Sunday, 25 December 2016

Thoughts on the week ending Dec 23, Trump Market Moving Tweets, Globe and Mail 2016 Dogs (and by association Coca Cola Femsa, and Trip Advisor)

A few quick thoughts on the week ended Dec 23, 2016 and on Mainstream Financial Media (take your pick, BNN, CNBC, etc.).

For the most part, BNN, CNBC, etc., usually aren't a source of anything newsworthy. I say usually, because on the odd occasion, these networks will have great guests on with compelling viewpoints, but I'd peg these occasions as infrequent, especially in Canada where we get to enjoy BNN, rife with regurgitated news, entire broadcasts devoted to marijuana grow-ops posing as going concerns, and "unbiased experts" pitching their books in the guise of top picks nightly (in their defense, if they didn't pitch their books to BNN viewers, they'd have nobody to unload positions onto).

My daily BNN/CNBC routine is as follows:

I check in at 7 AM to see if I've missed any headlines from the previous evening and then I switch off and watch the sportscentre highlights which are far more interesting. I also watch market call while working out in the evenings in order to draw inspiration for fighting through my workouts. I find that market call provides great fuel for pushing out extra reps, especially when the discussions are exceptionally stupid.

This week, CNBC was falling over itself on two themes. 1) Dow 20,000, and 2) Trump's Tweets.

First off, Dow 20,000

I'm probably not the first participant to state that Dow 20,000 is irrelevant, and I won't be the last. But to me, the Dow is entirely irrelevant. Why? Well, firstly, the Dow is one of the financial world's most closely watched barometers, and because of this, I find the barometer itself irrelevant. By virtue of everyone focusing on the Dow, I choose not to. Secondly, 20,000 means nothing. It's a price level derivation based on the price weightings of the underlying constituent companies. Here's the calculation courtesy of wikipedia:

 



So here we have an index construct moving higher (or lower) based entirely on price weightings of the constituent companies. For reference, here are the top price weighted companies in the Dow as of Friday Dec 23rd, courtesy of indexarb.com:




















Based on the above, it's not difficult to understand why the Dow has rallied 11% since Trump won the election on Nov 9. Goldman Sachs alone has rallied close to 40% in less than a month!

Being the cynical participant that I am, I've started to wonder about the fundamental underpinnings driving this move. What has changed so drastically as to support a 40% move in Goldman Sachs? The answer is something along the lines of: everything and nothing at the same time.

From my readings thus far, the move has been in anticipation of relaxation of financial regulatory and accompanying constraints and the potential repeal of the Frank-Dodd Act as a result of Trump's ascension to office. So, devoting an entire broadcast week (or month, or quarter) fixating on whether GS will rally another 10%-20% in order to move the Dow another 100 points is idiotic to say the least. I'd hazard a guess that GS is more likely to give up some portion of the 40% move in the next year vs. continuing up ad infinitum, and any pressure on GS will translate into pressure on JPM (and other financials) as well. These two constituents represented around an 11% weighting in the Dow as of Friday's close, so if Dow 20,000 indeed happens, it will happen when no one is watching (or cheering for it).

This brings me to my next point on Trumps Tweets

In my opinion, we are faced with an increasingly risky investing environment going into 2017. While the markets have vaulted to all time highs, the vault seems to have been built on anticipation of policy change due to a changing of the guard in the oval office. And the scary thing here is, this has become pervasively accepted investment rhetoric as participants seem to now all agree that Trump = good. When everyone seems to be lined up on the same side of the ledger, well, only good things can happen, right? My guess is that as 2017 unfolds, maybe, just maybe, some discernible level of doubt will rear its ugly hide and work to unwind some (or all) of the initial jump in optimism based on, well nothing (yet). I'm going to draw from Seth Klarman's 2015 annual Baupost letter as Mr. Klarman gives voice to short term exuberance much better than I can:

"Value investors must be strong and resilient, as well as independent-minded and sometimes contrary. You don’t become a value investor for the group hugs. Indeed, one can go long stretches of time with no positive reinforcement whatsoever. Unlike some other fields of endeavor, in investing you can do the same thing as yesterday but achieve completely different reported results. In the long run, the research and analysis you perform should overcome market forces; the fundamentals ultimately matter. But in the short run, markets can trump effort and insight. They move in unpredictable cycles, with investors stampeding this way and that. Businesses quickly come in and out of favor, and the same business can be valued by the market very differently in a matter of days, sometimes on the basis of new facts, but often because of mercurial investor perceptions or simply money flows"


This week, Trump tweeted about Lockheed Martin's F-35 fighter being too expensive which, according to the MSFM, "roiled" LMT. The stock was down close to 3% in the premarket and CNBC had a piece on questioning whether this was a buyable dip.

