He said, "You bought a Pershing, people on the
Bill Ackman (BA): I started copy of my book?!" I don't investment team side are
Bill Ackman investing in business school. A think many people had done pretty good investment
friend recommended that I that. analysts by the time they get
read Ben Graham's The here. They've already spent
Intelligent Investor and it three or four years training at
resonated with me. I decided investment banks and private
to go to Harvard Business “...if you can find a equity firms. Some may even
School and learn how to have finance experience from
become an investor. great business, and if their undergraduate programs.
Bill Ackman
appreciation for the value of a We size things based on how position.
quality business. Version 3.0 much we think we can make
was understanding the impact versus how much we think we The biggest investment we
of activism. More recently, can lose. We'll probably be ever made was Allergan
Version 4.0 is understanding willing to lose 5-6% of our (AGN), which, at cost, was
that if you can find a great capital in any one investment. approximately 27% of our
business, and if you can switch With Fannie (FNMA) and capital. There we were
out a mediocre management Freddie (FMCC), you have partnering with a strategic
team for a great one, you can highly leveraged companies acquirer and it had an
create a lot of value. That was where the government is immediate catalyst to unlock
an evolution over 22 years. effectively taking 100% of the value. It was a very high quality
profits forever. There's legal business. We felt it was hard
G&D: You manage a risk and political risk, and an for us to lose a lot of money,
concentrated portfolio and enormous of amount of so the position could be quite
there are some inherent risks uncertainty. We could large. Could we lose 20% of
to that. Broadly speaking, how realistically lose our entire our capital? Sure, it was
do you think about investment. That's a 2-2.5% possible, but very unlikely. So
constructing the portfolio position at today's market in some sense, we think about
today and how has that price. losing 20% on 27% as risking 5-
changed over time? 6% of our capital.
Bill Ackman
Railway (CP). He had turned the launch of a public entity BA: Probably not. If Carl Icahn
around two other railroads and a fair amount of internal had not come in and bought 17
including a Canadian capital, we're devoting million shares of stock, this
competitor. If you meet him, effectively all of our resources would have played out very
you'll understand his leadership to active investments. If you're differently. What made this go
qualities. It's easy if you're going to be active in a a slightly different direction
Professor Tano Santos
backing someone who's situation, it's very helpful to than we had expected was
listening to the panelists at already done it before. It’s have it be geographically Carl went first in a big way,
the 2014 Graham & Dodd more difficult when you are proximate, operating in the and that attracted a lot of
Breakfast. taking someone who has not same language, under the same other participants who viewed
been successful before and law, where you're well known this as a trading opportunity to
betting on their success. and you know the players. make money on a short
squeeze.
G&D: Do you have examples
of bringing in successful CEOs I don't think it affected the
who did not previously have ultimate outcome, and I think
relevant experience? “We’ve yet to hear we'll make more money as a
result, so maybe we were
BA: We focus on candidates one fact from investors compensated for the extra
with previous experience. You time by being able to buy a
can meaningfully reduce the that own the stock or bigger notional short position.
risk if you can find someone We bought a lot of put options
who's done it before. We have any bull case that in the stock in the $70s and
an affection for older CEOs in caused us to think $80s that we could not have
some sense. With both Seifi economically purchased when
and Hunter, they have 50 years Herbalife was a stock we first established the
of experience. Someone at position.
that stage of their career that you should buy as
has been successful is not G&D: I'm sure you've heard
really driven by financial opposed to one you an opposing thesis from any
considerations. It's more about number of smart investors. Is
legacy and the fun they have. should sell.” there any compelling piece of
That's why we think old CEOs evidence that has made you
are best. question your conclusions on
HLF?
G&D: Why hasn’t Pershing With a strategy where we're
invested in more businesses doing two things a year, maybe BA: No. We've yet to hear
outside the US? Certainly three, we don't need to go one fact from investors that
there are legal considerations outside the U.S. or Canada. own the stock or any bull case
from an activist perspective, We would be open to that caused us to think
but even among the passive something international at Herbalife (HLF) was a stock
holdings, there does not some point, but it would have you should buy as opposed to
appear to have been many to be extremely compelling. one you should sell. The
purely international focused We feel like we've got plenty quality of work done by the
businesses in the portfolio. of things to do here. people that own this stock is
really poor. If they continue to
BA: Passive investments have G&D: Let’s talk about a own it, they will lose 100% of
been placeholders until we find couple of ideas. One that their investment. 13-Fs are
the next activist investment. people love to ask you about is coming out on Monday for this
They've also been a way for us Herbalife (HLF). Do you think name (Editors’ Note: this
to have more liquid the return has been worth it interview was conducted in
investments in case we get relative to the amount of time November 2014). I will be
redemptions from investors. and effort you've had to amazed. I'm always looking
As our capital base has expend on this investment? forward to find out who
become more permanent with bought it. There seems to be a
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Bill Ackman
new victim each quarter. your Herbalife thesis? Americans find it a fancy thing
Statistically, it screens really that you don't do at home.
cheap. It's trading at 7-8x BA: Why was Bernie Madoff in They think there must be
earnings. That sounds cheap, business for 37 years? I don't something shady about it.
but it’s based on projected know, it seems so obvious.
earnings. We think earnings Herbalife's been around for 34 G&D: You mentioned you
projections are going to come years. It's on the New York only invested in two new
down meaningfully and they've Stock Exchange. It has a positions this year. Can you
already begun to. Ultimately, market cap of $8 billion. Yet if tell us about an idea that you
we think earnings will go you go to L.A. and ask people spent a lot of time on, but
negative. about Herbalife, they go, "Oh, ultimately decided to pass?
that pyramid scheme?" They've
G&D: Do you have a set had that thought for 20 years. I BA: We did a lot of work on
process to keep yourself think the company has done a McGraw-Hill (MHFI) a few
intellectually honest in terms very good job at creating the years ago. It is a conglomerate
of assessing the counterview perception of legitimacy by with several businesses and
to what your thesis is? products. One of them is the
S&P franchise, which we think
BA: We're always open to a is one of the best businesses in
contrary point of view, “We're always open to the world. Capital IQ is
particularly if it's someone another McGraw-Hill product
who's smart with a good a contrary point of that we use and like. It’s a
record that's on the other side great and valuable asset. The
view, particularly if it's
of something we own or company on the whole looked
something we're short. We someone who's smart undervalued and interesting.
want to hear it and we're going
to listen to it. With Valeant with a good record Ultimately, we couldn't get
(VRX), there are some well- comfortable with the potential
known short sellers, Jim that's on the other side liability associated with being in
Chanos in particular. I don't the bond rating business. We
know if he's still involved, but of something we own had a pretty negative view on
he was publicly short the how the ratings agencies had
or something we're
stock. I wanted to hear all of managed the crisis. We had big
his arguments. I called him, and short. We want to hear short positions in bond
he was very charitable in insurers that had AAA ratings.
sharing them. I appreciated him it and we're going to I met with the ratings agencies
doing that. many times to try to convince
listen to it.” them that their ratings were
One of the best ways to get just ridiculous to no avail.
confidence in an idea is to find
a smart person who has the surrounding themselves with We felt that MHFI had real
opposing view and listen to all legitimate people. Madeleine liability and the potential losses
of their arguments. If they have Albright is a consultant to the they may face from litigation
a case that you haven't company. They have a Nobel were unknowable considering
considered, then you should Laureate on their scientific the amount of bonds that were
get out. But they can also help advisory board. They brought purchased and the amount of
give you more conviction. If on the former surgeon general money that was lost relying on
what I've heard are the best in the last year. They sponsor those ratings. With our
arguments that can be made soccer stars, such as David strategy, we must be willing to
against being short Herbalife, Beckham, and the L.A. Galaxy. put 15-20% of capital into a
then I want to be short more. It's a brilliant scheme. particular idea. We can’t invest
in a security where it is
G&D: Why do you think it's Also, the general public is just possible that you wake up
been so difficult for the market not interested or comfortable tomorrow and it's worth 50%
to wrap their head around with short selling. Most or 80% less than what you
(Continued on page 8)
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Bill Ackman
paid. So that was something way to think about that story with respect to each of
we passed on even though we business. our failed retail investments.
thought it was unlikely that And there are retail
there would be a claim that G&D: One area that's been investments where we made a
wipes out the value of the difficult for Pershing in the past lot of money – Sears (SHLD)
company. has been retail. What has in 2004, Sears Canada (SCC),
made that sector so difficult and food retail businesses
We saw this as different from relative to some of your other would be examples. But I think
Fannie (FNMA) and Freddie areas of focus? retail is a very difficult
(FMCC) because we thought business, particularly fashion
MHFI was a potential double, retail. That's a tough category.
while we think we can make
25x our money in Fannie and G&D: Are there other
Freddie. A small investment in “Fundamentally what industries that you'd say are
Fannie and Freddie can still be you're looking for is too challenging?
very material in terms of
profits for the firm, yet if how much cash the BA: We have generally
something happens and we avoided technology as well as
lose our entire investment, we business can generate commodity-sensitive
won't really notice. For MHFI businesses. With commodity
to be a meaningful contributor, on a recurring basis businesses, it's very difficult to
it would have to be a big predict the future price of the
investment. over a very long period commodity – this year being a
of time. That's what good example. If you asked
G&D: Buffett uses the people at the beginning of the
concept of owner earnings. we do.” year, I don't know how many
Are there any particular would say that WTI would be
metrics you find helpful? below $76. So we avoid a few
sectors, but we try to stay
BA: I think the job of the BA: I think retail has become open-minded. For example,
security analyst is to take the much more difficult. A big part healthcare was something I
reported GAAP earnings of a of that is Jeff Bezos and would have put on that list a
business and translate them Amazon (AMZN), a large year ago. Right now, we have
into what Buffett calls owner company that does nearly $75 two healthcare investments
earnings. I call them economic billion in revenue growing comprising 40% of the
earnings. The next step is to faster than 25% annually. They portfolio. In every sector there
assess and understand the are reinvesting 100%, maybe are businesses that can meet
durability of those earnings. more, of their profits to our standard, but most won't,
Fundamentally, what you're improve the customer and that's why we haven't
looking for is how much cash experience, expand their spent a lot of time looking in
the business can generate on a reach, and so on. I think it’s an some of these areas.
recurring basis over a very incredibly formidable
long period of time. That's competitor that gets stronger G&D: Would you be willing to
what we do. GAAP accounting every year. When you grow at share your thesis on Zoetis
is an imprecise, imperfect those rates, that revenue is (ZTS) and what the playbook is
language that works for very coming from somewhere. He's going to be there?
simple businesses. For a widget got a better mousetrap. He's
company that grows 10% a got the support from his BA: I think it's a great
year, GAAP earnings are really investors to invest a huge business. It has a dominant
good at approximating amount of capital in the position as the largest
economic earnings. For Valeant business. That's a very difficult company in animal health.
