Companies

On Google

I’ve been enamored with Google for many years. I can’t think of another company whose products I use and love more than Google’s. Search, maps, e-mail, Chrome, contacts, calendar, YouTube, docs, drive, and Picasa have improved my life in many ways.

I started studying Google as a potential investment candidate a few months ago and even initiated a small position to force my thinking. Living in India, I’ve seen how much people rely on Google’s services and how it’s opened up possibilities, particularly for the poor. While riding around in rickshaws and cabs, I’ve observed how drivers use cheap Android powered phones to run their businesses, communicate with loved ones (primarily through What’s App), consume news, and help their children get access to the world’s information. Google’s mission and impact is tangible.

I’ve been battling confirmation bias because I believe Google is one of the world’s greatest social enterprises and am cheering for it to succeed. I’ve relied upon my checklist to avoid falling into dangerous psychological traps and have tried to spend most of time examining the bear thesis. I haven’t been able to mitigate a few of the large key risks facing Google and hence am unable to establish a large position at this juncture. My opinion might change in the future should new facts surface. I’ve outlined some of my higher level concerns below.

Search Could Be Disrupted: It’s well known that Google generates the majority of its revenue from search advertising (estimated 85%). With regards to desktop search, it is believed to have 85%-90% share of the market. However, internet consumption is gravitating more and more to mobile, where Google is facing pressure on two fronts. First, cost per click rates are less on mobile web than desktop because conversion rates are lower. Second, a large portion of what consumers do on their phones are through native apps rather than the mobile web where Google is the primary gateway.

In addition, Google is facing competition from Amazon, Facebook, Twitter, Instagram, Snapchat, Pinterest, LinkedIn, Yelp, TripAdvisor, Apple’s new spotlight search on OS X Yosemite (powered by Bing), and dozens of start-ups which are vying for a piece of the digital advertising pie. These products have powerful embedded search functions which could reduce consumers’ demand for Google’s search services. When we want to search for product reviews and pricing, we might go directly to Amazon, especially if we’re Prime members. When we want to discover the best local restaurant, we might go to Facebook or Yelp. When we’re looking for information on people, we might use any one of the social media sites. When we are searching for home décor, fashion/apparel items, or crafts, we might go directly to Pinterest. When we are searching for hotels, we might default to TripAdvisor. In the future, search could be disaggregated among a variety of niche applications.

It’s very difficult to predict with accuracy how new products will change consumer behavior. I am encouraged by Android adoption (which gives Google control over the user experience and eliminates traffic acquisition costs) and Google’s growth in mobile advertising, but Android is not without its own issues (see below).

Limited Access to Chinese Market: Google pulled out of the Chinese market in 2010 due to a cyber attack, suspected by Google to be led by the Chinese government, on Gmail accounts of human rights activists. In addition, although Android dominates the smartphone market in China, most phones don’t come preloaded with Google’s services. Google’s limited access to one of the most lucrative and fastest growing markets in the world cuts off a serious revenue engine for the company. The silver lining is that AdMob has a presence in China which should provide a small, but growing business for the company in one of the world’s largest markets.

EU Antitrust Case: The new EU commissioner, Gunter Oettinger, has re-opened the antitrust case against Google, which was heading towards settlement earlier this year. This effort has been heavily spearheaded by German publishing firm, Axel Springer, which claims that Google gives preference to its own properties (YouTube, local) in search results. Many German politicians are in the pockets of the media companies and are lobbying for Google to either be broken up or dramatically change the way it runs its search algorithms. The anti-Google sentiment has spread from Germany to other parts of Europe. This is a very serious antitrust case and stems from a deeper animosity European companies have towards American technology companies. Many Europeans believe that American tech companies have made European companies uncompetitive and destroyed their economies. The former EU commissioner went on record saying that the outcome for Google is going to be worse than Microsoft. Microsoft fought a decade long battle against regulators and was forced to pay $2 billion in fines. Google may have to pay multiples of that amount.

Financial penalties aside, there are deeper, structural implications for what’s happening in the EU. It’s bringing more awareness to Google’s market power and could lead to further regulatory scrutiny for the company in other regions.

Potential Adverse Changes to European Tax Policies: Google generates one third of its revenue from European operations. Ireland recently announced that it will abolish its controversial “double Irish” tax scheme which has enabled multinationals such as Google, Apple, and Facebook to dramatically reduce their tax burden. The loophole allows companies to send royalty payments for intellectual property from one subsidiary registered in Ireland to another, which resides for tax purposes in a country with no corporate income taxes.

