Whole Foods Market Analysis Following Q2 2014 Results

Insight's Whole Foods (WFM) model has been undated.  If you go by WFM's 5 year top line and EBITDA margin guidance (with margin acceleration in the out years), my discounted cash flow model (DCF) gives about a $70.00 target.  If you believe that WFM EBITDA margins will compress to WMT's then it's about a $50 target.  To get to the current stock price you have to basically believe that WFM's business model is going to fall apart due to competition in the organic area.  WFM has now missed on the bottom line for two quarters so it doesn't have much credibility. The question also is whether there's value there from an M&A viewpoint.  Basically there's a big vacuum as the stock moves from growth investor's hands  to value investors hands.  The stock may be dead money for a while at least, but it's hard to believe that longer term their brand equity, relationship with suppliers, and employee culture do not have value.  I'm reading a good book about Bezos, The Everything Store,  which shows the great credence he puts in a low price business model, and how influenced he was by Sam Walton at Walmart.  WFM's business model is a premium price one which is a liability in spite of the strengths I mentioned above.

Philip I. Frank, Ph.D.

President and Portfolio Manager,

Insight Asset Management LLC

e-mail: insight-asset@earthlink.net

Amazon.com and Market Risk Vs. Investment Risk

It is important to distinguish investment risk from market risk.  Market risk refers to volatility, while investment risk refers to permanent loss of capital.  This is a key weakness of the Capital Asset Pricing Model (CAPM).  It treats market risk and investment risk as synonymous. In Insight's view Amazon.com (Amazon) is a rare technology company in that its powerful business model, while not shielding it from market risk, does greatly lessen its investment risk, in Insight's view.

Leveraged Recapitalizations vs. Leveraged Buyouts

The dispute over the proposed Leveraged buyout (LBO) of Dell has caught my eye and got me to thinking.  One key argument against the Dell LBO is that the proposed price paid to shareholders is too cheap, and the advantages of an LBO can accrue to public shareholders through a leveraged recapitalization rather than an LBO.  The leveraged recap could be done through the company, while remaining public, taking on debt and then doing a massive stock buyback, thus of course shrinking equity.

While pursuing the MBA at Yale I argued the LBO model was the way to eliminate the agency problem in public companies by turning non-owner managers into owners.    I would tweak my argument now to say that while there should be a leveraging up it should be done at lesser multiples of EBITDA so as to make it a “conservative”  leveraging up.  You make a little less, but sleep better. That is in essence the way I run Insight's model portfolio—using margin but not too much of it.  Say you had 10 year long term noncallable debt to fund a public company leveraged recapitalization. Even so your stock price would go down in a 2008 like debacle, but assuming you could service your debt, the company would survive.  LBOs also lost value in the 2008 debacle, it’s just that it’s not public so you don’t see a publicly quoted price decline.  

When seen from this light many good quality public companies  are massively  underleveraged resulting in higher costs of capital, less ROE and lesser returns than are possible through a leveraged recap.  Let’s not forget the rationale of LBOs:  The less equity you put down and the more debt you take on (and can service) the higher the return.  This is why I am so enamored of the work of John Malone, and the public companies he is involved with as a whole currently represent a significant position in Insight's model portfolio. In essence Malone is doing LBOs within public companies.  It’s interesting to contrast the LBO approach to the eminent value investor Martin Whitman’s approach of finding unlevered low ROE, high NAV companies attractive.  In a credit panic or market rout for sure you see this approach’s utility.  It can also be argued that such unleveraged public companies are targets for LBOs and therefore are even more attractive than companies that already have undergone an LBO.  The problem is such LBOs may never happen, or if they do there could be attempts to buy the company cheaply.  In general, I will take a bird in hand, though there is an argument that today’s environment of  Central Bank activism  is fraught with risk.   My overall point is the same I made when I was at Yale:  In general many public companies are underleveraged.  When public non-owner managers run the show, why should they take the risk of leveraging? Since they own little stock there is little upside to them, and much downside in a credit crunch, for example.  

Philip I. Frank, Ph.D.

President and Portfolio Manager,

Insight Asset Management LLC

e-mail: insight-asset@earthlink.net

Amazon.com: An Inventor, a Facilitator of Invention, and a Transformational Technology Company

Amazon.com  (Amazon) is a key holding in Insight’s model portfolio, and in various of its client portfolios. How strong is Amazon’s competitive position? Is Facebook a competitive threat to Amazon?  I read an article recently which discussed e commerce companies operating on Facebook who are selling fashion products, sports gear, etc. and the big financial backers of various of these companies.  The article also pointed out that Facebook has about 6-7X more users than Amazon. Facebook offers the ability to see what friends are buying so that is a point in Facebook’s favor; yet Amazon does offer user reviews which at least to some extent blunts that Facebook edge.  As I think about this I consider the power of the Amazon brand.  For example, would I feel comfortable giving credit card information to a Facebook retailer?  Perhaps.  If that retailer can piggyback on the Facebook brand, it’s possible.  So I don’t think the Amazon brand is invulnerable from competition in the long term.  

