Weekend Reading

26 August 2016 | by Paul Perrino, CFA

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

World’s First Self-Driving Taxis Debut in Singapore (Annabelle Liang and Dee-Ann Durbin, @deedurb, AP via Bloomberg)

nuTonomy beat Uber out of the gate by launching their self-driving, ride-hailing fleet (6 cars to start) in Singapore on Thursday. The service will initially cover the “one-north” section of the city via limited specified stops, but they hope to expand soon. The company was started by Iagnemma and Emilio Frazzoli of MIT. To implement their vision, they partnered with Renault Zoe and Mitsubishi for the cars. According to the COO, David Parker,  “…autonomous taxis could ultimately reduce the number of cars on Singapore’s roads from 900,000 to 300,000. ‘When you are able to take that many cars off the road, it creates a lot of possibilities. You can create smaller roads, you can create much smaller car parks,’ Parker said. ‘I think it will change how people interact with the city going forward.'”

Be Mindful of Rich Valuations in Low-Volatility Stocks. If history is any guide, investors should expect future returns to be muted at best. (Ben Johnson, Morningstar)

Exploring a similar topic to our recent post WD-40: A Case Study of the Bubble in “Safe” Stocks, Morningstar observed that funds have been flowing into low volatility ETFs. Flows into these type of companies have caused their valuation metrics (P/E, P/CF, etc.) to reach higher than average levels. If you look at the history of subsequent 3-year fund performance for funds that have high valuations, they tend to be “muted at best.”

The Housing Market Is Finally Starting to Look Healthy (Niel Irwin, @Neil_Irwin, NYT)

Several years after the housing crisis, the housing market is starting to look healthy. There were more new homes sold in July than any other month in the previous ~100 months. The price of these new homes fell by almost $16,000 from the previous month. This could indicate that the new homes being sold are on the lower end of the market. Since the housing crisis, new home ownership by first-time home buyers has lagged the historical average, but the population of potential first-time home buyers continued to grow. This backlog is finally being filled. The percent of GDP in residential investment is still about 20% below the historical average (since 1947), indicating that there is still more room for improvement.

Wireless: the next generation (The Economist)

If you thought the jump from 3G to 4G was impressive, wait until you see what’s in store for 5G. It’s estimated that download speeds will be about 10 times faster, with a latency of less than 1 millisecond. This makes streaming services (Netflix) and online gaming (Playstation) much more enjoyable and easier to access. The execution of the 5G network may look different that previous versions. Stephane Teral of IHS, a market-research firm, said there could be a shift from a single, large antennae servicing a cell to many smaller antennae scattered throughout the cell, so it can send out a more direct, concentrated beam. There is also a push, mainly from the largest network in the world – China Mobile, for a “green and soft” network, “meaning much less energy-hungry and entirely controlled by software.” Countries, such as South Korea and Japan, are leading the push for 5G networks. They both want to have their networks upgraded in time for their respective Olympics (2018 and 2020).

 

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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WD-40: A Case Study of the Bubble in “Safe” Stocks

24 August 2016 | by Sean Stannard-Stockton, CFA

We believe that one of the biggest risks in the stock market today comes from investors overpaying for conservative, income-generating companies. In a sort of mirror image of the 1999 Dot-Com bubble, when investors overpaid for high risk, non-yielding stocks, the market today is characterized by eye-popping valuations for “safe” assets from bonds of all types to the most conservative sectors of the stock market. As an example, it is the “safe”, high-income Utilities sector that today sports a historically high multiple, while the “risky” Technology sector has an earnings multiple below its long-term average.

But broad generalizations are more easily dismissed than specific stories. In our continuous work to identify high quality, “moaty” businesses, we recently researched the long-time steady company WD-40 (WDFC) and in so doing discovered a seeming case study of a “safe” company whose valuation has been bid up so high by yield chasing investors that the stock now represents a very risky bet on a perpetual continuation of today’s abnormal valuations. Just as investors mistakenly thought back in 1999 that high-growth technology stocks would forever command historically high valuations, we believe that investors, deeply scarred by the Great Recession, are making the mirror-image mistake of assuming that income-paying, “safe” stocks will command historically high valuations far into the future.

WD-40, the maker of the ubiquitous household product that people use to make things stop squeaking, is a very solid company. A can of WD-40 can be found in over 80% of US households, meaning about as many people use the product as subscribe to cable TV. This is way higher household penetration than Coca-Cola, Gillette razors or most any other dominant household consumer brand.

wd-40-smart-straw-voc-3oz-3d-can

With no meaningful competition (famed professor of value investor Bruce Greenwald once used the company in a case study showing how any competitor would lose money and so there was no incentive to compete), the company generates healthy returns on capital. While they face no real competition, they also have limited growth opportunities since most households only buy a new can of this $3 product every couple of years and almost every household already owns a can. This has led the company to pay out a meaningful portion of their earnings as dividends given their limited opportunity to reinvest and grow their business.