Pharmaceuticals (VRX), for competitor for the retail There are very good trends
example, a company that's industry. supporting the growth of the
been very acquisitive, GAAP company. Rising income levels
accounting is not a very good Aside from that, there is a and increasing demand for
(Continued on page 9)
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Bill Ackman
protein in people's diets a super high quality business which these vehicles were out
benefit the company. The you can buy for a discount of favor in the investment
companion animal health where there's an opportunity community. Our Allergan
segment of their business for optimization? activist campaign was
should also benefit from rising somewhat unprecedented as
incomes. With more affluent G&D: Many respected well.
William von Mueffling ’95 cultures, people have more investors have publicly praised
of Cantillon Capital pets, but also care for them your investment creativity. It I don't think it's as much
Management speaks with more. It meets our standard seems to be one of the creativity as it is a willingness
Columbia Business School for a high quality business. It's defining qualities of Pershing to consider opportunities that
Senior Associate Dean Lisa also a spinoff, which can create Square. How do you cultivate are unconventional and outside
Yeh at the 2014 Graham & interesting opportunities. I that creativity? Is there a way the box. What's required is
Dodd Breakfast. don’t think we are ready for for someone to develop that that you have to have a basic
comment beyond that. ability? understanding of what's right,
what's legal, and what's
G&D: How do you typically possible, and not limit the
source ideas? Is there one universe to things that no one
method in particular that's had “What's required is else has done before.
a lot of success?
that you have a basic We are absolutely going to
BA: Interestingly, Allergan consider things that haven't
(AGN) and Air Products
understanding of been done before. We don't
(APD) were brought to us. what's right, what's need a precedent. We're just
That's a good way to get ideas. interested in things that create
We have a reputation for being legal, and what's value and we're going to look
a good, proactive investor. at them objectively. To
Canadian Pacific (CP) came possible, and not limit execute the strategy, you have
from an unhappy CP to be willing to do things
shareholder. Air Products the universe to things without caring what other
came from a happy CP people think. You need thick
shareholder who made a lot of
that no one else has skin. In this strategy, not
money with us and said, "Hey, done before.” everyone's beloved,
this is the other dog in my particularly on the activist
portfolio, maybe you can help." short side. You're not going to
Allergan came to us through make many friends in that
Valeant because they were BA: Someone once pointed business except for the first
looking for someone who out that almost everything person who took your advice
could help increase the we've done has been and got out.
probability of their success. unprecedented. We shorted a
company and announced to G&D: Given that we're in this
We're looking for big things. the entire world that it is a "golden age of activism," there
Today we have $19 billion in pyramid scheme. With General are lots of investors and capital
capital. We want to put 10% Growth Properties (GGP), we focused on activism. Have you
or more in an investment so bought 25% of the equity of a found it more difficult to find
we prefer companies with company on the brink of ideas to add to your portfolio
market caps above $25 or bankruptcy, convinced them to as a result?
even $50 billion. We are file for bankruptcy, and helped
looking for high business them restructure. We started BA: No. First of all, it depends
quality and opportunities to a company from scratch with on what you count. In terms of
make the business much more Howard Hughes (HHC). That dedicated activist funds, there
valuable. Some of our sourcing was a collection of assets we is something like $150 billion.
comes from reading the spun out of GGP and replaced That's a still a small number in
newspaper and just looking for the management team. We’ve the context of the size of the
companies that meet that very had two successful investments market. We are one of the
simple model. Where is there in SPACs during a period in largest at $19 billion. We are
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Bill Ackman
also one of the most lot of CDS outstanding, I recognize that the stability of
concentrated activists. A would be much more inclined your capital base has a huge
combination of concentration to do that than having to impact on your returns over
and scale means we're doing borrow stock to go short and time. The Buffett Partnership
very big investments and these risk the stock price rising. had no corporate level tax. At
are very big companies. Every Berkshire Hathaway he had to
company we've invested in, we G&D: What are you trying to work for $100,000 a year with
were the first activist who accomplish with the creation no stock options, and pay
bought a stake. of Pershing Square Holdings corporate level tax. This tells
(PSH)? me that he viewed the
Generally this is fertile ground. permanency of the capital base
I would say there's more as much more material than
activism happening in small and these other features.
mid-cap companies, so I don't “I do think companies
think it has affected us. I do That's basically what inspired
think companies are trying to are trying to fix us to create a public entity.
fix themselves before an We didn't want to pay
activist shows up, and that's a themselves before an corporate level tax so we
threat. As businesses become didn't want to merge with a
better managed and boards of
activist shows up...as corporation. While PSH is
directors replace weak CEOs, businesses become structured as an offshore
there's less for us to do. closed-end fund, we think of it
better managed and like an investment holding
G&D: You mentioned some of company. We have these
the benefits of having boards of directors subsidiary companies which we
permanent capital on your have a lot of influence over.
ability to do more activism on replace weak CEOs, We’re often on the board of
the long side. Are you going to directors and we own them
spend less time on shorts as
there’s less for us to for years. We add one or two
that shift continues? do” new businesses each year. Our
goal is to compound at a high
BA: After the MBIA (MBI) rate of return over a long
short where we made our period of time. This is different
thesis public, I was asked by from Berkshire Hathaway.
our investors if we were going BA: In 1957, Buffett formed Buffett is not an activist
to do this again. I told them it the Buffett Partnership. Eleven anymore. His past investments
was going to be a long time years later, after buying with Dempster Mill
before I did another one of control of Berkshire Hathaway Manufacturing and Sanborn
these big public shorts. It was (BRK), he gave investors a Maps had an activist bent
five years between MBIA and choice of cash if they wanted though.
Herbalife (HLF). Although, if to exit the partnership, or
this in fact goes to zero, stock if they wanted to merge The key for us was how do we
perhaps all we need to do the their shares into Berkshire get to permanent capital in a
next time is just say, "We're Hathaway. Buffett gave up the way that's investor-friendly so
short company XYZ" and it advantage of $100 million and we can do it in scale? We have
will go straight to zero and we the right to collect 25% of the what I think is a closed-end
won't even have to make a profits. He left that to be CEO fund with the biggest market
presentation. We hope it for $100,000 a year with a value – it's $6.6 billion. Why
works that way. public textile company which I did we do that instead of
think had a market cap of $30- reinsurance? Because I don't
Short selling is inherently less $40 million. know anything about
rewarding. We like shorting reinsurance, and I didn't want
credit as opposed to shorting Why would he do that? I think to mix investment risk with
equities. If we could find a big the answer is that if you are a property casualty risk. It's too
leveraged company that had a control-oriented investor, you complicated.
(Continued on page 11)
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Bill Ackman
G&D: From an investor values for the firm? What do as being places where you look
perspective, when they invest you look for in the people you for talent. Do you have a
in a public entity, they're have as part of your team? preference for people who
paying lower fees, they have have looked at businesses on
more liquidity. Do you think BA: We are very, very careful the private side?
PSH will impact the hedge fund about who we bring on to the
part of Pershing Square? team. I call our culture a BA: This year we've made two
functional family culture. This investments – Allergan at
BA: Most of our investors in is a very high quality, very beginning of the year and
the hedge fund part of Pershing smart, capable, motivated Zoetis at the end of year.
Square don't invest in publicly team. For the most part, we all That's a very different pace of
traded things. I think it's good like each other, which is investment when compared
for everyone that we welcome unusual in a business context. with your typical long-only
investors in whatever form hedge fund or mutual fund
they want to invest. firm. We have to find people
who are comfortable spending
G&D: You must have an a lot of time researching and
“At many hedge funds,
incredibly busy schedule. How analyzing, looking for the one
do you allocate your time? people are idea thing out of many that's going
to be interesting.
BA: Not as well as I should. junkies. It’s the idea of
It's the single biggest thing I At many hedge funds, people
need to work on. I have a the week. That’s why are idea junkies. It's the idea of
tough time saying no. I need to the week. That's why private
say no more. It's hard for me. private equity tends to equity tends to be a better
background for us. A private
be a better background
G&D: What about allocation equity investor might spend a
of time within investments – for us.” whole year working on a deal
what portion of your time is and if they are not the high
spent generating ideas versus bidder, they don't get it.
analyzing companies versus Whereas here, you might
engaging in activism? I interview everyone – every spend a lot of time working on
person who works at the something, but if we want to
BA: It depends. This year I reception desk, who cleans the make the investment, we can.
spent a lot of my time on offices, who works on the We have to pay the market
Allergan (AGN), the IPO of investment team. I think I'm a price, but we don't have to be
Pershing Square Holdings pretty good judge of character. the high bidder per se.
(PSH), and a little bit of time What we're looking for are
on Zoetis (ZTS). But we've got fundamentally good human For a person with a private
a very capable team focused on beings, people that you want equity background, it's a very
a few major things. to spend your day with, easy transition. We've never
because you're going to. That really hired anyone from a
It's much more of a team is a key success factor. It hedge fund. Effectively, our
approach and strategy than a depends on the role in terms approach is private equity
typical investment firm. Usually of what we're looking for, but without buying control.
you have a back office and an we like hard working, honest,
investment team. At Pershing, smart people who are fun to G&D: You've been
we are totally integrated in spend time with. extraordinarily generous to
everything we do – public Columbia Business School over
presentations, legal analysis, We have very little turnover at a long period of time. Why is
compliance, and so on. Pershing Square, even at the philanthropy important to you?
reception desk.