Well, here's LMT monthly as of Friday's close. Is it time to buy the dip yet?

























In my opinion, the fact that the most influential politician on the planet resorts to tweeting is ridiculous, and my prediction for 2017 is that Trump will continue tweeting, and will rattle markets horrendously at some point during 2017 by being a moron on twitter. Maybe a Trump tweet will be stupid enough as to actually cause a real buyable dip (as opposed to a CNBC or BNN broadcasted buyable dip)!

Globe and Mail 2016 Dogs

Well, we got our 2016 dogs courtesy of the Globe and Mail this weekend. Included in the dogs are two very interesting ideas which the Globe (and by extension everyone else) seems to have written off, link here

First up Coca Cola Femsa (by extension from the Globe's write-up on the Mexican peso).

I'll start with a monthly chart and elaborate on the story behind it:
























Why KOF? Well, firstly, the Globe profiled the Mexican peso as a casualty of Trump's ascension to office, and as the Mexican peso goes, so too, by logical extension, will the Mexican economy go, maybe. Funnily enough though, balance of trade has swung to a surplus in Mexico recently as a lower peso has resulted in higher exports to the US, go figure. Now, recently is way too short a time period to draw meaningful conclusions, and a repeal of or significant modification to NAFTA could materially impact future trade flows. There is huge uncertainty here, but the largest casualties of the threats thus far have been anything Mexican (from the peso to Mexican Bolsa constituent companies) dependent on continued unmodified free trade with the US. KOF is impacted by virtue of its exposure to purchases in US dollars. As the peso weakens, it gets more costly for KOF to purchase formula from Coca Cola under the terms of its existing bottler agreements. KOF has also taken on a significant amount of US dollar denominated debt in order to build additional bottling capacity over the last three years. I've plotted a correlation study between KOF and EWW over time, and we can see that KOF pretty closely tracks the performance of the Mexican stock market in general.

The story behind the last three years of abysmal performance in KOF is a function of the imposition of a soda tax in 2014, which hammered Coca Cola Femsa's sales. Prior to the imposition of the soda tax, KOF was firing on all cylinders. I have no idea why it rallied at a 51% CAGR clip between 2009 & 2013, but I'm going to guess that highly mobile capital flows looking to deploy capital into levered bets out of the 08/09 crisis chased KOF up to unsustainable levels predicated on higher estimated per capita consumption of soft drinks in Mexico (and the rest of Latin America), extrapolated forever (this type of logic couldn't possibly apply to capital chasing Goldman Sachs +40% now could it?).

The following infographic courtesy of Statista, link here, details growth in per capita consumption of soft drinks by country between 1991 and 2012 (just before the imposition of the soda tax):




















Guess what! Mexico, Panama, and Argentina round out 3 of the top 5 countries on the list, they all ranked ahead of the US with the exception of Argentina, and all three of these countries are major stomping grounds for KOF. What looked like permanent strength in trend (price trend, not valuation trend) between 2010 and 2013 has given way to an economic reality adjustment over the ensuing three year period since the soda tax was introduced, and with reference to the company's most recent annual report, the soda tax had a material impact on the company in terms of volumes, especially in the initial years after introduction. And if a soda tax wasn't bad enough, now comes the depreciation in the peso vs. the USD! Talk about the consensus paying $160 per share back in 2013 and getting it entirely wrong!