Slow growth companies like WD-40 can make for great investments when they command strong returns on invested capital that allow them to return significant capital to shareholders in addition to producing modest growth. For instance, from 2001 through 2007, the stock price appreciated annually by 6.6% while generating 3.2% returns from dividends giving investors a total return of 9.8% per year. Not too shabby given the low-risk nature of the investment, especially when you compare it to the fact the S&P 500 generated annualized returns of just 5.3% during the time period. This strong, steady performance with significant contribution from dividends is exactly what historically made dividend yield-focused investing attractive.

The 2001-2007 time period began and ended with 10-year treasury yields of about 5%. Using this yield as a proxy for the risk-free rate of long-term assets, we can see that the 2001-2007 time period was one with generally stable investor attitudes towards low-risk assets. WD-40 benefited from a little bit of multiple expansion during the period but stayed within the 15x-20x range that has characterized most of the companies trading history.

But the 2007-2016 period saw the onset of the Great Recession and a significant shift in investor preferences for low-risk assets with the last three years, in particular, appearing to represent a sort of bubble in these assets, a mirror image of the 1999 bubble in high-risk assets.

Below is a table showing WD-40’s annualized price appreciation, dividend return, and starting and ending PE ratio.

Period Price Return Dividend Return Starting PE Ending PE
2001-2007 6.6% 3.2% 17x 18x
2007-2013 8.8% 3.1% 18x 22x
2013-2016 29.2% 2.2% 22x 34x

The dividend generating power of WD-40 is essentially unchanged from 2001-2016. Nothing much has changed in terms of demand for their products nor the competitive landscape. Growth expectations for the years ahead are no different from the low, but steady growth that has characterized the last 15 years. But today, investors are paying twice as much for each dollar of earnings as they did during the period prior to the financial crisis. We see a similar willingness to pay excessively high valuations for “safe”, income producing assets in the behavior of the 10-year treasury yield with the yield falling from 5% in 2007 to 3% in 2013 to just 1.5% today. This is the equivalent of the PE ratio on the 10-year treasury going from 20x during the 2001-2007 time period to 33x in 2013 to 67x today.

Here’s a chart that displays WD-40’s PE ratio over the last two decades.

WD-40 PE

After trading in a range of 15x-20x for 15 years, in the wake of the Great Recession investors started bidding up the price of WD-40 until today its valuation stands at an eye-popping 34x. For those without strong context for historical PE ratios, at the peak of the 1999 Dot-Com bubble, the S&P 500 was trading at a PE ratio of 30x. While certain high growth companies might be fairly valued at these levels, highly mature, low growth businesses like WD-40 have no history of trading consistently at these sorts of rich valuations.

So what happens from here? Our guess is that WD-40, the company, keeps chugging along. Things will keep squeaking and people will keep using WD-40 to fix them. No competition is likely to emerge and the company is likely to continue growing modestly and increasing their dividend. But the high price appreciation of WD-40’s stock has brought the dividend yield down to just 1.4%. Over the next decade, if we assume the dividend is increased at 5% per year, the dividend contribution to total return will be just 1.7%. If we assume earnings grow at 5% per year and the PE ratio stays constant (ie. the bull case which assumes that investors will perpetually assign a historically high valuation to the stock), total return annual will be just 6.7%.

What if the PE ratio returns to the 17.5x pre-crisis average? Then, assuming the same 5% earnings growth rate, the stock will end the next 10-years at a price of $93, down over 20% from today’s price of $117. The total return will be a terrible -0.6% per year.

WD-40 is a good microcosm of how investors, understandably scared by the way risky assets got crushed in the wake of both the Dot-Com bubble and the Great Recession, are making the same mistake again, but this time through chasing what they think are safe assets up to unsustainably high valuations. The fact is these assets — quality, dividend paying stocks like WD-40 as well as high-quality bonds — are “safe” in the sense that their fundamental performance (their ability to make interest payments or pay dividends) is secure. But when investors overpay for these characteristics, they turn a safe company into a risky stock.

The idea that WD-40’s PE ratio (and therefore stock price) could be cut in half seems outrageous. This is, after all, a steady dividend paying company and these stocks of stocks aren’t supposed to be risky. But given how low the dividend yield has gotten today, if the stock price is cut in half the dividend yield would still only be 2.8%. Which just happens to be approximately the average dividend yield that prevailed in the 2001-2007 time period. In other words, if the stock got cut in half, it still wouldn’t appear to be all that cheap, but instead would have just returned to a more historically normal valuation.

WD-40 isn’t an outlier in today’s market. Quality, dividend paying companies of all sorts are trading at abnormally high valuations, while higher growth, more speculative companies are trading at historically lower than average valuations. While much investor concern has been voiced about the overall levels of the stock market, we think the most important risk that investors face today is making sure that they do not buy into overvalued, “safe” assets. These very assets are being bought for their supposed safety, yet they are the stocks that contain the most long-term risk to preservation and growth of investors’ capital.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Weekend Reading

19 August 2016 | by Paul Perrino, CFA

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Too much of a good thing (The Economist)

Most articles I’ve read focus on the benefits of growing profits. The Economist looked at the recent recovery and found a few interesting points. The profits in this recovery didn’t expand capital investment but went back to shareholders. This may eventually revert because this rise caused greater income inequality, which could lead to lower demand. The persistence of these profits was also unexpected. Typically, as a firm experiences excess profits, this draws competition and reduces or eliminates those excess profits. This hasn’t been happening. “An American firm that was very profitable in 2003 (one with post-tax returns on capital of 15-25%, excluding goodwill) had an 83% chance of still being very profitable in 2013; the same was true for firms with returns of over 25%.” The high M&A during this period helped those companies widen their moat to help protect their excess profits.