G&D: In terms of putting BA: One of my colleagues,
together Pershing Square, what G&D: You mentioned some of Paul Hilal, got us involved at
would you say are the key the larger private equity firms Columbia and came up with
(Continued on page 12)
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Bill Ackman
this idea of an investment class biology. We have a pretty Amazon Cloud and other
that’s become Applied Security broad, eclectic range of development resources. I think
Analysis and the Pershing philanthropic endeavors. I would be starting a company
Square Challenge. But I would There's not an overarching today as opposed to managing
say Columbia is on the smaller strategic plan. We're money. You can always manage
side in terms of what we've experimenting. money. In fact, if you do well in
Bruce Berkowitz of done philanthropically. whatever you do, you're going
Fairholme Capital with G&D: Before we close, do to have to manage your money
Michael Schmerin. We've given away more than you have any advice for anyway. It's good to learn the
$250 million over the last six students who are interested in skills. I think we have enough
years. What's interesting is I've potentially starting their own people in the investment
come to believe that I can fund or going into investment business. We want some more
make a much greater management after they start-ups.
contribution in my for-profit graduate?
life than my not-for-profit life. G&D: Thank you for taking
I'm working to figure out how BA: You should only work the time to sit down with us.
to get a higher return on with someone that you like,
investments in the not-for- trust, and admire. You should
profit activity. be smart about who you
choose to work for.
G&D: How have you decided
which areas to get involved in In terms of starting something
philanthropically? right out of business school,
it's something that I did a long
BA: We're trying to address time ago. I was fortunate to be
problems. I think there are lots able to have a 2.0 – Gotham in
of different ways to do that. some ways was a training
My first choice is to find a for- ground for Pershing Square. I
profit solution. There are think I was much more
some problems that do not successful at Pershing Square
appear to have for-profit because of the experience I
solutions, or at least someone had at Gotham. You can have
hasn't thought of one yet, and that kind of experience
then we help fund not-for- working for someone else. It
profit solutions to these wasn't really my nature to go
problems. work for someone else which
is why I didn't do it, but you
In terms of things we get can learn a lot that way. I
involved with, usually it's wouldn't worry very much
driven more by the person about how much money you
running it. There are lots of make. I'd worry much less
important problems – it's very about compensation than I
hard to rank them. Criminal would about what you can
justice reform is something learn.
we're interested in. We're also
interested in economic I also think that in order to be
development and education. a great investor, it's very
We've done some things for helpful to understand business
New York City on the cultural and how to run a business. I
side. We helped start think it's a really interesting
something at Harvard called time because it's so easy to
Foundations for Human start a business today,
Behavior, which is basically relatively speaking. Start up
behavioral economics costs are much lower due to
integrated with psychology and the ease of access to the
Page 13
1991 and has yielded an came together. pay for dinner that night, so to
annualized net return of hear that we're worth half a
14% since inception. G&D: Who were some of million dollars was sort of a
your earliest influences? Were novel concept. That day we
Graham & Doddsville there any early career learned that you're not worth
(G&D): How did you first experiences that were what your bank account says
become interested in investing? important to your you’re worth, you’re worth
development as an investor? your future earnings potential.
Jay Petschek (JP): My dad
was an investment banker and JP: My dad was my earliest Another professor I had was
we talked stocks constantly influence. He always Fischer Black. He taught us
when I was growing up. I’ve approached the world from a about his options model, but
Jay Petschek also always been good with quantitative perspective. He the real takeaway for me was
numbers and liked games and taught us the binary system at the importance of change.
puzzles where you have to a young age and joked that Future volatility can be very
guess an outcome based on there are 10 types of people in different than past volatility,
partial information. Investing is the world – those who especially when an unexpected
similar, only this “puzzle” is understand the binary system event occurs. If you just used
based on financial data. You’re and those who don’t. I historical volatility, you would
trying to estimate, with only a developed a similar get the wrong value of an
company’s past financial quantitative sharpness as my option. He helped us
information, how well it can father, and that has helped me understand the potential
perform in the future. You throughout my career. valuation discrepancies and
have to invest on what isn’t investment opportunities that
fully appreciated and isn't fully can arise when change has
understood. That’s how you “I’ve also always been occurred.
get an edge.
good with numbers and SM: While I was at Columbia,
Steve Major ’94 Steve Major ’94 (SM): I I worked as a summer intern
liked games and
worked as an investment at Millennium and fell in love
banking analyst at Goldman puzzles where you with spin-offs, value investing,
Sachs after college. But I ended and situations with companies
up realizing that investment have to guess an going through change and
banking wasn’t where my transition. I ended up at
passion was. In those days, outcome based on Oppenheimer where I wrote
there was no internet, so research on post-reorg
Goldman would distribute on a partial information. equities. But my good fortune
daily basis printed copies of the really started when I met Jay in
Investing is similar,
firm’s equity research. I found 1996 at Ladenburg Thalmann.
myself really excited every only this “puzzle” is Who would have known that
morning to come into work Jay and I would quickly become
and read equity research based on financial investing soul mates and close
reports that were left in my friends. We shared a common
inbox bin – a plastic, data.” philosophy and approach to
rectangular, black, physical valuing spin-offs, companies
tray; not a Microsoft Outlook coming out of bankruptcy,
inbox. Company analysis and I later attended the Sloan multi-divisional companies, and
stock valuation ignited a spark School at MIT to get an MBA companies with a change in
inside me. After banking, I in finance and investing. Robert corporate activity. At the age
went to Columbia Business Merton, the famed Nobel Prize of 28, I was given the
School and took classes on winner, one day told our class incredible opportunity to
leveraged buyouts, investing, that he would buy 10% of our manage money on my own,
and stock-picking with Bill future income for $50,000. Of and that was unusual. Jay and I
Comfort, Paul Johnson, and Jim course, we were all students became partners over time and
Rodgers. That's where it all trying to figure out how we'd the rest is history.
(Continued on page 14)
Page 14
Andrew Wellington
(Continued from page 1)
became a principal and In late 1995, I met Rich Pzena, fund. I was co-PM in 2002, and
portfolio manager. He who had just left Sanford Bern- then I became the sole PM in
then went on to Neu- stein where he ran their do- 2003 when Bob left to start his
berger Berman where he mestic equity portfolio. He was own hedge fund.
became the sole portfolio starting his own firm, Pzena
manager for their institu- Investment Management, and I G&D: What is your invest-
tional mid‐cap value prod- joined Rich as his research ment philosophy and has it
uct, growing it from $1 analyst. Rich’s business partner changed over time?
billion to $3.3 billion in in that venture was Joel
AUM, and earning a five- Greenblatt. I worked with AW: Throughout the almost
star Morningstar rating. them for over five years. I 20 years I’ve been investing,
Andrew Wellington He was also a managing couldn’t ask for two better the style and philosophy has
director at New Mountain people to learn value investing always been similar. First and
Capital, where he played a from. foremost, there is a focus on
key role in establishing and value. I am a deep value inves-
managing the $1.2 billion tor. By deep value, I mean I
New Mountain Vantage look for the companies that
Fund, a value‐oriented, “There are no style are trading at the biggest dis-
long‐only, activist hedge counts to intrinsic value that I
fund. Early in his career, points in investing. We can find. The bigger the dis-
Mr. Wellington worked as count to intrinsic value, the
a management consultant
don’t get extra bigger the return you generate
at Booz Allen & Hamilton percentage points for when you’re right. No matter
and First Manhattan Con- how great a business is, no
sulting Group. Mr. Wel- making money on a matter how well you know it,
lington graduated summa if it’s not undervalued, you
cum laude from the Uni- stock that’s really can’t make a superior return
versity of Pennsylvania’s investing in it.
Management & Technolo- difficult to understand.
gy Program, earning both Then there are two things I’ve
a Bachelor of Science from
If you make a huge settled on that improve the
the Wharton School and a return on a really odds of success – quality and
Bachelor of Science from analyzability.
the School of Engineering. simple stock, that still
The emphasis on quality is the
Graham & Doddsville counts.” Joel Greenblatt influence rub-
(G&D): Tell us about your bing off. Amongst the cheapest
background prior to Lyrical. stocks, I only want to invest in
those that are also fundamen-
Andrew Wellington (AW): The firm had a great deal of tally good businesses. Good
I graduated from the Universi- success both in terms of in- businesses have flexible costs,
ty of Pennsylvania’s Manage- vestment performance and stable sources of demand, rich
ment and Technology Program fundraising. It grew from basi- margins that provide more of a
in 1990 and first started my cally nothing to over $1 billion gap between cost and reve-
career in management consult- around the five-year mark. nues. When things go wrong, a
ing. Investment management Toward the end of my time at lot of times you don’t even
wasn’t even on my radar at Pzena, I was promoted to be a notice because good business-
that point. It was a different portfolio manager and a princi- es are able to offset it. On the
world back then – hedge funds pal, but I still wanted more other hand, when little things
were rare and nobody was autonomy to make my own go wrong with a bad business,
watching CNBC yet. I spent decisions. I left in early 2001 to it tends to result in dispropor-
five years in management con- join Neuberger Berman. It was tionately big problems.
sulting before I started to look a co-portfolio manager role
more seriously at investment with Bob Gendelman in their Analyzability is important be-
management. institutional mid-cap value cause the simpler the business
(Continued on page 22)
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Andrew Wellington
is, the more transparent it is, When we see businesses that you get the margins right,
the smaller the problems it’s are difficult to get right, we you’re almost all the way
facing, the easier it is to accu- skip them and keep looking. As there. You don’t need to build
rately determine future earn- I like to explain it, we work a complicated model. A com-
ings. If you get the future earn- really hard to find the easiest plicated model with the wrong
ings right, you get the invest- investments. margin assumption is not going
ment right. to do you any good.