It’s unclear what the impact would be, but reports and analysis by major publications peg it in the low single digit billions range, a significant number.

Concerns Over Privacy/Potential Reputational Harm: Google owns perhaps more data than any non-intelligence organization in the world. In light of Wikileaks’ revelation of NSA spying programs over the past few years, the public has become increasingly worried about personal data and privacy. Although Google takes extreme measures to protect user data, it can’t escape from the fact that it uses a lot of data to sell advertising programs to advertisers. A simple review of news commentary, Twitter chatter, and Google’s public relations efforts suggests that Google’s image in the mind of consumers is becoming increasingly negative.

The greatest risk Google faces is an uncontrollable, unanticipated event where private user data is breached. With 60,000 employees and thousands of data centers, Google has the nearly impossible task of protecting its data from multiple points of access. It will take only one negative event to destroy Google’s reputation and cause a mass exodus of users from its services.

Net Neutrality: Netflix set an unfavorable precedent earlier this year by agreeing to pay sums of money to Comcast and Verizon for better connection rates for consumers. Although this didn’t violate net neutrality rules, it lays the foundation for last mile providers to charge fees to high bandwidth producers. Furthermore, the issue of net neutrality is one which is constantly debated. Should the FCC change its stance in the future, Google may be required to pay hefty sums to push its traffic into consumers’ homes.

Google is trying to upend the cable cartel through its Google Fiber project, which is off to a great start. This is a potentially disruptive business which could produce many beneficial outcomes for the company.

Android‘s Future is Uncertain: Despite the headline numbers (80% market share, 1 billion devices), it’s still too early to declare Android the winner in mobile.

The first issue is industry profitability share among device manufacturers. Currently, Apple is capturing nearly 70% of all the profits generated by handset device sales. The remainder is going to Samsung. This is not a healthy outcome for Android. If HTC, Sony, LG, Motorola, Lenovo, Asus, and other Chinese handset manufacturers can’t make a sustainable profit, they will exit the phone business. This would leave Samsung as the only legitimate partner for Google and shift all the power in Samsung’s favor. Samsung has been developing another open source operating system (Tizen) which it could use as an alternative. The main issue is that Apple is dominating the premium phone segment, where the most profitable customers are, and has achieved lock-in with its customers (90%+ repeat customers) by way of its cloud services, iTunes, and high customer satisfaction ratings. The Chinese upstarts, including Oppo, Oneplus and Meizu, selling high spec phones at bottom basement prices are cannibalizing Samsung, not Apple. If the entire Android handset ecosystem devolves into a profitless endeavor, Google will be left without hardware vendors to partner with. Google is trying to change this with its new set of Nexus products, which are being marketed as differentiated, premium products at premium price points.

The second issue is handset fragmentation. The open source initiative has its positives and negatives. Similar to the issue Linux has faced over the years, there are numerous versions of Android running on thousands of different devices around the world. This makes development more difficult and expensive for developers because they have to design software for various software and hardware architectures, and different screen sizes. This contrasts greatly with Apple’s iOS platform, where there are a limited number of devices and most users are on the same OS (93% of iOS users were on iOS 7 soon after it was released, as opposed to only 25% of users on the latest version of Android KitKat 4.4). If you listen to what developers are saying, it’s evident that start-ups and growth stage companies are developing for iOS first, and much later for Android (many quality apps like Tweetbot are iOS only). Apple is benefiting (by design) from a number of factors: (i) its users are more affluent and have a higher propensity to buy paid apps and/or make in app purchases, (ii) software development is cheaper and easier on iOS, (iii) most people in the technology industry, particularly developers, are heavy users of Apple products, and (iv) iOS users engage significantly more with their devices, both with apps and mobile web. We’re at a point where this could create a virtuous cycle for Apple whereby the best apps are iOS only → people purchase iOS devices → customers are locked in as they put their information in Apple’s cloud and store all their purchases in iTunes → developers develop more for iOS → people purchase more iOS devices.

Android certainly has a lot of momentum and with a billion devices, there’s a lot to keep developers interested, but these markets can tip very quickly, especially if Apple makes the decision to go down market and further open up its ecosystem. Android is critical to Google’s future; if it doesn’t have control over the device, its services could be locked out by device manufacturers. Google is well aware of the issue and is trying to streamline the experience with its Nexus and One strategies. It’s to be seen how much traction this gains in the market.