What I think is a more powerful competitive advantage for Amazon is its fulfillment and shipping operation, leading to immense overall pricing power.  Amazon is spending vast amounts of money in this area and recently bought a robotics company to bolster their warehouse and inventory operation.  While niche retailers on Facebook such as a fashion company with a hot product could compete,  I don’t see how as a whole e-commerce competitors on Facebook could stand up to Amazon’s price advantage given its huge power over suppliers (resulting in negative working capital and additional free cash flow), and scale advantages.  I look at Costco in this regard.   Its low cost advantage over competitors has stood the test of time.  So in the end while I think the power of the Amazon name by itself and its first mover advantage by itself is not a sufficient competitive barrier, it’s scale and fulfillment operations combine to give it a pricing power durable competitive advantage.  Again my view is niche retailers on Facebook could be competitive, but Facebook is way behind in terms of an infrastructure which could compete with Amazon on price and fulfillment, and it would be extremely difficult for Facebook to build such an infrastructure from scratch.  Note also that if Facebook did try to build a fulfillment infrastructure it could be viewed as putting itself in competition with businesses that advertise on Facebook, and advertising revenue is a key part of Facebook’s business model.

Insight is  fortunate to have a network of exceptionally talented professionals whose work spans corporate finance, bond investing, real estate analysis, investment banking, private equity, hedge funds, and equity research.  I often discuss investment analysis with these professionals, and their comments are invaluable.  One of these professionals pointed out that Amazon could  form a joint venture with Facebook in which it provides a cost saving private label outsourced fulfillment infrastructure for Facebook and its retailers which would also provide additional business for Amazon.   In fact as discussed in Jeff Bezos’, Amazon’s CEO, 2011 letter to shareholders Amazon through the development of its cloud infrastructure is providing operational help to other businesses.  Amazon , as is pointed out in this letter, is a facilitator of invention by others, through cloud infrastructure but also through its own warehouse infrastructure to its family of retailers, and as well to writers through which through the e-reader kindle device Amazon invented enables writers to in essence be their own publishers.  Amazon because of its powerful competitive position is able to both cooperate with and compete with other businesses.

 

Amazon is also busy extending its own powerful brand. I passed a bus stop the other day in Manhattan and saw a picture of a woman in beautiful pants with the title “Amazon Fashion”.  So now it looks like Amazon is setting up its own fashion brand, extending the power of its brand.  They are doing the right things to building long-term value, ignoring Wall Street’s obsession with the short term.  Amazon is also competing with Groupon, by e-mailing its vast database of customers with discounted offers of interest, such as discounted restaurant offers and even discounted dental services. 

In line with what  Bezos has pointed out, Amazon is  fundamentally a technology company, and it has used technology to transform retailing.  The analogy of an octopus extending its diverse tentacles through countless nooks and crannies fits the Amazon business model well.  Amazon started as an internet bookseller, a platform it has used to disintermediate the inferior bricks and mortar business models of sundry booksellers.    Amazon in the present uses technology to expand its own powerful online retailing business as it moves into a vast array of retailing categories.

But Amazon goes further still and is both an inventor itself and a facilitator of invention.  Amazon  has the rare ability to fundamentally transform businesses and even industries.  From a valuation point of view, how is the present value of such a company impacted by this rare ability?  It is significantly augmented, I would argue.  The company is using the e-reader kindle it invented, an invention I think which is as great as the invention of the printing press, to transform the publishing business, and support and profit from the self-publishing movement.   Now Amazon is going beyond this as it becomes the operational backbone of a wide array of internet businesses, thus reinforcing and broadening its dominant competitive position further still.   Amazon has shown the ability to transform both itself and the business world, as it  has used technology, invention, and the facilitation in others of invention to reinforce its powerful strategic position.

One brief note.  Insight wishes to thank its clients for the confidence shown by referring friends and acquaintances to Insight.  Insight prefers to build its business by referral and word of mouth, and views referrals as the best form of flattery.  Insight is currently accepting new clients.

 

Philip I. Frank, Ph.D.
President and Portfolio Manager
Insight Asset Management LLC
e-mail:  insight-asset@earthlink.net

Note:  Insight Asset Management LLC is currently long Amazon.com (AMZN) in its model portfolio, and in various client portfolios

LinkedIn Has A Powerful Business Model

LinkedIn, the online professional network company has an interesting business model in Insight's view. The company's  network effect based business model is innovative.   The LinkedIn member network becomes ever more resistant to competitive threat as it grows (a la Facebook, Microsoft), and the company has  a first mover advantage as well.  LinkedIn has a dual stream of revenues from advertising as well as from those seeking employees.   It is intriguing  that LinkedIn at the same time disintermediates recruiters and also is a must have tool for recruiters

The company has an ingenious way of  inducing members to make public private information which serves to greatly expand their network as well.   When I first signed up to become a member, I was asked to grant access to my  e-mail contact list so those people could be added to my network of LinkedIn contacts.  While you might not want all the people in your contact list to be made available to every LinkedIn contact you have, if you agree once, this process  makes it automatic, and increases the size of the LinkedIn network in an exponential-like way.   This making public of personal information is also a Facebook modus operandi, in Insight's view.