G&D: How would you de-
There are no style points in scribe your research process? G&D: What is your process
investing. We don’t get extra What do you focus on? for replacing a stock in the
percentage points for making portfolio?
money on a stock that’s really
difficult to understand. If you AW: At a high-level, this is
make a huge return on a really “When we see how our process works. First,
simple stock, that still counts. we start with a valuation
businesses that are screen on the top 1,000 US
Our process is to first sift difficult to get right, listed stocks. That screen is
through the statistically cheap- where we generate all our
est stocks, just on the num- we skip them and investment ideas.
bers. We find that most of
those stocks are either not keep looking. As I like We pick one company at a
very good businesses or time from our screen to re-
they’re complex. But there are to explain it, we work search, analyze, and investigate,
exceptions, usually a handful of and typically spend about a
stocks, that don’t have any
really hard to find the month on it. At the end of the
major problems and aren’t easiest investments.” research process, we will
very complicated that we can come to a conclusion on quali-
go research and analyze in ty, analyzability, and valuation
more detail. If you have a of the stock. If it meets all our
small, concentrated portfolio, AW: Our research and analy- criteria, then it goes onto our
you can fill it with just these sis is really about immersing bench. Through this process,
exceptions. Because they don’t ourselves into the history of a we end up with a handful of
have major problems and be- company – seeing how it per- stocks on our bench.
cause they are good business- formed quarter after quarter
es, you can get a high percent- after quarter, looking at what We’re always looking at what
age of them right. past long-term objectives were are the best names on our
and how they were realized or bench versus what’s already in
One metric we track is our not realized, and examining the portfolio. When we think
batting average – how often what caused the under or out- the portfolio would be materi-
we get something right. For us performance. Then, you can ally better by replacing a name,
to be “right,” the stock has to build a deep qualitative under- we make the switch. It has to
outperform the market. We’re standing of the business. You be overwhelmingly better, hit-
able to track this because we see how that matches up with yourself-over-the-head kind of
don’t do any trading around the financials so you can make better. Replacing a 30% upside
positions. 65% of the invest- a quantitative forecast of fu- stock to buy one with 40%
ments we’ve made at Lyrical ture earnings. upside just doesn’t make that
have outperformed the market much of a difference on a 3%
over their life. This is a fairly Modeling is an element of what position.
high batting average, but it is we do. To value a business, we
not because we are much bet- need to estimate its future We employ a “one-in, one-
ter analysts than everyone else. earnings and so we need a out” philosophy and keep the
Rather, we have a high batting model. But a model is simply a number of names in the port-
average because we invest in tool. The critical part is using folio constant, which enforces
stocks that are relatively easier the correct assumptions. If you a certain discipline in our pro-
to get right. get the sales growth right and cess. So what typically happens
(Continued on page 23)
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Andrew Wellington
is we patiently wait until one of is huge now, and you start to With 3% positions, I can be
our stocks appreciates and focus more on the 50% chance completely analytical and dis-
approaches fair value. Normal- you lose $1 million and you passionate about everything.
ly, we look to replace a stock probably don’t take the bet. We make better decisions
when it has 5-10% upside to because we’re able to stay
fair value. But we will replace it There are fantastic risk/reward unemotional about them and
before then if the new oppor- opportunities that you are that leads to better risk/
tunity is significantly better. willing to do at 3% of your reward in the portfolio.
portfolio that you might be
We also sell if we ever lose unwilling to do at 10%. When a G&D: On a related topic, why
conviction in the fundamental position gets that big, you look is every position a 3% weight?
thesis. There’s no room in a for perfection and there’s no Why not adjust position sizing
concentrated portfolio for such thing. You become overly based on conviction?
stocks you don’t really believe sensitive to the downside, re-
in. mote as it may be. And for AW: I don’t have equal con-
every unit of downside you viction, but I’ve learned that
G&D: How did you determine eliminate, you tend to sacrifice my conviction does not add
that 33 is the optimal number multiple units of upside and, value.
of holdings? Buffett’s famous over the long the run, end up
quote is that no one gets rich with lower returns. I did not start out with the
off their sixth-best idea. Have idea of running an equal-
you considered more concen- weighted portfolio. I looked
tration? back at the three and a half
year period I managed a fund
“There are fantastic
AW: Well, the sixth-best idea at Neuberger Berman. Over
we’ve owned is Jarden Corp risk/reward that period of time, I outper-
(JAH). We’ve made 827% on formed the U.S. equity markets
that, which goes to show you opportunities that you by about 1000 basis points per
can do ok on your sixth-best year. I went back and analyzed
idea. But to address the ques- are willing to do at 3% what my performance would
tion, the 33 comes from a few have been if I had equally
things. An academic statistical of your portfolio that weighted my portfolio, thinking
study shows that when you get that the analysis would show
to the 30s, you’ve captured
you might be unwilling how much extra alpha I creat-
almost all the benefits of diver- to do at 10%. When a ed with my judgments about
sification. So there is definitely conviction weights. Instead, I
a risk mitigation benefit of 33 position gets that big, discovered that my weighting
versus six or eight. decisions had cost me 70 basis
you look for points per year.
I also believe our returns are
higher with 33 stocks than perfection and there’s Since that original analysis, we
they would be with six or have expanded it to look at all
eight. This gets into the psy-
no such thing.” mutual fund managers. What
chological and behavioral as- we found was that we’re not
pect of investing. Let’s play a the only ones that don’t add
game. We’ll flip a coin and if any value with conviction
it’s heads, you win $500, but if A key driver of success in val- weighting. Contrary to conven-
it’s tails you owe $100. That a ue investing, besides making tional wisdom, most funds
5:1 payoff on a 50/50 bet. I judgments about businesses, is would generate higher returns
would hope everyone knows to realize that nothing’s per- by simply equal weighting their
that’s a good bet. Now let’s fect. There are risks with eve- portfolio.
make one change. Heads you rything. You need to be able to
win $5 million, tails you lose tolerate uncertainties and po- G&D: How actively do you
$1 million. It’s the same risk/ tential downside. trade in your portfolio?
reward but the size of the bet
(Continued on page 24)
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Andrew Wellington
AW: Our turnover is around We don’t trade around posi- multiple we use comes from
17% per year, which implies a tions. When our stocks aren’t the history of the market.
six-year average holding peri- doing well, we don’t add more. While we know the market
od. Some stocks we’ve held for When they are doing well, we has historically been valued at
as a little as a year. There have don’t trim them back. The only about 15.5x one-year forward
been a lot of stocks we’ve held trades we do in our process earnings, our analysis of histor-
for six years and counting. The are when we sell a position in ical valuations suggests the
bigger the discount to intrinsic its entirety and replace it with market is valued at about 9x
value, the more patient you a new position at full weight. five-year normalized forward
can be. If the upside in your It’s contrary to the way every earnings. Sometimes the mar-
investment is only 5%-10%, other manager I know in the ket is at 10x like it is today. In
you better realize that gain business operates but we have other periods, such as in 2008
Bruce Berkowitz of
Fairholme Capital address-
quickly. But if you’re upside is tested both methods and or 2009, the market could be
ing a question from the 60%+ and it takes you five found our way actually per- below 6x. But the market has
audience during the 2014 years instead of two or three, forms better. always reverted back towards
Graham & Dodd Breakfast that’s okay because that’s still a 9x over time.
panel. substantial amount of outper-
formance per year. “The only trades we We don’t use different multi-
ples for different businesses or
We’ve realized it’s impossible do in our process are industries because we hope to
to determine how long it will capture everything that might
take for a stock to work. We when we sell a make one company or industry
might be able to estimate what better than another in the fu-
the earnings will be but you position in its entirety ture earnings number. There’s
have no idea how long it might elegance to the framework
take the market to recognize
and replace it with a that allows us to compare dif-
those earnings. new position at full ferent companies from differ-
ent industries with different
Goodyear Tire (GT) is an in- weight. It’s contrary to stories and still have one abso-
teresting example. Over the lute valuation paradigm.
six years we’ve owned it, GT is the way every other
up 370%. That’s 210 percent- G&D: How do you assess the
age points better than the mar- manager I know in the quality of management?
ket. Yet it’s still at 9x earnings.
They’ve done a great job
business operates...” AW: In terms of management
growing earnings and reported skill and running a business,
record margins but it’s still G&D: What valuation meth- what I’ve learned over the
cheap because the market is odology do you rely on? years is it’s really hard to tell
slow to accept that this level of how good management is.
profitability is sustainable. It’s AW: One fundamental law in Some businesses you can tell
been a great investment in part economics is that the value of they’re great because you can
because of how cheap it was in a business is the present value see how much better their
the past and also their funda- of its future earnings. But in business is performing relative
mental success in improving the real world, there are all to peers. We look for a high
profitability. kinds of problems with the level of competence. If we
traditional DCF formula, in- were to grade management,
The tougher ones are where cluding figuring out terminal we would want to grade them
you expect the company to growth rates, discount rates, with an ‘A’ or a ‘B’. We would-
improve but there are bumps etc. We take that same con- n’t want to own a company
along the way. Part of what cept but apply it in a more where we would give them a
separates great investors from practical framework. ‘C’. In some businesses, there
less good ones is the ability to are more capital allocation
sift through the noise and fig- Our approach is to value com- decisions to be made. You
ure out if the company will panies on their five-year for- want to be able to rate those
ever get things right. ward normalized earnings. The management teams an ‘A’. We
(Continued on page 25)
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Andrew Wellington
own AerCap (AER), an aircraft dervalued because there is an will not be investing in any
leasing company, for example. I inflection point and the future airlines.
would not want to own an is expected to be much better
aircraft leasing company with than the past, but those are It’s really interesting to com-
‘B’ management. Fortunately, I rare exceptions. Most of our pare the differences between
think AerCap’s management is stocks are undervalued be- the car rental and the airline
an ‘A+’. cause they are benignly ne- business because they have
glected by the market. There is very similar sources of de-
One major factor we analyze is nothing going on today that is mand. The biggest driver of
capital allocation. If the compa- different than what was occur- demand for car rental is de-
ny generates a lot of free cash ring last year or the year be- planements. People go on air-
flow and the management team fore, but because of random planes and when they land,
proceeds to waste it, that free ups and downs in the market they rent cars. But these two
cash flow has no value to in- or through earnings growth business are structurally very
vestors. Capital allocation outpacing price appreciation, different. One business we
doesn’t have to be perfect or the stock has become under- love, the other business we
optimal. I just don’t want to valued. won’t touch. Even with the
see it wasted. benefits of consolidation, air-
lines are still not a good busi-
Acquisitions are the biggest “We are short ness to us because the cost
way a company can blow itself structure is fixed. If your busi-
up. When companies do acqui-
companies that are ness earns only a 10% margin,
sitions, you want to make sure significantly and there’s a 10% fall in de-
that they’re buying at an at- mand with most of your costs
tractive price and realizing overvalued and yet being fixed, you can get a 100%
synergies. Otherwise you’d like fall in earnings.