Tech Giants Gobble Start-Ups in an Antitrust Blind Spot (Steven Davidoff Solomon, @StevenDavidoff, NYT)

Like many other aspects of technology, it’s also disrupting the M&A landscape. The outdated view and metrics used by antitrust regulators aren’t capturing the essence of most technology companies, monthly active users. The top tech companies (Google, Facebook, Amazon, etc.)  have amassed billions of monthly active users. In most of their respective markets (internet search, social media, internet shopping), their audience is typically materially higher than their next competitor. Some of these companies have been consolidating, such as Microsoft buying LinkedIn or Facebook buying WhatsApp. It remains to be seen what this type of consolidation will mean for the market and consumers/users. Other mergers of brick and mortar companies with technology companies are driving competition among the top. Walmart, the largest retailer in the world, acquired Jet.com in an attempt to compete with Amazon. While Walmart may be a behemoth in brick and mortar retail, Amazon is dominant in internet sales. This should lead to increased competition and benefit consumers.

You’ve got a nerve (The Economist)

The race for Artificial Intelligence (AI) has been strong over the past few years. One version of AI has been to make computers resemble the brain, in a process called neuromorphic computing. IBM has been a dominate player in this space and made a leap forward earlier this month, with a paper published in Nature Nanotechnology. It describes their development of an artificial version of a neuron. This is different than other AI, which creates artificial neurons in software programs, called neural nets. This may work, but it’s thought to be inferior. As the article put it, “That works, but as any computer scientist will tell you, creating an ersatz version of something in software is inevitably less precise and more computationally costly than simply making use of the thing itself.” They’re working on linking these neurons to create networks, which could eventually be built in small devices or standard computer chip processors.

Bond Funds Turn to Emerging Markets (Carolyn Cui and Mike Bird, @Birdyword, WSJ)

In a world where some government bonds have a negative yield, the search for yield is never ending. In this search, some investors are extending their risk profile in order to maintain a >1% yield. “The average bond yield on Bank of America’s developed-market index is 0.56%, compared with 4.44% for emerging-market sovereign bonds.” This extended risk profile is causing funds to flow to emerging market bonds. This flow to emerging markets is causing yields to compress. Debt maturing in 2020 from Ecuador that was yielding 22% has seen the yield drop to 10.4%. These flows to emerging markets are not being driven by credit fundamentals. “Credit quality is also deteriorating. Nineteen corporate issuers have defaulted in emerging countries this year, up from 15 at the same time last year, according to S&P Global Ratings. Nearly one-third of all emerging-market issuers are at the risk of being downgraded.”

 

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Of Moats & Media – Part Deux: Disruption!

16 August 2016 | by Arif Karim, CFA

In our previous post on moats in the media space, Setting the Scene, we discussed the history of the US Pay-TV industry as a partnership between Media companies and Distribution companies and the value it created for investors as strong moat, high ROIC industries and for consumers by bringing them a vast selection of content with better quality than their alternatives.

We highlighted the key moat qualities that Media companies exhibited, namely  scale-driven advantages like access to a portfolio of channels to the end consumer through distribution networks, the content talent seeking financing and an audience, and access to low-cost financing needed to develop a portfolio of content.

Distribution networks, initially just cable and satellite companies then later telecom companies, acquired their moats by physically building, acquiring, and owning the physical connection (copper wires, fiber, satellites, spectrum and associated electronic infrastructure) to the consumer and owning the billing and service relationship with the consumer.

The Media companies took ownership of developing the content while Distribution companies had the customers and means to deliver the product to them. In order to optimize both the service they were providing large groups of customers with disparate tastes while optimizing revenue, service, and scale effects, the content was categorized into individual linear feeds called channels that were then bundled into a handful of service tiers.

Consumers signed up and paid to get video content in this traditional video service model. In order to deliver the content, the distribution companies allocated bandwidth over their physical network as an implicit part of the offering to the end user, since consumers only valued and paid for the content they were receiving and not the underlying infrastructure it was provided by. It wasn’t really until consumer friendly web browsers and HTML began creating and making the Internet usable for non-technical people that bandwidth came to be seen as a valuable service in its own right to consumers wishing access to the explosion of information and services available on the Internet. Offering Internet service (an open slug of bandwidth essentially) became a very profitable offering for the Distributors, driving higher profits even, as we’ll come to see later, their video service margins underwent compression.