Are we at the point of maximum pessimism yet? No idea, but I do note the following:
  • The universe of $160 per share cheerleaders through soda consumption rhetoric extrapolaters are all likely gone by now (good riddance)
  • The current investing paradigm surrounding Mexico is now bearish
  • There is huge uncertainty surrounding what changes to NAFTA Trump may make
In support of KOF, I performed my own attempt at analyzing the company and performed my own valuation, and I note the following:
  • Notwithstanding the +60% decline in the price of the stock since 2013, the company has a moat and a potential runway by way of future Latam soft drink consumption. While the imposition of a soda tax hit volumes in the first years after introduction, interestingly, consumption seems to have adjusted from the initial reaction, per WSJ, link here:























  • Despite the drop in sales, KOF seems to have been able to maintain operating margins at 15%. No easy task given the absolute % drop in sales since 2013, per below:















While sales are off -25% since the 2013 peak (just before the introduction of the soda tax), EBIT margins has remained constant at around 15%. Taking a closer look, gross margins have actually improved slightly vs. 2012/2013 (on a tttm basis), and have remained constant at around 53%-54%, so I take this to mean that even in the face of the soda tax, the company has maintained pricing power.
















And the valuation metrics haven't been this low for some time (ignoring 2008 & 2012 as outliers):

















For comparison's sake, here's Coke itself:

Caveat, this is a bit of an apples to oranges comparison because KOF is a bottler and KO sells the syrup, so very different business models with very different capital requirement constraints. Even so, whether KOF deserves a multiple 33% lower than KO on a ttm PE basis, 44% lower than KO on a ttm EV/EBIT basis, or 48% lower than KO on a ttm EV/EBITDA basis, is up to the individual investor to decide.


















A more suitable comparison would be to compare KOF to other regional botllers, such as CCE (Coca Cola European Partners), reproduced below, courtesy of gurufocus:














While I don't know where KOF may bottom (somewhere between $63 and $0 in theory), on a free cash flow basis, I get the following matrix of potential valuations at different growth rates:
















Arguably, if KOF got to $45 from here, and assuming 2.5% growth, we'd be looking at a very interesting situation, based on the following:

















Risks:

  • Soda tax doubles from here, further impairing sales
  • Peso continues to drop vs. the USD, impacting future margins
  • KOF can't renew it's license agreements with Coca Cola on favourable terms, impacting future margins
  • Material changes are made to NAFTA which could affect KOF's future purchase supply chain 

Finally Trip Advisor

Courtesy of the Globe and Mail, here's this week's write up on poor old TRIP, categorized as one of 2016's dogs:




















Superficial write-up in my opinion, and my questions are as follows:
  • Was valuation really relatively high?
  • Why did marketing costs soar?
  • Why wasn't TRIP able to capture market share to competing alternatives?
  • Does TRIP have a moat?
Was valuation really relatively high?

Yes, and no. In order to answer this, I have to look at closest comparables. When I think of Trip Advisor, I think of online travel, and closest comparables might be Priceline, Expedia, and to a lesser extent, Travelzoo and C-Trip. But there are differences in the models between the comparables. Priceline & Expedia are OTA's (online travel agencies), and are customers of Trip Advisor. TRIP earns revenue from CPC's by virtue of referring (directing) traffic to OTA's and other direct customers (hotels).

Superficially, TRIP entered 2016 at some pretty lofty multiples relative to the above group. 34x EV/EBITDA and 47x EV/EBIT, based on 12/31/15 reported #'s.

This compares to 18x EV/EBITDA and 20x EV/EBIT for Priceline and 12x EV/EBITDA and 18x EV/EBIT for Expedia, based on 12/31/15 reported #'s.

So we know that valuation looked relatively, high, but the next question is why? Why were participants content to own TRIP at 34x EV/EBITDA and 47x EV/EBIT up to the end of 2015, and how have these multiples adjusted during 2016?

My first observation regarding 2015 is that included in operating expenses was a one time donation of TRIP shares to the Trip Advisor Charitable Foundation of $67M. Normalizing 2015 EBIT for this donation, I get EBIT of $300M. This puts 2015 adjusted EV/EBIT at 39x EV/EBIT vs. 47x as originally thought. Per review of the company's 2015 10K, the contribution was made in Q4 2015, so the ttm numbers also reflect the Q4 contribution.

Currently, TRIP can be had for 26x ttm EV/EBITDA and 46x EV/EBIT. While EV has dropped by close to 50% since the end of 2015, EBIT hasn't improved much if at all, so on a superficial basis, TRIP is still expensive despite a 50% drop in pps. EBIT dropped from $232M at the end of 2015 to $131M on a ttm basis, but adding back the $67M Q4 charitable contribution, normalized EBIT on a ttm basis should be closer to $198M, and normalized EV/EBIT should be closer to 31x. A little better than initially thought.