to see the excess cash eventu- they’re very simple
ally returned to shareholders. Contrast that with car rental.
and easy to analyze In the car rental business, 70%
Our preference is for compa- of costs are variable. They’re
nies to employ cash for stock
but are often able to right-size their busi-
buybacks because we believe overlooked by ness. They don’t need the
every stock we own is under- economy or demand to return.
valued. A dividend distribution traditional short- They could shrink to current
may not be optimal, but it’s levels of demand over a few
hardly a bad thing, so we don’t sellers because there’s quarters and get back to prof-
get too worked up over that. If itability. That’s a much better
they want to leave some cash no catalyst.” business structurally. It’s a
on the balance sheet for stra- much more robust business to
tegic options or for safety, that the ups and downs of what can
might be sub-optimal but I We do own a few stocks happen in the future. You can
don’t have a problem with that which are beneficiaries of con- afford to take more risk be-
either. solidation, such as Avis (CAR), cause the resiliency and flexi-
Hertz (HTZ), and Western bility of the business is risk-
G&D: Do you also look at Digital (WDC). Consolidation mitigating.
businesses or industries that is one element of the thesis,
reach potential inflection but consolidation by itself isn’t G&D: You recently launched a
points? For example, a situa- enough to make the invest- long/short fund. What was the
tion where significant capacity ment attractive. We own them rationale for doing so?
came out of an industry? because they are quality, ana-
lyzable businesses at significant AW: My business partner, Jeff
AW: We look for quality, ana- discounts to intrinsic value. Keswin, co-founded Greenlight
lyzable businesses at significant The airline industry is benefit- Capital. He has substantial ex-
discounts to intrinsic value. ting from consolidation but we perience in the long/short
Sometimes a company is un- world so even though we de-
(Continued on page 26)
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Andrew Wellington
cided to initially focus on long- We aren’t short stocks such as many other funds. Why is that
only at Lyrical, we thought Tesla (TSLA) and Netflix beneficial versus employing a
there might eventually be an (NFLX) because I don't know larger team with coverage on
opportunity to manage a long/ what they’re going to earn in specific sectors or industries?
short fund as well. Betting on five years. Those are new
ourselves, we started our long/ business models. No matter AW: When you only buy, on
short fund in early 2013, initial- how expensive they are today, average, five stocks a year,
ly with just internal capital. no matter how likely they are how many people do you
to be overvalued, if I don't need? That’s less than one eve-
We’re doing shorts because know with a high degree of ry two months. I have a lot of
we believe we can be as good certainty what their future titles at the firm, but my main
on the short side as we’ve earnings will be, then that’s not job at Lyrical is Junior Analyst.
been on the long side. If I did- a very good investment for us. If I pick the right stocks, every-
n’t think we could be, I would- thing else at Lyrical is easy.
n’t be interested in diluting our
reputation or degree of suc- I think part of our edge comes
cess. We really believe that we from the fact that I, along with
have a differentiated approach “We aren’t short my co-portfolio manager Car-
to shorting. stocks such as Tesla oline Ritter, bring a lot of ex-
perience to analyzing business-
What’s driven our success on and Netflix because I es.
the long side is looking for
significant misvaluations in don’t know what On the margin, we make bet-
businesses where we have a ter decisions because we’re
high probability of getting the they’re going to earn the ones listening to every
future earnings right. That’s earnings call. We’re the ones
exactly what we look for on in five years...if I don't going through the financials
the short side as well. We’re know with a high and seeing it all first-hand as
not short accounting frauds. opposed to having junior staff
We’re not short businesses we degree of certainty do that, and then processing
think are going to disappear. what they have.
We are short companies that what their future
are significantly overvalued and G&D: Would you be willing to
yet are very simple and easy to earnings will be, then walk us through a current
analyze but are often over- idea?
looked by traditional short that’s not a very good
sellers because there’s no cata- investment for us.” AW: It’s interesting that the
lyst. second-best stock we’ve ever
owned is AerCap (AER) and it
We believe we can be relative- still shows up as one of the
ly accurate at estimating future cheapest stocks in our portfo-
earnings power and reliably For the first six months, we lio today. Even though it has
identifying stocks that are sig- shorted ETFs as a placeholder appreciated 1,200% since we
nificantly overvalued. until we could build a portfolio first bought it, AER trades at
of single-stock shorts. We 7.9x this year’s earnings. When
Many people think you have to have been running single-stock we first got involved in January
short bad businesses. In some shorts now for 18 months. It’s 2009, AER was priced around
cases, we’re short great busi- working exceptionally well. In $3 a share and had $2 a share
nesses. These stocks often fact, over that 18-month peri- of earnings. You don’t need a
have high multiples for long od, our batting average on the very sophisticated screen to
periods of time. If a great busi- short side is 75%, compared to identify stocks at 1.5x earnings.
ness is worth $100 a share but 68% on the long side.
the stock is at $150, that’s a AER is in the business of rent-
good short. It doesn’t have to G&D: Lyrical has a smaller ing commercial airplanes to
go to zero to be a good short. investment staff relative to airlines around the world. If
(Continued on page 27)
Page 27
Andrew Wellington
you looked at airlines in the While the stock is up, it was down the low-end business
U.S. in 2008, you’d have a pret- cheap before the deal and the and the related plants. That
ty negative view of businesses earnings power increased so takes a lot of time and ac-
that rent airplanes to airlines. much that, on a prospective P/ counting charges – you can’t
There are a lot of things wrong E basis, the stock still is incred- just do that overnight.
with that view though. First, ibly cheap. It hasn’t been a
A Graham & Dodd Break- airlines in America aren’t the good performer in 2014 even Along the way there were dis-
fast attendee looks over same thing as airlines around though they’ve executed on appointments. In 2007, syn-
the morning’s agenda. the world. There are different the integration of ILFC excep- thetic rubber prices spiked
trends in different regions. tionally well. with oil. They were able to
They are very healthy and pass through the costs but it
growing in the Middle East and took several quarters. They
in Asia. Also, airlines around were finally ready to start mak-
the world are often supported “If AER’s customers go ing good profits in 2008 but
by their governments, so they then the global recession hit.
don’t have the same financial bankrupt, it can With 80% of their tire sales
stress. being replacement, and only
repossess the airplane 20% to OEMs, the recession
While it sounds risky to rent shouldn’t have had as big of an
and easily find
an airplane to an airline, when impact on the business. But
you look at the business and someone else who OEM car production fell by
the history of it, you see that 50%, enough to lower capacity
losses are really minimal. With wants to rent it. AER’s utilization at their factories and
AER, what matters most is not hurt their overhead cost ab-
if an airline goes bankrupt, but business was nowhere sorption. GT did some more
do they have the right planes, restructuring, and earnings
those in demand by most air- near as credit-sensitive started coming back.
lines? If you own a 757 that
as one might think, but
people aren’t really flying any- I think people got frustrated
more, and it is repossessed, it’s back in 2008, it was with GT and moved on to oth-
going to be hard to find some- er things. I passed over it on
one else to buy it. If it’s a mod- priced that way.” the screens a number of times.
ern, fuel-efficient 737 or A320 The truth was obscured by
that everybody around the lots of noise. Investors just had
world uses and where there is to peel it back and sift through
a production backlog today, G&D: You mentioned Good- it. When you did, you saw a
there is much less risk to the year Tire (GT) earlier in our company that was positioned
collateral. If AER’s customers conversation. What makes it a to do very well. They previ-
go bankrupt, it can repossess good business? ously had peak earnings in
the airplane and easily find 2007 of $1.66. They were sup-
someone else who wants to AW: GT has not always been posed to make $3 a share this
rent it. AER’s business was a great business. It used to be year, record earnings, record
nowhere near as credit- a lousy business that we would margins, and while the stock is
sensitive as one might think, have never touched before. up to $28, it’s trading at a
but back in 2008, it was priced modest valuation of just over
that way. The company used to make 9x earnings.
low-end commodity tires and
AER earned $2.63 last year, high value performance tires. There’s a lot of institutional
and this year they’re projected Asian imports killed the low- memory in stock valuation.
to earn $4.95. That big jump end part of the business. With Most of the time it’s right, but
was because year they ac- factories and unionized labor, you can find exceptions. In our
quired ILFC in December of it took GT the better part of view, there’s nothing wrong
last year from AIG and the the first decade of the 2000’s with Goodyear. It’s cheap be-
deal was incredibly accretive. to exit that business. The cause of an outdated view of
whole US tire industry shut what the business is. Today,
(Continued on page 28)
Page 28
Andrew Wellington
it’s a good business and still Another successful short for multiples adjust to the right
significantly undervalued. us has been Whole Foods level.
(WFM), a similar story to
G&D: Is there a short you Coke. We expected them to G&D: Thank you for taking
would be willing to discuss? continue to perform at the the time to speak with us.
high level they had been per-
AW: We are short Coca-Cola forming but even if they did
(KO). Coke’s a great company. that, they were significantly
They make a great product. overvalued. And now we may
But Coke trades at about 20x be seeing a negative inflection
earnings. They’ve grown their in the business with increased
earnings at only 5% a year for competition nipping away at
the last five years and they’re their position. They still might
not expected to grow that be the best organic foods mar-
much faster over the next five ket, but their competitors are
years. Why does Coke have a selling more organic foods and
20x multiple? Because Coke at lower prices.
used to be worth 20x and in-
vestors have become anchored The stock is already down a
to that multiple despite funda- lot but now the company is
mentals. earnings less than we initially
estimated. We believe it has
If you go back to the late ‘90s, further downside and still
Coke was a global growth looks like a really attractive
powerhouse. They produced short here despite the fact that
double digit EPS growth year we think it’s a great company.
after year and penetrated
emerging markets. But now, The vast majority of the names
they have reached a certain we are short, I’d be happy to
maturity level. We are also be long if they were at a signifi-
starting to see some cracks in cantly lower valuation. Any-
the business. Consumers don’t thing we’re long, if it were at a
like carbonated soft drinks as significantly higher valuation, I’d
much anymore and you’re see- probably be happy to be short.
ing that category shrink. The difference in valuation is
everything.