We illustrate the value delivery segmentation with the following diagram reproduced from the excellent Stratechery.com website:

media value chain

Source: Stratechery.com

The traditional Media company is at its heart an aggregation company that will also have some significant creation and production/financing aspects to it.  However, it will also license/buy content from third party content creators/studios to fill its content portfolio in its role as aggregator. That portfolio of content is then categorized and used to fill the channels it is given access to by the cable companies/Distributors in exchange for an “affiliate” fee that comprises some portion of the video service fee subscribers pay the cable company.

One reflection of the powerful moats that the media/distributor complex built were regular increases in service fees and bigger video channel bundles provided to the consumer. A classic characteristic of a moat is  the ability to raise prices at the rate or faster than cost increases. According to the 2013 FCC’s cable pricing report, expanded cable bundle pricing increased at nearly 3x the rate of inflation between 1995 and 2012 and rivals the bogeymen we usually describe as having runaway costs — the US healthcare system and higher education! While this is terrible company to keep from a cost perspective, its great from a consumer spend priority perspective.

 

FCC Cable Prices

Source: 2013 FCC Cable Pricing Report

cable price per channel

Source: Comcast SEC Filing 

The table and chart above show big increases in video service fees driven by both increasing numbers of channels bundled into the service and, until the Great Recession of 2008/09, average fee per channel also increased. This made for a fantastic business where both units and per unit prices can be increased, resulting in strong revenue growth!  However, despite a tripling in channels offered to the consumer from 1999 to 2013, average channels watched has only grown 35% as average viewing time per subscriber grew a similar order of magnitude from about 4 hours to over 5 hours per day.

Channels

Source: Matthew Ball and Tal Schacher at Redef.com

This makes any argument about service cost justification based on the booming number of channels provided a red herring from the consumer’s perspective. The real service cost measure to the subscriber is the cost per min or hour of viewing, which was increasing every year. However, this wouldn’t necessarily be a negative if the value/quality of the content has also increased in lock step. There are reasons to be doubtful of that service cost increases have delivered equal or better value since subscriber penetration has been declining since 2010 in the face of alternatives (discussed below).

The perception among individual subscribers is that they’re still watching 15 or 17 or 20 channels but paying for 150 with a large multi hundred dollar monthly bill associated with it (though the subscriber is also paying for other services on a common bill, like broadband service and telephony that accumulates to a  “cable bill” averaging $120-150 per month, exacerbating the perception that they are paying a substantial sum every month for their TV service). Despite the perception, the reality is that Pay-TV is still one of the most affordable forms of entertainment with an average hourly cost of of 0.25-0.30 per hour per person (assuming 2 person HH average and 5 hours of average viewing per day).

In the process of fattening the bundle of channels and charging higher fees for them, large media companies have garnered increasing revenue from network fees charged to cable companies while cable companies passed on costs to the end user. Despite the distributors’ upper hand in owning the customer, as subscriber growth matured, media companies have taken the upper hand in fee growth since that is the content that kept subscribers paying for Pay-TV service. Broadly declining margin percentage on video services among cable companies in recent years demonstrated that content has taken more of the value of each incremental video subscription dollar than distribution, demonstrating the relative moat dynamics between content and distribution. It’s become a regular occurrence for a Media network to black out its channels while negotiating contract renewals with an aggressive distributor in order to demonstrate its relative value to subscribers and strengthening its negotiation position.

In a filing with the SEC, Comcast reported that between 2004 and 2013, the cumulative change in its programming (content) costs grew 6x the rate of CPI! Also notice that the average fees charged to subscribers reported in the FCC report above grew at roughly half the rate of overall programming costs reported by Comcast. It’s not apples to apples comparison in that the cost per “unit” of content/channel is not reported. As channel bundles get bigger, the overall “units” of content sold also increases. In addition, we’re comparing industry average subscriber service pricing data to programming costs reported by a specific video service provider. A like for like analysis would be more rigorous, but inline with our overall argument above, the net per unit cost of video consumption (whether per channel or per hour) for the subscriber has effectively grown at a much faster rate than CPI rate for decades.

Comcast pricing

Source: Comcast SEC Filings

Making things worse, it is the case that many markets in the US are oligopolistic with 2-3 video service/broadband providers (cable and telco) who tend to be equally bad at customer service (cable and telco companies are listed as having among the worst customer satisfaction levels). So you end up with a scenario where the subscribers of Pay-TV are over-served by a huge number of channels at ever increasing real prices by an industry notorious for being difficult to deal with, making it ripe for the traditional Christensen definition of disruption:

“the phenomenon by which an innovation transforms an existing market or sector by introducing simplicity, convenience, accessibility, and affordability where complication and high cost are the status quo. Initially, a disruptive innovation is formed in a niche market that may appear unattractive or inconsequential to industry incumbents, but eventually the new product or idea completely redefines the industry.”

Cue the Internet…

We believe the Internet disrupts the traditional moat structure by fundamentally democratizing the content/service “channels” between content/service creators and the end customer. A broadband Internet pipe is effectively a big fat channel that the end users pay to control in the physical distribution network. They choose what comes through that channel instead of flipping content channels that have been pre-selected or curated for them.

