Cox & Kings Ltd – Report

I’m publishing on Cox & Kings Ltd.  I believe that at current valuation levels, an investment could deliver 20%+ compounded returns over the next ten years, with great potential for further upside from there.  Please see report for detailed analysis.

COX Report

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Update

It’s been a few weeks since the last post. I’ve been following multiple threads simultaneously and have a number of thoughts in the queue, which hopefully should be released over the next few weeks. In addition, my wife and I are moving back to California in early December and have been busy wrapping up our work here in Bangalore.

A brief commercial break – I’m currently seeking employment opportunities in the investments field in southern California.

For now, here is a brief summary of what I’ve been working on.

  • Cox and Kings: I mentioned in a previous post that I have been researching the tourism sector in India. The simple thesis is India has severely lagged the rest of the world in terms of per capita consumption of travel and is due to catch up over the coming decade. Last year, India accounted for only 17 million of 1 billion international tourist arrivals worldwide despite generating ~7% of the world’s GDP (on a PPP basis). There are only three tour operators of meaningful size in India, of which Cox and Kings is the largest. Although seemingly commodity in nature, I believe there are structural reasons why large winners are emerging in the industry. Cox and Kings’ stellar margins and returns on capital indicate strong competitive positioning and protective barriers. I have a favorable view of management as it has focused acquisitions on improving the customer experience and expanding into adjacent areas. Moreover, the metric management speaks the most of is return on equity. Today, you can buy fractional ownership in a business which should generate high teens ROE and grow owner earnings at 15% for the next 5-7 years, for ~10x earnings. I’m writing up a report which I will publish when complete. I am in the process of building a concentrated position.
  • Bitcoin: I started studying Bitcoin in earnest a few weeks ago after watching some interviews of venture capitalists I follow. Bitcoin isn’t easy to understand, particularly for those without a strong background in math and computer science. I read a book, read articles, watched instructional videos, and discussed with some friends who are engineers. I still probably understand only 25% of what there is to know, but I know enough to appreciate the genius of the technology and its disruptive potential. Bitcoin is the first currency in history with a decentralized ledger. A decentralized ledger provides unparalleled security and eliminates practically all the royalties on money we pay daily on transactions – international remittances are a prime area for disruption. Bitcoin is also infinitely divisible and could facilitate a micro-payments economy which would see whole new business models emerge. Imagine if we could consume media for fractions of a penny, or pay micro sums for the right to send e-mail. These models could save publishing, journalism, and music, and fully eliminate spam. Bitcoin has a number of other advantages, including low inflation risk, low political risk, simplicity (transactions can be conducted via mobile phone), transportability, and anonymity. Bitcoin offers freedom from any one government, bank, or payment processor which today are all monopoly like entities. The blockchain – the underlying technology which maintains the ledger and clears transactions – has served the Bitcoin network for nearly five years without a single reported case of fraud. Bitcoin as a technology still faces a number of roadblocks to widespread adoption, but so did the Internet in the early 1990s.
  • Solar: I bought a small stake in SolarCity to force my thinking on the solar industry. I’ve done a fair amount of research on rooftop solar over the past year and believe it has enormous potential.  What I am not clear about is whether permanent winners will emerge. There are three critical questions to answer: (i) can solar achieve grid parity without government subsidies and low interest rates, (ii) how will utilities charge consumers to utilize the grid for energy export and power backup, and (iii) where in the chain will value be created and can real winners emerge. The problem with large markets is that it invites sufficient competition to drive returns down to the industry’s total cost of capital. SolarCity pioneered the leasing model which made distributed solar popular and through sheer execution has raced out to a large lead in the market. But, the market is catching fire and now there are a number of companies playing somewhere in the solar value chain. SCTY currently enjoys advantages in cost, financing options, market reach, brand recognition, a large referral base, and experience/best practices. The key advantage is cost and it’s unclear whether SCTY can maintain cost leadership for a long period of time. It’s an iterative function – cost depends on scale and scale depends largely on cost. As the industry grows, utilities and large financial institutions may enter. Utilities, due to size, will have an immediate advantage in cost of capital and marketing. NRG, with 3 million retail customers, will be a good case study as it is getting into distributed solar in a big way. SCTY has vertically integrated to drive down cost and provide a seamless customer experience, but it’s still not clear whether owning panel manufacturing will lead to sustainable cost benefits given the scale of overseas suppliers. I am digging into the cost dynamics at a very micro level. Nevertheless, if the world had to achieve 40% penetration of solar by 2040, it would require 400 GW of solar deployment per year for the next 25 years. Currently, SCTY has deployed less than 1 GW of total solar cumulatively since inception. There’s a potential exponential function here which is worth exploring.

Books I’ve recently read include Into The Plex – Steven Levy, How Google Works – Eric Schmidt, Mastering Bitcoin – Andreas Antonopoulos, The Second Machine Age – Erik Brynjolfsson, Jab, Jab, Jab, Right Hook – Gary Vaynerchuk, and Tap Dancing to Work – Carol Loomis. The Second Machine Age is perhaps the best economics book I’ve ever read. The authors propose that economic growth is driven primarily by one variable – productivity growth. Productivity is defined as output per capita. The way to achieve greater amounts of output per capita is through innovation – technical or process related breakthroughs which allow humans to produce more without additional labor. And innovation is a rare phenomenon typically achieved by a tiny fraction of the human population.

Achieving growth in real per capita GDP has always involved combining ideas with capital and labor to increase productivity. In history, the nations best able to foster this combination are the ones which created the highest standards of living for its citizens. For this reason, it’s better to look at how a country is enabling and incentivizing its innovators when evaluating economic conditions. Are the brightest students going abroad or staying in country? Are students encouraged to learn and think creatively or are they forced to memorize concepts? Does immigration policy allow bright individuals to obtain citizenship and contribute economically? Are contracts and property rights honored? Culturally, are individuals encouraged to pursue their ideas and will society welcome them back if they fail? Are industries protected due to strong political tie-ups and crony capitalism or is there a free market in which disruptive ideas can win? These are the key factors which seed future economic growth. Economic measures such as interest rates, inflation, unemployment, trade balance, etc., are mostly a byproduct of these cultural and political factors.

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.

Links: October 25, 2014

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.