We feel we can reasonably
estimate the future earnings of Interestingly, while we are long
a company like Coke. Margins value, we are not short
are stable. Sales growth is growth. The businesses in our
pretty stable. Not a lot of cata- short book don’t grow any
lysts that can dramatically faster than those our long
move the earnings of a compa- book. They have high multiples
ny of that size and scale and because they grew really fast a
scope. long time ago. There’s a cer-
tain stickiness to multiples. We
Coke is getting credit for con- see that with Goodyear too. It
tinued high performance, but if still has to shake off that repu-
things don’t go that well, tation of its past and continue
there’s much more downside. to perform. On the flip side,
It’s been a very profitable you also see it with Coke. Mul-
short over the past 18 months tiples are slow to adjust. Over
for us. It has underperformed subsequent years, as the earn-
the market by 16% at this ings come through, eventually
point. the market catches on, and the
Page 29
nue on multiple large projects (Topaz, Desert Sunlight) that $100 $3.23 $86
$3.0
$2.5
were negotiated in 2011-2012 in a significantly higher pricing $80
$2.43
$2.0
$60
environment. $40
$2.02
$1.68
$1.5
$1.0
Power purchasing agreement (PPA) prices have fallen from $20 $0.5
some PPAs signed below $50/MWh in 2014. Lower PPA Source: GTM PPA ASP/W
2) The U.S. utility-scale market is saturated and will not be able to sustain the volumes that FSLR
needs to maintain the current level of earnings.
The step-down of ITC from 30% to 10% in 2017 has pulled forward a significant amount of demand, as a pro-
ject needs to be completed and connected to the grid by 2017 to receive the ITC. Installed utility-scale solar
capacity will double vs. 2013 in the next 2 years as 13.5GW of current project backlog will come online.
Demand is driven by state renewable portfolio standards (RPS), and states with significant RPS have already
contracted the majority of MW needed to meet them. California accounts for 62% of planned and existing
solar capacity. The three main CA utilities have contracted the majority of solar capacity needed to meet RPS
by 2020, with only 1.3GW of additional capacity required through 2020 (or only 220 MW/year).
None of the three major U.S. developers – FSLR, Sunpower, or SunEdison – have project backlog beyond
2016. New PPAs signed in CA and NV are for 2019 power delivery, showing that utilities only need to fill out a
small amount of remaining back-end compliance demand.
ITC expiration acts as a major demand headwind, as project costs will increase by 20%.
Increasing competition for fewer projects is driving some developers to sign PPAs at uneconomic levels ($30-
40/MWh signed in latest Duke Energy RFP) or build projects without PPAs (FSLR’s Barilla, TX project).
3) Increasing competition will make it difficult for FSLR to compensate for a slowing U.S. business by
expanding overseas and management is overstating FSLR’s ability to compete internationally.
International projects account for only 10% of FSLR’s current pipeline. Project development is a local business,
requiring knowledge of local politics, permitting, and regulations (the reason why foreign developers have not
been able to penetrate the U.S.).
Page 30
5) Potential margin compression as prices fall and project lead-times shorten can act as an additional catalyst.
Project margins have fallen from 36% in 2013 to 27% in 3Q’14. Margins are likely to fall further due to increasing compe-
tition and expiration of ITC, as the loss of 20% ITC by customers should put further pressure on pricing.
Costs have historically fallen slower than prices (-58% module pricing vs. -18% cost in 2010-2013). Module pricing is
already low and balance of systems (BoS) costs are difficult to decrease due to labor and shipping as significant compo-
nents.
Transition to smaller projects due to limited demand and difficulty of finding suitable locations creates less project lead
time and less opportunity to take advantage of cost declines during the life of a project.
Valuation
Given that project volumes will peak in 2015 and will then begin to normalize, I believe that a price target based on an average
of earnings over the next 3 years (2015-2017) is the most appropriate way to value FSLR. My $30 price target, which repre-
sents a downside of ~25%, is based on a blend of EBIT (8x) and EPS (12x) multiples (historical average multiples over the last 3
years). The value of the operating business is ~$13 per share, with the remaining value consisting of average cash/share of
~$17. Given FSLR’s volatile WC needs and potential for WC to remain trapped in projects held on balance sheet for longer
than anticipated, cash/share may be significantly lower, which represents potential additional downside. Note that 2017 gener-
ously assumes recognition of 800MW of project revenue while FSLR currently has no 2017 backlog.
Key Insights:
1) The initiatives announced are low hanging fruit and results will exceed management guidance
In mid-November, JetBlue outlined three initiatives (Fare Families, Cabin Refresh and Other) to achieve an additional $450
million of pre-tax operating income by 2018 ($0.79 EPS) and add at least 300 bps to ROIC by 2017. I believe management
was abundantly conservative. JetBlue will exceed its objectives by at least $100 million.
Fare Families: JetBlue will price tickets based on the bundling of services and features. At the cheapest level of service,
JetBlue will charge first checked bag fees which are currently free. Execution will be easy (systems already installed) and
the impact is predictable (many historical examples). I model additional operating income of $208 million and $222 million
in my base and bull scenarios, respectively.
Cabin Refresh: JetBlue will increase seat density on its A320s (65% of its fleet) by decreasing seat thickness and pitch.
The total number seats on the A320 will increase from 150 to 165 and will increase JetBlue’s available seat miles (ASM) by
7.2%. Management expects at least a $100 million run rate of incremental operating earnings. This is the biggest opportunity
to exceed guidance. Even with the conservative assumption that the new seats yield 62% of the revenue of other seats, the
initiative would add $232 million of additional revenue per year. After accounting for additional costs, JetBlue would earn
$185 million of operating income from seat densification.
Other Initiatives: This includes six initiatives that management expects to earn $150 million in operating income by 2018
($0.27 EPS). Management’s guidance appears abundantly conservative considering that three of the six (Even More,
TrueBlue, Mint) will conservatively generate $155 million. Even More will generate $68 million of incremental operating
income with 2% annual price increases. TrueBlue will generate $60 million according to contracts that management is
currently finalizing. Mint will earn $26 million with no expansion. This leaves us with a free option on the other three
initiatives (Wi-Fi and ancillary product sales) which could yield $30-40+ million.
Page 32
Valuation
JetBlue currently trades at 9.2x enterprise value to forward adjusted EBIT (2015). If we apply an 8.0x multiple on
forward adjusted EBIT (the industry average is 8.3x), it implies JetBlue will worth $26.42 per share (74% upside) in
2016 (8x FY17 adj. EBIT). At my target price of $26.42 in 2016, JetBlue would be trading at 11.8x forward earnings.
ROIC will grow from 8.5% in 2015 to 15.0% in 2018. ROIC will exceed management’s guidance of 10%+ in 2017 by
about 290 bps.
In my bull scenario, load factors reach all-time highs without pricing concessions. At 8x EV/Forward 2017 adj. EBIT,
JetBlue would be worth $29 per share in 2016 (94% upside). In my bear scenario, load factors drop and ancillary fees
are
Page 33
Norway and Sweden, generating 10-15% EBITDA Blocket €12.8€16.4 (3% pa) and EBITDA
2) Schibsted’s dominant online classified proper- the bag” due to Jan 2015
investment banking analyst at expiration of Spir agreement
3) There is an extreme monetization gap between Schibsted’s Scandinavian properties and its other 20+
dominant sites: Schibsted’s properties Norway + Sweden = 12m internet
in Norway and Sweden are monetizing at users; 145m additional internet
levels significantly higher than its other users in red box + >600m additional
in 20+ countries with #1/2 positions
30+ #1/2 sites due to dominance across
all four major verticals in Norway and
Finn and Blocket having established their
#1 position 7-10 years prior, allowing for
many years of price increases in inelastic
markets. Schibsted has generated €131m
in TTM EBITDA in Scandinavia, yet the
population of the countries of the other
six sites in the table is 14x that of Nor-
way + Sweden.
Schibsted Media Group (SCH: NO) - Long (Continued from previous page)
(and migrating upwards a few % annually). Further, LBC’s real estate vertical has been under-earning in France and will
accelerate rapidly in 2015/2016 due to the expiration of the legacy “Spir” agreement at the end of 2014. It is estimated
that this venture generates ~€50m in revenue (versus #2 site Seloger’s €125m), of which LBC only receives €10-15m
despite driving 80%+ of the traffic due to the poor economics to LBC of the original deal when it was a small player.
Beginning in 2015, LBC should start to see a revenue lift of €40-50m as it can earn 80-90% of the economics versus the
15-20% today. Given LBC’s traffic is larger and growing faster than #2 Seloger, a similar €125m run rate in 2015 for
real estate alone should prove to be an easy target. Further, I estimate LBC’s Auto TAM to be ~€450m: 5.5mm used
cars sold annually in France at $10k; $100/car (1% take-rate) = ~€450m TAM.
5) Schibsted’s “Core five” classified properties in 2017, (Norway, Sweden, France, Spain & Italy) are esti-
mated to be worth €10-13bn, or 70%- 2017e EV /EBITDA Ente r pris e V alue
120% greater than Schibsted’s valuation Eur (m) EBITDA Low M id High Low M id High
today: while Schibsted does not break out Norw ay
Sw eden
96
72
12x
12x
14x
14x
16x
16x
1,152
870
1,344
1,014
1,536
1,159
financial details on sites in France, Spain or Franc e 287 14x 16x 18x 4,024 4,599 5,174
Italy, I have conservatively modeled France by Spain 137 14x 16x 18x 1,917 2,191 2,464
Italy 133 14x 16x 18x 1,858 2,124 2,389
vertical and arrive at a 2017 rev/internet user Total 726 14x 16x 18x 9,821 11,272 12,723
of €6.5, or ~40% of that achieved by Blocket.
Although Blocket is more mature, it is only Current Sc hib sted Enterpris e Value 5,852 5,852 5,852
"Cor e 5" as % of Cur re nt Schibs te d EV 168% 193% 217%
dominant in two verticals versus LBC’s four,
emphasizing the conservatism in these estimates. I have thus used €6.5 rev/user as the proxy for revenue potential for
Spain and Italy, and then adjusted this figure by GDP/capita to arrive at similarly conservative estimates.
6) Schibsted’s “Other Non-Core Established” sites in Brazil, Ireland, Finland, Austria, Thailand, Indonesia,
Bangladesh and Malaysia are likely to contribute at least 15% of Base Case EBITDA Growth; and this
ignores the optionality of the 20+ other dominant sites covering ~770m internet users by 2017.