It used to be that Distributors had to select the Media companies to share access to their limited number of channels in order to maximize revenue, retention, and profitability, resulting in the most widely watched content with the strongest audience viewership ratings/advertising interest being produced and pushed to subscribers. This meant content producers (individuals or “studios”) had to either have scale or had to sell their content to the large Media companies that owned channel access in order to get their shows to consumers. Media companies were the default curators, shapers, and financiers of content (and culture) as a result.

Having access to a large bandwidth uncontrolled and democratized “channel”, consumers can now pull the content they are interested from content producers who have developed the marketing ability to make their potential audience aware of their existence, no matter their scale. Beyond traditional TV, large media has to compete for audience attention with other types of fast proliferating content that does not even play by the traditional formats of the 30 minute sitcom, 1 hour drama, and 2 hour movie that traditional audience had been trained to accept.

Now content can be a 10 second Snapchat/Vine/Periscope/Facebook Live user generated amateur video up to a multi-day “binge” of a high-end professionally produced series on a smartphone, tablet, or TV and often two of these devices simultaneously. There is no ubiquitous standard of any kind and the potential for content format/type disruption is unprecedented. The effect of the democratization of network bandwidth, mobile devices, social media networks, and digital brands and marketing can be seen in the following charts, which demonstrate trends based on the behaviors of younger vs older cohorts.

Overall, traditional TV watching has declined by 16 hours per month or 10% over the last 6 years with the steepest drops among the age group most coveted by media companies and their advertising customers, the 18-49 year olds. The “Millenials” generation is the next biggest cohort of the US population after the “Baby Boomers”, comprising the 18-34 year old group, are watching 40% less traditional TV (where traditional media companies still have the best positioning) — an ominous sign of things to come to TV!

Avg Hrs of Trad TV per Mth by Age

Source: Matthew Ball and Tal Schacher at Redef.com

That’s led to what looks like a peak in TV viewing hours per month and declining relevance (TV viewing as a % of total hours spent). The average adult in the US now spends more time on a connected device per day than with their TV, with all of the change coming from the sub-50 year old group. This makes having significant digital presence vital to long-term growth, profit, and ultimately survival!

Time per Day w Major Media

Source: eMarketer.com

These trends have driven the first ever decline in US Pay-TV penetration rates outside of a recession (“Peak Cable”). Subscriber declines appear to be continuing at about 2% per annum according to the most recent company reports. Given the tendency of technological change to start slow then accelerate rapidly, the acceleration in declines since 2014 is likely to continue to some much lower base threshold.

Pay TV sub penetration

H/T: BusinessInsider.com

Since audience attention is at the heart of the business model for media company economics (higher audience “tent pole” content that draws in larger crowds is more valuable directly in the revenue it generates from broadcasters/syndication and from the advertising it draws as a result), hits that can bypass traditional media are a huge threat. With a lower distribution bar to get to the consumer directly over the internet, a higher threshold to surmount among all content types vying for attention, and lower cost to experiment with new types of content, the traditional scale-driven moats of media companies are severely threatened. Hit content (both produced within traditional Media companies and at independent studios) becomes even more valuable since it’s needed to attract audience attention while non-traditional buyers, such as SVOD services like Netflix, Amazon, and others, also compete to license/own rights to it.

In addition, with greater customer choice comes the need for better product-customer fit in the form of content-viewer matching, customer service, and convenience. “Delighting” the customer is the catch phrase probably most associated with Apple’s products but is apt for almost all internet-driven/competitive customer experiences where choice is unlimited and switching as close to costless as they’ve ever been.

The best summary of the impact of broadband Internet is that the moat is quickly migrating from control of Distribution in the Media business to control of Attention.

The most successful and most talked about attention-takers since 2010 have been YouTube, Facebook, and Netflix. We’ll use charts compiled by Matthew Ball and the team at Redef to illustrate the point below. We’re big fans of their insightful work and highly recommend reviewing their in depth publications on the Redef.com website.

Netflix is the most interesting one to talk about first, given the ability to compare its service directly to traditional video services, as an example of a company that has acted as the classic disruptor in the media space. It came out with a limited, low cost streaming service at a price point well below any cable bundle, but has been a technology, user interface, and service leader with its offering. This graph below illustrates how disruptive technology generally finds its market beginning by serving the low end of an “over-served” market as discussed in Clay Christensen’s classic book The Innovator’s Dilemma.

Disruption Graph

Source: www.slideshare.net/RaymondEbbeler/disruptive-innovation-50159934

Netflix’s service was initially seen as non-threatening by the rest of the industry (or at least there isn’t much evidence in their actions that they saw Netflix as a serious threat prior to 2012). After launching its streaming service in 2007 as a free add-on and shifting the main focus of its business to streaming from a DVD by mail service (2011), it has seen great success in winning audience attention, albeit at the cost of its profitability.

Its disruptive strategy of offering a limited content but “good enough” VOD (Video On Demand) solution at a low $7.99/month service allowed it to grow from 21.7MM US subscribers in 2011, when it first charging for the streaming service, to 45MM US subscribers in 2015. It could be argued the streaming service aided the legacy DVD business growth from 9.4MM subscribers in 2007 to 21.7MM in 2011 as a cost free value-enhancer. It’s very likely that Netflix truly believed this service to be a complement to traditional TV in the beginning but over the past couple of years it certainly has become a more competitive solution for a significant part of the US population.