Google X is a Wild Card: The bulls are almost unanimously excited about Google because they believe (i) Google’s existing services are under monetized, and (ii) Google X is available as a free option on a number of potential multiple billion dollar businesses. Both points are valid, but point (ii) is difficult to bank on. Microsoft has bankrolled its own powerful research group, Microsoft Research, for many years and has yet to see one multiple billion dollar business come out of it. These projects are called moonshots for a reason – they’re extremely low likelihood, high impact projects. I don’t believe it’s a defining variable to base a large investment on, particularly given some of the key risks facing Google’s core business.

It’s Still a Technology Business: Google is in the technology business. Disruption is becoming increasingly common in all industries, but the information technology industry in particular is at risk due to the sheer number of innovators in the ecosystem. Furthermore, Google seems to be in the cross hairs of a number of powerful companies and governments: Facebook, Pinterest, and Twitter in social; Microsoft and Apple in mobile OS and cloud services; Amazon in e-commerce and cloud services; and governments around the world. It’s the only big technology company being universally attacked.

The history of the technology industry suggests that large companies, even innovative ones, can’t maintain their edge and are eventually overtaken by upstarts. We’ve seen this many times: IBM (by Microsoft), Microsoft (by Apple/Google), Intel (by ARM), Myspace (by Facebook), and even Google (by social media) and Facebook (by Pinterest, Twitter, and Snapchat). Consumer preferences and the way consumers consume digital content changes rapidly. It’s unclear whether Google will be in a position to catch the next wave.

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Tourism

Recently, I’ve been reading Overbooked by Elizabeth Becker. I was surprised to learn that the worldwide tourism industry is $7 trillion, or >10% of global GDP. It is larger than the oil and gas industry. Curiosity is an innate human trait and mankind will forever want to see the places which he/she has not seen. Tourism has been exploding around the world over the past decade and is poised to grow as the world’s middle class expands, tourism opens up in more countries, and services improve. More significantly, millennials are extremely interested in and willing to spend substantial money on travel, particularly at a young age. The world has become increasingly global and the internet has made travel much more transparent and easy to facilitate. In India, travel is especially popular among young adults a few years out of college. College graduates are typically well paid and either live at home or with roommates, providing for large sums of disposable income. As is the case with most young adults, they spend money on restaurants, mobile phones, movies, and… travel.

The number of Indians traveling outside India today numbers around 15 million. This compares to nearly 100 million Chinese tourists. There is enormous potential in both outbound and domestic tourism in the country.

I was attracted to the sector after reading Prof. Bakshi’s thesis on Thomas Cook India last year. In mid 2012, Fairbridge Capital, a subsidiary of Prem Watsa’s Fairfax Financial, acquired a 75% stake in the tour operator. Watsa laid out his thesis and intentions clearly in his annual letter – Thomas Cook has incredible growth potential and would serve as Fairfax’s investment vehicle in India. For nearly a year, investors had the opportunity to buy into Thomas Cook India for a price comparable to what Fairbridge paid. I didn’t pay enough attention to the opportunity and missed an extremely attractive entry point (the share price has tripled in the last 12 months).

I’ve done a lot of work on Thomas Cook and can’t quite justify paying the price where it is currently trading. In addition, there are a few factors which give me pause. First, the company acquired Sterling Resorts, a timeshare business, which I have mixed feelings about. It’s a very capital intensive and competitive business and the brand has deteriorated in recent years due to poor facility maintenance and customer service. Second, the company’s wholesale forex business is likely to decline in the long term. As such, it’s a company I’m keeping an eye on, but not investing in at current levels.

My work on Thomas Cook naturally led me to Cox & Kings (CKX), the leading domestic and outbound tour operator in India. Cox & Kings and it’s various travel brands are the most widely recognized in India and are associated with high quality and best-in-class customer service. CKX is benefiting from two important macro factors at work in the Indian travel sector. First, organized travel players such as CKX and Thomas Cook are taking share from unorganized players (unorganized players are the small mom and pop travel shops which have very limited services, e.g. only transportation). It turns out that many people would rather book an organized tour than book all the individual components themselves, particularly when traveling outside the country. Booking a tour saves time, provides peace of mind, reduces on the ground hassle, and assures travelers that accommodations will meet certain standards.

Second, the large organized players are taking share from smaller organized players. Although the services are somewhat commodity in nature, scale matters in this industry. Large players such as Cox & Kings have much larger advertising budgets, increasing brand awareness and reach. Second, volume players are able to strike more favorable deals with tourism suppliers, creating favorable pricing. CKX is able to charge lower prices than competing operators, but actually maintains a price premium due to its strong reputation. Cox & Kings generates ~22% gross margin in its tourism operation vs. ~10% for Thomas Cook.