This leads into the next point:

Why did marketing costs soar and why wasn't TRIP able to capture market share to competing alternatives?

Superficially, marketing costs soared as a result (or consequence) of erosion in CPC's in the company's hotel user base. This makes sense on the surface, as average # of hotel users dropped and CPC per hotel user dropped, the company theoretically played defense in order to win back customers by virtue of ramping up marketing spend, logical right?

Well there's more. Prior to 2014, the company identified a couple of problems with its business model, which were 1) failure to monetize (convert) unique site visitors into clicks, and 2) leakage. Leakage was a direct consequence of 1), and as a result, the company began spending heavily on transitioning its old user interface model with mutiple pop ups redirecting visitors to non TRIP / OTA sites, to an Instant Booking ("IB") model which allows visitors to book hotel travel directly within TRIP's interface without leaving the site.

The IB roll out commenced in 2014 and according to management's most recent quarterly 10Q, is now complete, so any analysis of prospective results must look to what IB may bring as opposed to focusing on the transitional time period during between 2014 and now. Management clearly explains the risks surrounding IB integration in its 2015 10K, including IB not resulting in closing the monetization gap, and/or OTA partners not buying into the new IB model.

There is a fantastic article on the potential of IB over at seeking alpha recently, link here, which outlines the case for IB in great detail. The author demonstrates that over the last few years, revenue per hotel shopper and EBITDA margin per hotel shopper have declined from close to $.60 per hotel shopper in 2014 to $.45 and from 42.7% per hotel shopper in 2014 to 32.4% most recently. The author argues that these declines are due in part to lower conversion rates on IB vs. metasearch, and low initial commission rates offered to OTA's as an inducement to adopt IB. The author makes a convincing argument that the pressure on margins is likely temporary, and goes on to explain that over time, IB adoption and conversion could very well eclipse metasearch conversion on a CPC per hotel user basis, resulting in CPC per hotel user getting back to pre 2014 levels. The missing clues were commitments from large OTA's, and interestingly enough, Priceline and Expedia have now signed agreements with TRIP under the new IB model.

Hypothetically speaking, what would TRIP's valuation look like in 2017/2018 if IB adoption results in CPC per hotel user returning to $.56 per visitor? For argument's sake, I modelled using EBIT margins at 30% as opposed to using EBITDA, despite the company being capital light. EBIT margins reflect operating income after stock based comp, R&D / marketing spend (which should drop post IB rollout) and non cash charges which I'm going to assume will approximate actual spend on ongoing capx / intangible.  Here are the results:
















Assuming $.56 per hotel user, x 1.6B (ttm) annual hotel visitors (source: Trip Advisor Q2 2016 supplemental financials, link here) works out to $879M in IB hotel revenue. I modelled display based and other hotel revenue using TTM 2016 numbers, and used ttm non-hotel revenue of $338M.  The real key here is whether EBIT margins per hotel user will revert back to pre-IB rollout. Assuming 30% EBIT margins works out to an overall $393M EBIT contribution from hotel (net of negative contribution from non-hotel for now). The key to this assumption is the gearing in converting top line revenue into EBIT. The company seems to be a capital light compounder, so assuming cessation of 2014-2016 spend on IB going forward, any uptick as a result of conversion should flow directly to the bottom line.

Based on the above scenario, I get a current P/E of 25x and EV/EBIT of 15x, a lot different than conventional superficial analysis would have us believe. But that's our job isn't it? Looking beyond superficial summary reporting and asking how/what/why/where! If it wasn't for widespread groupthink like that published in this week's Globe, investors wouldn't have any work to do! This leads to my last question:

Does TRIP have a moat?

I'd say yes, but with a caveat. Borrowing from John Huber's writings on ROIC, TRIP seems to have characteristics of a two sided network. It is an accepted central hub for community ratings globally, but the problem facing the company has been converting these unique community visits into money! Therein lies the $1M question, is TRIP currently in the throes of a gradual move towards obsolescence as evidenced by falling revenue and EBITDA per user, or will it reinvent itself by virtue of rolling out IB? Only time will tell.

My bet is that IB will work.


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