NFLX subs mins

Source: Matthew Ball at Redef.com

The fact that most subscribers already had a Pay-TV service and yet found it deficient enough to find Netflix’s value proposition compelling enough to subscribe to, makes Netflix’s achievements even more impressive. We can see that engagement, or audience attention, showed steady increases over time as content, quality and selection and increasing numbers of internet connected devices engaged customers for longer periods of time everyday. Experimentation also played a key part as Netflix allowed people to binge watch entire seasons of shows they licensed and later produced as soon as they were launched (vs. traditional model of weekly episodes) and as it continuously refined its matching algorithms to improve its committed content utilization while increasing its customer engagement.

Netflix used the new broadband Internet channel paid for by its customers to effectively create a new “bundle” of video content.  It collated a  set of content that would traditionally have been categorized by channel and instead used the new technology to present the content as categories and sub-categories to allow the right audience to find relevant content.  It also used real time data collected from individual user viewing to make suggestions for new content based on the viewing habits of other subscribers with similarly viewed content (sometimes obvious fits, and sometimes unexpected).  More recently, it leveraged its massive trove of subscriber viewing data to select and price bids for exclusive content it wanted to buy rights to.

It essentially used the new Internet technology to overcome the traditional bandwidth limitation for distribution (bypassing the traditional gatekeepers/moats) and realigned its offering to fit a more natural way for people to categorize content (by category vs channel) and delivered it on demand (convenience). Broadband Internet service enabled all of those aspects of its new service. In addition, the need to fit its product to the customer online led it to create easily used search features (instead of kludgey programming guides) and algorithms to help users find the right content fit (better matching of content and viewers).  In addition, its customer service is easy and a great experience — it’s easy to sign up and easy to cancel and accessing the service is seamless across all devices. Initially this was only available on a computer (inconvenient and limited), but quickly extended to all connected devices including TV’s (ubiquitous access, super-convenient). By 2014, it’s service became the bar to beat for video service from its humble beginnings in 2007.

It’s online and offline marketing prowess, developed over the previous decade in selling its DVD subscriptions, enabled it to cost effectively reach consumers with an Internet connection with its message. As it developed its own content, it was able to create the buzz around its new content to draw additional customers. It stood out from the crowd of content choices available to the consumer with enough of a draw to get them to subscribe.

Over just 5 years, with growing subscribers and attention, Netflix has effectively grown to become the 6th largest Media network in minutes of content delivered per month in the US.

Monthly Mins Growth by Netwk

Source: Matthew Ball and Tal Schacher at Redef.com

However, Netflix’s success in grabbing its subscribers’ attention has come from other traditional networks’ audience share. Though we highlight Netflix here, the same can be said of other internet based media companies as we’ll see shortly.

Min by Network

Source: Matthew Ball at Redef.com

Even more dramatic than a whole market view in terms of share, is the impact Netflix has had within its subscriber base, in which it captures an average 60% share of their  viewing time (20% share of total household hours/33% Share of households) for about 12% of their Pay TV video bundle price (assuming $80/month Pay TV service average and $10/month Netflix). Of course some significant portion of subscribers use Netflix 100% of their time while those subscribing to the traditional cable bundle likely spend significantly less than 60% of their time, but the overall theme is that Netflix is offering a substantial and broad offering to its subscribers that appears to offer much more value than the cable bundle. Part of this may also be the fact that Netflix does not include advertising in its content, which further enhances its value by optimizing its customers entertainment time.

Hours Delivered by Network

Source: Redef and Ensemble Capital Management

Netflix is an example of a video content provider that’s leveraged the wide open Internet “channel” to get to the end customer and effectively built the capabilities (marketing, service, payments) to effectively grab the customer’s attention with its content offering.

In contrast to the traditional value chain diagram we showed earlier, it realigns its value delivery elements and capital investments in order to create a new model that better leverages its access to the customer without physically owning the connection. Again, Stratechery.com’s Ben Thompson has created a nice diagram that illustrates the change well.  Netflix has moved closer to the customer over a now virtual network and uses its ability to attract those customers and their subscription dollars to buy the product that will continue to retain and grow the subscriber base. It integrates the roles of both Distributor and Media companies to create greater value for the customer. By controlling the growing subscriber revenue base, it can reinvest in both more and better content and technology, enhancing its value for all subscribers, while continuing to fuel greater subscriber growth through marketing efforts at a scale than ever possible before.

NFLX Disaggregation

Source: Stratechery.com

YouTube, Facebook, and SnapChat are among others that have done similar things to get around the traditional moat that only large media companies could access in the past. Given the proliferation of connected devices and especially smartphones, short form content that these new platform cater to has taken off and account for large portions of the 5 hours/day the average American spends on their connected device while pressuring the time they have left to watch TV.