Today, you can buy into Cox & Kings for less than 10x operating income. The stock has tripled in the past year, but is still undervalued. The largest overhang on the stock is extremely high debt levels. Debt / cash flow is currently greater than 5x. The company is taking measures to reduce the debt burden, including selling off non-core assets and bringing outside equity investment. In addition, the company has a number of assets it could sell to cover its obligations. Moreover, earnings currently cover interest charges by greater than 2x.

I’ve been adding some Cox & Kings to the portfolio between Rs. 300 and Rs. 320 per share. I’ll share more detailed thoughts once I’ve finished my work and gone through the checklist. If everything checks out, this will likely become a concentrated position.

CDW Corporation (NASDAQ: CDW)

An interesting area to look for excess returns in the equity markets are public LBOs.  These are moderate to highly leveraged businesses (typically with debt amounts greater than 4x cash flow) which benefit from both growth in earnings and rapid debt repayment.  When thinking about debt repayment, the returns on cash deployed typically are not very high.  A 4x leveraged business in today’s credit environment carries a borrowing cost of 7.5%-8% all in, which after tax, costs shareholders ~5%.  This is clearly a much lower return amount than most corporations are able to earn on equity.  However, highly levered entities engaging in debt repayment offer some unique benefits to shareholders.

  • Equity holders have the benefit of owning the corporation with much fewer dollars deployed.  For example, CDW currently trades at a market capitalization of $5.8 billion with net borrowings of $3.1 billion.  This means prospective owners can buy into an $8.9 billion corporation for $5.8 billion.  When looking at prospective returns, if the company were debt free, book value would grow by a projected ~$500 million in 2014, or 5.6% on $8.9 billion (assuming P/BV multiple stays constant).  When considering current debt levels of $3.1 billion, book value would grow by a projected ~$360 million (taking into account after-tax cost of interest), or 6.2% on $5.8 billion.  The return figures are affected by a few variables, namely equity value in relation to enterprise value, return on equity capital, and the cost of borrowing.  But, generally, low cost leverage serves to increase equity returns and is a large factor driving private equity and real estate returns.
  • As debt is repaid and the balance sheet is “de-risked” valuation multiples tend to improve, providing an additional boost to returns.

A slew of private equity portfolio companies have come to the public markets over the past two years due to (i) a spate of behemoth LBOs from the 2005-2007 vintage which are now being monetized and (ii) very favorable valuations present in the public market.  I’ve been searching through some of these issues for investment candidates.

The Business

CDW is a company I’m familiar with from past experience.  It is the leading direct market reseller (DMR) of technology products in North America.  In simple terms, CDW partners with blue chip technology providers (e.g. HP, Cisco, Lenovo, VMware, Apple, EMC, Microsoft, and many more) to sell hardware and software products to 250,000+ customers including small and medium sized businesses, governments, healthcare institutions, and educational institutions.  CDW sells these products through a sales force of 4,400 coworkers, including 1,800 field sellers, skilled technology specialists, and advanced service delivery engineers.

CDW operates in a commodity business, cataloging and selling such products as PC laptops and desktops, servers, software licenses, and networking equipment.  It is trying to build up a value added solutions business (converged infrastructure, cloud solutions, virtualization, etc.), but solutions only accounts for 3% of total revenue.  The numbers tell a fascinating story.  Since 1993, the company has grown sales by 20%+ annually (8.5% since 2000), while slightly improving margins.  The company has outpaced the market and its primary DMR competitors and has increased market share every year.  I was very curious to know how a commodity reseller has been able to consistently improve market share while enjoying greater than twice the operating margin of its peer group.

We can silo the company’s operations to determine whether any competitive advantage exists.  At its core, CDW is engaged in three distinct operations: (i) procuring and managing commodity technology products, (ii) selling, marketing, and providing customer service to a large customer base, and (iii) investing in and managing working capital.  When you think about the nuclear units of the business, it becomes evident that the company has developed strong competitive advantages over time.

Scale is an important advantage in this industry and CDW’s size relative to its peers (larger than its four closest competitors combined) bestows it with important benefits in procurement.  Technology partners are primarily focused on moving greater volumes of product and provide substantial incentives to channel partners who can sell in vast amounts.  CDW benefits from significant vendor rebates, cooperative advertising arrangements, and favorable payment terms, which is reflected in its superior gross margin (16.5%) relative to peers (13.5%).