7) The JV with Naspers announced on 11/13/14 was a game changer: Schibsted and Naspers are the leading
players in online classifieds, with either ranking #1 in most countries with little geographic overlap, but both had been
investing heavily to win the Brazilian market in past years. To the market’s delight (+34% stock move on the announce-
ment), Schibsted created a global online classifieds JV with Naspers, immediately ending capital-intensive marketing
wars across these markets, in particular Brazil, where Schibsted was investing more than €100mm per year. Additional-
ly, Schibsted has now ensured dominant competitive positions in huge and attractive markets. Brazil is a market of
200mm people (20x Sweden) where Schibsted’s “Blocket” generates €100mm+ in annual revenue.
8) Avito (Russia’s now dominant classified site) merged with the #2 and #3 sites and is a good case study
for future Schibsted monetization: Avito was crowned the winner in Russian classifieds in May 2013 when it
merged with the #2 and 3 sites. Prior to the transaction, Avito was generating rev/internet user of ~€1 and a negative
EBITDA margin; now 1.5 years after the deal, Avito is generating 4x the revenue and has dramatically reduced its in-
vestment spend, resulting in Q314 EBITDA margins of 65%. This is clear evidence that the moment a winning site is
crowned, revenues grow rapidly, marketing spend is cut, and EBITDA margins expand dramatically.
LTM 2017E
EURm 2011 2012 2013 9/30/2014 Dow ns ide Bas e Ups ide Ups ide +
Re ve nue
Total Classif ieds 412 494 506 546 835 1,236 1,816 2,449
Total Media Houses 1,306 1,358 1,199 1,188 906 1,076 1,076 1,076
Other 134 148 103 31 0 0 0 0
Total Re ve nue s 1,852 2,001 1,808 1,765 1,741 2,313 2,892 3,525
EBITDA
Total Classif ieds 135 149 102 156 321 636 953 1,206
Total Classifieds ex-Investments 221 221 229 371 661 978 1,231
EBITDA Margins
Total Classif ieds 33% 30% 20% 29% 38% 51% 52% 49%
Total Classifieds ex-Investments 45% 44% 42% 44% 53% 54% 50%
Total Media House 14% 12% 12% 11% 0% 9% 9% 9%
Total EBITDA 15% 14% 11% 13% 15% 29% 35% 36%
Adj. EPS (Euros ) 1.82 1.78 1.14 1.10 1.46 4.34 6.56 8.24
Thesis Points
CDK will see solid topline growth, as
the recession resulted in underinvest-
ment in dealer information services
systems. N. American new vehicle
sales have normalized and increased
dealer profitability enables them to
reinvest in their businesses. This is
badly needed (some systems are still
DOS based) and CDK will benefit as
the industry transitions from analog to
digital. In addition, N. America dealer
consolidation should drive more deal-
ers to switch over to enterprise-grade
solutions like CDK (CDK already has
7 of the 10 largest US dealers). Digital
marketing will also gain in importance
as dealer allocation of advertising spend to digital media lags consumer shopping behavior and preferences. By 2017,
eMarketer forecasts that US digital automotive ad spend will reach $9.3 billion, representing a 15.7% CAGR from 2013
spend. Lastly, there will be an EM growth opportunity as auto sales in China grow faster than most Western markets.
This is a remarkably resilient business - during the economic downturn, CDK’s N. America organic revenue declined
by 4% between FY09 and FY10, while US car sales volumes declined 21% from CY08 to CY09 and 760 dealerships
closed (3.6% decline nationally).
CDK’s margin opportunity is significant. It has 2x the employees of REY and is clearly overstaffed. REY was taken
private in 2006, at which time it had a similar margin structure to CDK today. REY was able to boost its EBITDA
margins to over 50% (nearly 60% at peak) by turning over a relatively expensive workforce ($110,000/year average
salary) and cutting other costs. Diligence checks with industry experts suggest there is no reason why REY and CDK
should have different margins and that CDK has a lot of fat to cut. CDK’s management indicated as much in its first
conference call, saying they can increase margins without too much effort and targeting at least 100bps of margins
expansion annually. A 10% reduction in headcount at $100,000/year would boost EBIT margins by 5% and save CDK
$90 million or $0.57/share annually. Headcount will likely be cut more and salaries are likely higher, implying even
greater potential savings.
CDK is currently underpricing its competitors. Industry sources have hinted to pricing as being as much as 20% below
REY which is clearly impacting margins and unneeded given REY’s poor reputation in the dealer community for service
and technology.
Page 36
Valuation
At the current price of $40.29 (12/19/14), the market is not giving CDK any credit for realistic margin expansion or
topline growth. REY clearly laid out the playbook when they increased margins from 20% to 52% shortly after the
LBO. All of my primary diligence leads me to believe that CDK will be able to increase margins to at least 30%, and
40% more realistically.
The market seems to be only currently pricing in that CDK will improve margins to the low 20%s, a level which can
be achieved with minimal headcount reduction. If CDK grows at the midrange of management’s guidance and makes
minimal EBIT margin improvements (still at a substantial margin differential to REY), that alone justifies the current
price. This also assumes no buybacks and no increase in dividends. My model assumes CDK will rapidly expand mar-
gins as they cut costs and increase prices. Additionally, they will be able to modestly grow topline revenue.
At present, CDK trades at 11x 2018 FYE FCF, which is absurdly low for this high-quality of a business. As manage-
ment executes and jumps over the one-foot hurdles ahead of it, CDK will rapidly grow earnings and FCF, allowing it
to repurchase substantial amounts of stock (36% of the current market cap by 2018 FYE by my estimates).
CDK will earn $3.73 in 2018 FCF and should be able to trade at 17x FCF. Adding cumulative dividends over that
time results in a $65 price target, or 61% upside the most recent price. A DCF model results in a similar conclusion.
CDK has further upside optionality from a potential SaaS conversion over time (discussions with industry profession-
als and dealers lead me to believe this will happen in the future, albeit not likely anytime soon). The math below
illustrates how an eventual SaaS conversion will boost CDK’s topline and should also result in higher margins.
Page 37
Valuation
We believe management guidance for Retained Value / Watt is too aggressive. Their guidance assumes 90% renewal
rates at 90% of the 20 year forward PPA price, continued. We think 90% renewal is only possible at 60% of the price
given system cost declines and solar escalators can be above utility cost growth.
We assume lower revenue escalators and continued elevated sales & marketing spend given industry competition.
Blue Sky
Even using aggressive assumptions, we can only justify a stock price that is 77% of the current price
Key assumptions include: 1) 40% revenue CAGR over the next 11 years, 2) OPM expanding to 16% over time, 3)
14x exit EBIT multiple
Page 39
Thesis Points:
ATM Usage Is In Secular Decline. As we move towards a paperless
economy, ATM usage has begun to decline. Since 2009, ATM usage has
declined 1.1% per year and is accelerating to the downside. However, man- 6
agement has indicated that they expect same-store-growth to increase at 3-
ATM Withdrawls
Edward Reynolds ’16 5.9
5% annually, despite almost-zero same store transaction growth over the
(billions)
Edward is a first-year past few years. 5.8
student at Columbia
Business School. Prior Declining Organic Business. Over the past four years, CATM has seen 5.7
to CBS, Ed was at returns on capital shrink meaningfully. Today, CATM is barely earning above 5.6
a return above a standard cost-of-capital, yet is framing their business as
Citadel in the Electronic 5.5
Execution and Market- “growing double-digits”. Incremental returns on invested capital have been
below 5% for two of the past three years and negative in 2013, illustrating 2002 2007 2012
Making groups.
that CATM is unable to find attractive places to deploy capital. In
addition, CATM’s organic revenue has declined meaningfully over 2010 2011 2012 2013
the past few years as revenue per transaction has fallen more than
20% since 2010 .
Reported EBIT $70 $83 $97 $110
Acquisitions / Accounting Games Are Masking Decline. less: incremental D&A (5) (9) (10) (26)
Despite a rotting core business, CATM has shown ~15% annual Fundamental EBIT $64 $74 $87 $84
revenue growth and ~25% annual earnings growth through a combi-
nation of acquisitions and changes to accounting estimates. These Invested Capital $379 $612 $691 $846
acquisitions have not been creating shareholder value; however, as
Kevin Lin ’16 ROICs have consistently degraded under this strategy. In addition,
ROIC (with acquisitions) 17.0% 12.1% 12.5% 10.0%
CATM has adjusted the useful life estimates on its equipment in
Incremental ROIC 4.2% 15.8% (1.6%)
Kevin is a first-year order to reduce depreciation expense.
MBA student at
Columbia Business 2008 2009 2010 2011 2012 2013
School. Prior to CBS,
Kevin was an analyst at Depreciation Expense $38 $37 $40 $46 $59 $66
Sansome Partners. Gross PP&E 231 253 291 362 460 632
Declining Interest Rates Have Inflated Operating Income. For the machines that CATM owns, CATM is
responsible for providing ‘vault cash’ (stocking the ATMs with cash). This cash is borrowed at a spread above LIBOR
from large banks. CATM has benefitted meaningfully from the compression in interest rates; however, this benefit is a
double-edged sword and CATM is likely to see a significant compression in profitability as interest rates increase.
Valuation
Fair Value
CATM currently trades at a 4% cash flow yield,
9x LTM EBITDA, and 35x our view of normal- Precedent Valuation $21.80 $29.91
ized earnings.
Our analysis suggests that Cardtronics’ shares
have downside potential of 40% to 80% over
Free Cash Flow Yield $15.52 $19.40
the next twelve to eighteen months.
The main catalyst for decline will be the loss or
reduced economics associated with the 7-
Eleven contract, which we believe will be con- Comparables $22.66
cluded well in advance of the June 2017 roll-off.
In addition, we believe the core business will
continue to accelerate to the downside and
investors will see the declines start to bleed Discounted Cash Flow $8.02 $11.97
through the M&A-masked figures.
We believe the potential upside in the shares
(or downside to the short) is in the range of
15% to 20% over the same period, implying a Current Share Price $39.37
3:1 short-term upside-to-downside associated
with our recommendation.