YT FB SC views

Source: Matthew Ball and Tal Schacher at Redef.com

If video over the internet is a big growth engine going forward and growing in importance for audience attention, then the contrast between the traditional Media companies’ share on traditional TV and new internet-focused media companies online tell a clear story of a starkly different landscape. The 2% white bucket in the graph below that includes TV Everywhere refers to Pay-TV content viewed through apps vs through a subscriber’s set top box, and reflects Pay-TV’s lack of success thus far in capturing audience attention away from its traditional TV stronghold.

download bandwidth share

Source: Matthew Ball and Tal Schacher at Redef.com

However, there is a new element here in that virtual distribution over the Internet, with a direct relationship with the end user, allows a Media company to target customers globally on a direct basis. Previously, Distributors had to build out physical infrastructure to access each customer, which makes the undertaking a lot more capital intensive and took a long period of time. For traditional Media companies, despite some global presence via regional distribution, their revenues have traditionally been heavily dependent on their home region presence (with Discovery Communications being a major exception). However, new content providers offering service over the Internet (commonly referred to Over The Top or OTT), have the ability to create a global scale service, which changes how we need to think about scale economics and its impact on business profitability. All of the new Internet media companies target global scale content and distribution economics, with a target customer measuring in the billions, an order or two magnitude larger than the scale of the traditional players. This past January, Netflix announced it would be available in every country in the world except China while International subscribers are likely to surpass its US subscriber base sometime in 2017, only 6 years after launching its first market outside of the US.

NFLX Intl Map

Source: Netflix

So if important elements of the traditional moats (scale, capital, distribution) in the Media business have been blown away by the Internet, what are the implications of future businesses in the space and are there any moat-led investable (i.e. sustainably high-ROIC) companies left in the video content creation and delivery space as the changes we’ve discussed play out? What will future moat characteristics look like? What elements of the value chain will become more important and less important in terms of value creation? Will any of the traditionally successful large players be able to adapt or will they cede their leadership and, more importantly, their outsized ROIC to the new internet-focused media companies?

Tune in next time for our view into the future of media!

Ensemble Capital’s clients own shares of Discovery Communications (DISCA), Netflix (NFLX), and Time Warner (TWX).

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Weekend Reading

12 August 2016 | by Paul Perrino, CFA

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Thirty Years – Reflections on the Ten Attributes of Great Investors (Michael Mauboussin @mjmauboussin, Dan Callahan, and Darius Majd; Credit Suisse)

After decades of investing, Michael Mauboussin reflects on what he has learned and consolidated it into ten well-constructed and concisely-written attributes. 1) Be numerate (and understand accounting); 2) Understand value (the present value of free cash flow); 3) Properly assess strategy (or how a business makes money); 4) Compare effectively (expectations versus fundamentals); 5) Think probabilistically (there are few sure things); 6) Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected); 7) Beware of behavioral biases (minimizing constraints to good thinking); 8) Know the difference between information and influence; 9) Position sizing (maximizing the payoff from edge); 10) Read (and keep an open mind). He ends with a recommendation for how to achieve peak performance within an investment organization.

America’s Best Days Are Not Behind Us (Bill Gates, @BillGates, gatesnotes)

This is Mr. Gates’ response to Robert J. Gordon’s book The Rise and Fall of American Growth. The dramatic change in the standard of living from 1870 to 1970 was astounding. We went from candle lit homes, chamber pots, and transportation by horse to electric lights, computers, plumbing, cars, and planes all within 100 years. Mr. Gordon cannot imagine that the next 100 years will have the same dramatic increase. Mr. Gates “couldn’t disagree more.” The headwinds Mr. Gordon references may be the very problems that could get solved over the next 100 years, causing this century to be deemed great.

Distractions Cost Investors 115% (Michael Batnick, @michaelbatnick, The Irrelevant Investor)

Seeing the signal through the noise is incredibly difficult. Since the Great Recession, the S&P 500 grew at an annualized rate of 18.1% while individual investors in the SPY (S&P 500 index ETF) only had an annualized return of 11.8%. There was no shortage of noise during this period to distract investors. Headlines such as “Europe’s debt crisis. Companies still not hiring. The Gulf oil spill. These are uncertain times to say the least”  are dramatic and eye-catching. This is great for news providers (more ad revenue) but detrimental for investors. To apply the work of Daniel Gardner and Philip E. Tetlock in Superforecasters, it’s important for investors to weigh various outcomes and continuously make small adjustments to those forecasts and not let your own biases drive your investment decisions.

Aviation Experts Urge Caution on Releasing Self-Driving Cars (Daniel Michaels and Andy Pasztor, @DanMichaelsWSJ, WSJ)

As someone that commutes to work by car, self-driving cars are extremely attractive. The ability to read and use the time more productively is invaluable. Airline pilots are reminding us that we’re in the early stages of autopilot and to proceed with caution. This comes at a time when there have been several accidents involving Tesla’s autopilot function, including one fatal accident. As with most computer systems, there are limitations and as Shawn Pruchnicki, a former commercial pilot said “It’s quite ridiculous we would give somebody such a complex vehicle without training.” Tesla is taking steps to address these concerns and vows “to step up efforts to educate customers about the way its autopilots work.”