The company also runs the most productive and efficient sales force in the industry.  Revenue per sales employee of ~$2.5 million compares favorably to ~$1.5 million for peers.  The company has found the most effective way to organize and incentivize its sales team and has also been able to sell a larger variety of products through a narrower team of coworkers.  The net result of these efforts is an operating margin of ~7% vs. 3% for competitors.  CDW is also the industry standard bearer for managing the cash conversion cycle; it generates the highest returns on working capital in the industry.

The company’s margin advantage gives it a significant cost advantage over its peers, particularly tiny resellers.  It can offer the greatest breadth of product and service, match any price offered by competitors, and provide extremely well paid account managers to serve customers’ needs.  These factors explain CDW’s ability to outgrow the market and take share.

Key Long Term Risks

  • Technology: The consumption of technology changes rapidly and it’s therefore difficult to predict the impact of future development on the company’s revenue streams.  Most resellers have been quick to adapt to the latest trends in the market.  In the early 1990s, CDW made its living selling Apple Macintosh and IBM PCs, Windows software, and computer peripherals.  Today, it sells everything from routers to cloud software to converged infrastructure solutions.  If the world were to fully migrate to the cloud, where Chromebooks were omnipresent, it could have a meaningful impact on CDW’s business.  Thus far, the cloud has only served to benefit the company as it’s provided a boost to its Chromebook business, servers, storage, and cloud solutions.  As long as overall IT spend is growing with GDP, CDW will be well positioned to capture a share of the market.
  • Dell / HP:  The technology solutions market is still dominated by the direct channel, where customers purchase directly from vendors. For small and midsize businesses, however, channel providers such as CDW are valuable as they are a one stop shop for purchases, warranty, servicing, advice, and technology solutions.  It becomes very costly for a small IT department to manage multiple vendors, product defects, servicing, contracts, licenses, and warranties. Nevertheless, HP and Dell are in the process of reinventing themselves and are re-positioning their businesses to focus on business IT solutions.  They have been building out their account specialist teams and adding software solutions to their suite of offerings.  In the hardware channel, CDW is an important partner for HP, moving $2 billion of product annually, and is unlikely to face direct competition from its key vendor partner.  Dell, on the other hand, only sells direct and is focused on controlling the customer relationship.  As a private company, Dell is now able to make as much investment in this area as it deems necessary to compete.  Despite Dell’s push into this area, it will not be easy to displace CDW as there is a certain level of stickiness among customers who are accustomed to working with long tenured account managers.  Where Dell and HP are likely to win long term is in the value added solutions business, which is a growing, albeit tiny portion of CDW’s revenue base.

Valuation

By my estimate, current valuation in the market is fair for the company.  The stock is up nearly 80% since its IPO in July 2013, and the whole enterprise trades for 10.5x 2014 operating income.  It took the company 15 years to get to $5 billion of revenue and 9 more years to get to $10 billion.  It’s reasonable to think that CDW could get to $19 billion of revenue by 2025 (from $11 billion today).  Assuming slight margin improvement from today’s levels (there’s very little operating leverage in the business), the total equity IRR comes out to ~10%.  This doesn’t meet our hurdle of a minimum 15% return.

Conclusion

CDW is a franchise business, possessing a durable margin advantage and economies of experience with regards to its sales operation.  These advantages should snowball as further scale is achieved.  Management has historically been extremely prudent with capital, only making 2 small acquisitions in the company’s 25+ year history and operating successfully with a significant debt load.  Management has also focused on its core geographic strength in North America and not spent precious shareholder capital chasing potentially low return international opportunities, where CDW has no incoming advantage versus incumbents.  Further, the business only requires investments in working capital (and to a lesser extent IT systems) to grow, and the incremental returns on this capital are in the stratosphere (90%+).

The one constraint with this business is the lack of operating leverage.  The company must hire additional sales representatives to grow its business; there’s eventually a limit to the amount of business a single account manager can handle.  In addition, the more an account manager sells, the more commission he or she earns.  Operating margins have improved by a paltry 70 bps over the past 17 years.  As such, operating income will tend to grow with revenue, which in turn should grow a few points above GDP.  In my view, it’s unlikely this business can achieve an exponential outcome in earnings performance.

At current valuations, the opportunity is uninteresting.  Nevertheless, it’s a wonderful business and worthy of putting on the tracker.  At the right price, it would be a worthy name to add to the portfolio.

Feedback and conversation is most welcome.