$- $10 $20 $30 $40 $50
Key Risks
Per Share Value
Continued M&A. Management has done an
excellent job of showing the Street growth in
both the top-line and bottom-line by making acquisitions with balance-sheet cash or incremental debt. To the extent
that management is able to continue to make acquisitions, it may continue to mask declines in the core business,
although we believe that universe of attractive M&A opportunities is much smaller than a few years ago.
7-Eleven Contract. While we view the odds of Cardtronics winning the 7-Eleven contract as extremely unlikely
(and, even if that unlikely event occurs, we believe the economics will be substantially reduced), we do acknowledge
that small-probability events can cripple a short thesis. Having spoken to members of the investment community, we
believe the potential overhang in the stock today is ~10-15%, which we believe is the short-term upside associated
with this risk.
Timing
Consistent with all short investments, we view timing as very important, especially given the biggest catalyst (the loss or
economic adjustment of the 7-Eleven contract) will not occur until 2017. However, given (i) the continued deterioration
of the core business, (ii) the increased overhang that will likely develop in the stock as 2017 approaches, (iii) the current
extreme valuation of the business, and (iv) the potential reduction in the actionable M&A universe, we believe investors
should consider engaging at these levels.
Historicals Forecast
2010 2011 2012 2013 2014 2015 2016 2017 2018
Number of ATMs 36,970 52,886 62,760 80,594 80,594 80,594 80,594 80,594 80,594
Transactions Per ATM 11.2 9.8 11.2 10.7 10.6 10.5 10.4 10.3 10.1
Number of Transactions 413,780 516,564 704,809 860,062 851,461 842,947 834,517 826,172 817,910
Revenue Per Transaction $1.29 $1.21 $1.11 $1.02 $1.02 $1.02 $1.02 $1.02 $1.02
Revenue $532 $625 $780 $876 $868 $859 $850 $842 $834
% growth 17.4% 25.0% 12.3% (1.0%) (1.0%) (1.0%) (1.0%) (1.0%)
COGS $360 $420 $536 $587 $587 $587 $588 $589 $590
Gross Profit $172 $205 $244 $290 $281 $272 $263 $253 $244
SG&A 44 56 65 84 84 84 84 84 85
EBITDA $128 $149 $180 $206 $197 $188 $178 $169 $159
% margin 24.0% 23.8% 23.0% 23.5% 22.7% 21.8% 21.0% 20.1% 19.1%
Page 41
Progressive’s margins vary amongst its three operating regions. The company operates with EBITDA margin of 36% in Can-
ada, which is a highly consolidated market where Progressive and Waste Management command market share of ~75%.
Progressive operates with EBITDA margin of 25% in the US South and 21% in the US North East, which is a fragmented and
competitive region.
Investment Thesis
1) New management team brings focus on ROIC improvement in a historically poorly-managed business.
As a result of rapid growth through acquisitions in the past, Progressive has historically operated with ROIC that has lagged
Jay Ju ’15
its competitors (4.7% in 2012 compared to 9-10% at WM and RSG). The new management team seeks to enhance ROIC to
Jay is a second-year MBA a targeted 8-10% through profitability improvements and disciplined use of capital.
student at Columbia
Business School. Prior to Vertical integration of collection, transfer and landfill services enables Progressive to benefit from improvements in its inter-
CBS, Jay was a portfolio nalization ratio, or the percentage of waste volume tipped at its landfills from its collection operations. Internalization al-
manager at Mirae Asset lows the avoidance of third-party disposal fees, a steady supply of waste and greater pricing power with third-party collec-
Global Investments. tions companies. By increasing route density in markets where Progressive also offers landfill services, the company can
strengthen the internalization and margin profile of its existing operations. Progressive’s internalization stands at 45% today
compared to 68% at WM and RSG.
Management has been executing on its strategy of optimizing pricing and volume arrangements in its US operations. In the
North East, recent lower volumes reflect management’s focus on reducing non-profitable collection volume to drive higher
margins. EBITDA margins in the North East improved to 21% in 3Q13 from 16% in 1Q14.
Other capital improvement initiatives include extending the life of its trucks through better/preemptive maintenance to
decrease replacement capex, use of CNG-fueled trucks to decrease fuel costs, use of automated trucks to decrease em-
Steve Lin ’16 ployee injuries, and improvement of route productivity to decrease the number of trucks needed.
Steve is a first-year MBA 2) Change in industry dynamics brings various tailwinds for both pricing and volume.
student at Columbia Prior to 2012, WM was known for price aggression (notably underbidding RSG for a large contract with Home Depot),
Business School. Prior to depressing prices in the industry. Following a restructuring in 2012, WM has begun to pursue a strategy of raising prices and
CBS, Steve was a Vice cutting costs, a marked change from previous share-maximizing behavior. In 4Q13, WM’s pricing on existing volumes in-
President at Investcorp’s creased 4% while volumes declined 2.2%, despite increasing volumes for other public competitors. WM is currently guiding
FoF and Technology PE for price increases of 2-2.5% in 2015 which should benefit Progressive as well.
groups.
Residential, commercial and industrial waste volumes are expected to increase at CAGRs of ~1% in the US and Canada as
household formation, commercial and industrial activity recover and recycling/diversion levels have moderated.
Page 42
3) Improving free cash flow generation enables attractive options for capital allocation
Capex has been elevated (13.5% of revenue in 2013) due to a number of discretionary infrastructure projects that
amounted to ~$80 million of investment from 2012-2Q14. Post-completion, total capex is expected to be 10% of reve-
nue going forward. Expected replacement capex was revised from 10% of revenue to 8%, attributed to capital spending
discipline and pre-emptive servicing of trucks to extend useful life.
Progressive announced in its 3Q14 earnings call that it expects its go-forward effective tax rate to be 25% compared to 35
-40% in prior years due to changes in its internal financing structure and its Canadian domiciling.
Progressive has shown a willingness to return capital through dividends (25% of FCF generated from 2011-2013, 1.9%
dividend yield) and share buy-backs ($135 million in 2011 and 2012). Progressive will generate $1 billion in free cash flow
over the next three years compared to its current market cap of $3.4 billion, and will likely be able to increase the
amount of capital returned to shareholders.
Tuck-in acquisitions can be particularly accretive for Progressive. M&A has been discussed by both WM and RSG, who are
able to acquire collection companies for 6-7x pre-synergy EBITDA or 4-5x post-synergy EBITDA. Progressive has circled
$600 million in revenue at 25% pre-synergy margins for acquisition over the next 5 years. Assuming Progressive can find
targets at similar economics, ROIC on such acquisitions should be higher (~10%) than current overall ROIC. Its tax rate
advantage (WM and RSG have higher tax rates of 35%) should give it an advantage against other acquirers as well.
Valuation
Our base case target price of $46
is based on a 13.8x forward mul- ($ in millions) Base Case Bear Case Bull Case
tiple of 2018P EBITDA-CapEx of Forward EV/(EBITDA-CapEx) 13.8x 12.4x 13.8x
$490 million. An EV/(EBITDA- 2018P EBITDA $757 $524 $875
CapEx) multiple best reflects the 2018P CapEx 267 221 291
earnings power of the company 2018 EBITDA - CapEx 490 304 583
as margins expand and capex 2017 Enterprise Value $6,773 $3,764 $8,061
declines. We believe using an Less: 2017 Debt 2,005 1,511 2,266
average peer (WM, RSG, WCN) Plus: 2017 Cash 606 423 540
multiple of 13.8x is justified as we Implied Market Capitalization $5,374 $2,676 $6,335
forecast the company’s EBITDA
Dil. Shares Outstanding 115 115 115
margins to move closer to that of
Implied Price per Share $46.84 $23.32 $55.21
its peers (31-32%). Progressive
Current price $29.67 $29.67 $29.67
currently trades at a 15x forward
Upside (%) 57.9% (21.4)% 86.1%
EBITDA-CapEx multiple as it has
over the past couple of years.
Financials ($US M) 2012A 2013A 2014E 2015P 2016P 2017P 2018P 2019P '14-'19 CAGR
Revenue $1,896.7 $2,026.0 $2,000.0 $2,160.4 $2,325.6 $2,495.9 $2,671.3 $2,851.9 7.4%
% growth 6.8% (1.3%) 8.0% 7.6% 7.3% 7.0% 6.8%
EBITDA $511.3 $521.6 $503.6 $560.3 $623.6 $689.1 $757.1 $813.0 10.1%
% margin 27.0% 25.7% 25.2% 25.9% 26.8% 27.6% 28.3% 28.5%
FCF1 $181.8 $282.7 $262.0 $290.9 $328.5 $367.5 $408.0 $439.1 10.9%
% growth 55.5% (7.3%) 11.1% 12.9% 11.9% 11.0% 7.6%
EPS $0.81 $1.02 $1.17 $1.25 $1.46 $1.68 $1.91 $2.07 12.1%
% growth 25.8% 14.1% 6.9% 17.0% 15.1% 13.7% 8.2%
ROIC2 4.7% 5.5% 6.8% 6.9% 7.7% 8.6% 9.5% 10.1%
(1) Cash flow from operations - maintenance capex
(2) NOPAT / (Net Debt + Equity)
Key Risks
EBITDA margins don’t improve as expected due to lower price increases and increased competition
Internalization stays significantly below competitors’ levels
Capex requirements are higher than expected
Tuck-in acquisitions may not be available or accretive
Get Involved:
To hire a Columbia MBA for an internship or full-time position, contact Bruce Lloyd,
Director, Employer Relations, in the Office of MBA Career Services at (212) 854-8687 or
valueinvesting@gsb.columbia.edu.. Available positions also may be posted directly on the Co-
lumbia website at www.gsb.columbia.edu/jobpost.
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Contact Us:
mford15@gsb.columbia.edu Graham & Doddsville Editors 2014-2015
ppan15@gsb.columbia.edu
tschweitzer15@gsb.columbia.edu Matt Ford ’15
Matt is a second-year MBA student and member of the Heilbrunn Center’s
Value Investing Program. During the summer, Matt worked for Signpost Capital, a New
York-based long/short equity fund. Prior to Columbia, he worked as an analyst for Res-
ervoir Capital, Farallon Capital, and Bain Capital/Sankaty Advisors. Matt graduated from
The Wharton School of the University of Pennsylvania with a BS in Economics and BA in
East Asian Studies. He can be reached at mford15@gsb.columbia.edu.