Think Amazon’s Drone Delivery Idea Is a Gimmick? Think Again (Farhad Manjoo, @fmanjoo, WSJ)

The offering of Amazon Prime has greatly increased the importance of speedy deliveries. This has made them more reliable on delivery partners and the infrastructure (roads, airports, etc.) they use. The first step to address the issue was abandoning their price advantage (not collecting sales tax) in favor of building warehouses all over the US. This allowed them to meet the 2-day shipping service offered in Amazon Prime. The more difficult step is going to be expanding their shipping capacity, which may include re-thinking the way goods are delivered and reducing reliance on outside companies. The warnings from the department of transportation and missing of deliveries during the holidays two years ago (due to UPS being overwhelmed) are clear incentives to re-invent deliveries. Drones could be the solution to their problem. It might not work for all items and geographic locations, but it could be very disruptive.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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With Unemployment Below 5%, Is There Still Slack In The Job Market?

5 August 2016 | by Sean Stannard-Stockton, CFA

Recently a client asked us about the idea that the “real” unemployment rate is higher than the reported unemployment rate (currently 4.9% or about the level considered “full employment”) due to many people having left the workforce in recent years. These “discouraged workers”, according to this idea, should really be counted as unemployed, but are not since they are no longer actively looking for a job. The flip side of this theory, if it is correct, is that the labor market still has considerable slack and therefore the economy is unlikely to be nearing the end of the current expansion.

While at Ensemble Capital we don’t focus on using macroeconomic forecasts to drive our investment decision-making, it is critical for investors to have an evidence-based understanding of the context in which they are investing. For instance, bottoms up research on a staffing company like Robert Half International (for example) wouldn’t be complete without the investor having a sense of where the economy is in the employment cycle.

Below is a chart showing the US workforce (actual number of people employed and/or actively looking for employment) and the participation rate (the workforce as a percentage of the working age adult population).

Labor Force

You’ll note that the workforce has grown pretty consistently since 2011. However, it hasn’t grown as quickly as the population has grown. If the participation rate was 66% (the pre-crisis level) instead of 63%, we’d have an additional 7.6 mil jobs. Since 2008, we’ve seen 4.3 mil jobs created. But, in order to keep the participation rate steady, we would have had to have seen 11.9 mil jobs created. So as far as how many workers might be “missing” from the official statistics, it might be reasonable to suggest it is about 7.6 mil (you’ll see below that this number is similar to another, more direct way of measuring this issue).

However, labor force participation has been declining since 2000. From 1970-2000, workforce participation for woman increased from 43% to 60% as women who had historically stayed at home started working. During that same time, the participation rate for men fell steadily from 80% to 75%. This decline happened in the context of a strong economy and was likely due to the aging population as well as a decrease in men working as more women started bringing home paychecks.

From 2000-2008, the declining trend in the male participation rate continued, while female participation flattened out. Since the crisis, both male and female participation has been declining rapidly. Some portion of this is likely a natural outcome of an aging population. But some portion is likely “discouraged workers” who stopped looking for a job because there was none available in the areas where they lived or needing the skills they had.

Participation Rate

But the discouraged worker trend seems to be starting to reverse. Note the recent hook up in the total participation rate from a low of 62.5% to 63%, the first material increase since the crisis. See also the chart below which shows the number of people who are not in the workforce (not actively looking for a job) but say they want a job. These are self-identified “discouraged workers” and you can see they peaked at 7 million in mid-2012 (blue line). The red line in the chart below shows the number of unfilled job openings. You can see that in mid-2009, there were 6 million self-identified discouraged workers and only 2.2 mil job openings. But job openings have been increasing. Just this last quarter the number of job openings actually exceeded the number of discouraged workers for the first time post-crisis.

Not in Labor Force

So why aren’t these jobs being filled (or at least filled quickly)? One reason is a skills mismatch. The jobs that are being created in the service sector require skills that discouraged workers from the manufacturing and construction industries don’t have. Skill mismatches take a long time to resolve, but we’re now at the point where seven years of new workers have entered the workforce since the crisis and these young workers are more likely to have obtained skills better suited to current needs.

The other issue is the lack of housing mobility. A worker who is underwater on a $200,000 home might be able to make the $800/month mortgage payment, but they can’t afford to sell the house for less than their mortgage let alone come up with a down payment on a new home. So while there may be jobs in other states, these workers can’t move to fill them even if they have the right skills. This has been a rather large problem as housing prices nationally only recently returned to pre-crisis levels. As home equity starts going positive it becomes easier for unemployed workers to start moving to where the job openings are.

We think that jobs are one of the most important indicators of economic health and net-net the job market has been slowly but steadily improving ever since 2009. It is impossible to know exactly where we are in the employment cycle, but since recessions generally occur once the unemployment rate hits full employment and then hooks back up it is useful context to know that it may be possible for the economy to keep adding new jobs without pushing the unemployment level down to unsustainable levels if in fact there is a pool of workers on the sidelines who may rejoin the workforce in the years ahead.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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