LinkedIn  has many ways of making the network valuable to the user by enabling  users to not only keep up with job openings and make themselves available to recruiters, but to keep up with alumni, join groups with similar interests, etc.   Another example:  Say  you are a salesperson, and want leads for cold calling.  The LinkedIn network provides you with an entrée  that you wouldn’t have otherwise ( Hello I am xx a friend of a friend of a friend, etc.).

Insight often uses a pro forma  approach to valuation, which Insight has found especially useful in analyzing  technology companies with seemingly high price/earnings ratios.  Herein research and development expense is amortized rather than fully expensed, additional income from an increase  in deferred revenue is added to stated net income, and  cash spent on capital expenditures to grow the business is added back to net income, so as to subtract only maintenance capital expenditures from the addback to net income of depreciation.    In LinkedIn's case pro forma net income is greatly increased thereby, and there is thus a bullish valuation argument for a substantially higher stock price, in Insight’s view.

In the short run the stock price could be vulnerable if unemployment began to rise again since employment growth is a driver of LinkedIn's valuation. Then again, many stocks would be vulnerable if unemployment grows.  The major point though is that LinkedIn's network effect business model is impressive—as LinkedIn’s network gets bigger LinkedIn  becomes ever more resistant to competitive threat.  LinkedIn's business model provides it wth significant competitive advantages over the long term, in Insight's view.

Philip I. Frank, Ph.D.
President and Portfolio Manager
Insight Asset Management LLC
e-mail:  insight-asset@earthlink.net

Insight Asset Management LLC is currently long LinkedIn common stock (LNKD) in its model portfolio and in its client portfolios.

Reflexivity, Reality and Markets

I have been trying to make sense of the developments in Europe, and especially the huge up move on October 27, 2011 in the US stock market as the plan was announced in Europe to leverage up the stabilization facility (EFSF).   George Soros’ concept of reflexivity comes to mind. I had been wrestling with whether the reported European debt relief plan amounted to just kicking the can down the road in which a debt problem is endeavored to be solved with ever more debt, or whether it amounts to something more substantive. Suddenly it occurred to me that in a way it doesn’t matter, and that the answer lies in reflexivity. Reflexivity is the case where perceptions create a reality which then leads to further actions reinforcing that reality. When you have an illness and you go to a doctor,  the doctor will do an assessment and possibly tests to ascertain the exact illness. You either have the illness or you don’t; the illness is an objective reality. This is not the case in finance and economics, where perceptions can create reality to a high degree, one reason why there are so many tail or rare events in finance. In the case of the Europe sovereign crisis, if a critical mass of market participants believe in the viability of the debt plan and then go on to buy financial assets such as stocks, thereby lifting the price and improving the market and confidence , thereby improving the real economy, increasing tax revenues enabling government debt burdens to be reduced: the perception becomes a reality: In other words real conditions can improve or deteriorate via reflexivity. Reflexivity is close in concept to that of animal spirits, but reflexivity explains the process more exactly.


Of course, perceptions are based at least to some extent on reality. It’s not just a matter of unreasoned reflexivity but of the market now having some evidence via the announced deal that Germany will do anything to save the Euro including issuing Eurobonds or having the ECB print money if need be, even if it has to be forced on Europe via market turmoil.  I think the market  believes Germany will throw overboard its hyper-vigilance regarding inflation to save the Euro. So it’s not so much that the announced deal as given is so good but what it portends for the future. Of course a reflexivity generated reality must in the end must be backed up by the facts. Should there be evidence that Europe is balking at implementing the above scenario, stock markets could fall substantially. In addition, the problem of European growth remains. PIIGS countries are not able to devalue their Euro currency, thus inhibiting one means of future growth, and then there is the general problem of a socialized Europe with structural unemployment. But I do believe that as long as markets see money printing on the horizon they might even be able to live with a managed exit from the Euro for one or more of the PIIGS countries. In the end though ,money printing is no substitute for true debt reduction and restraint in government spending.

I do believe though that more fundamentally through increased fiscal restraint Europe is taking some steps toward a more substantive solution along the lines suggested by Reinhart and Rogoff in their seminal book, This Time Is Different. And grudgingly through mandated cuts (unless the US Congressional Super Committee comes to a solution, which I doubt) , the US may also be pursuing some fiscal restraint. The central question is whether US entitlements of Medicare and social security will be reformed in the next presidential term. Taxing the rich would provide just a drop in the bucket toward reducing a trillion dollar debt problem. There is no long term solution to the US debt problem without entitlement reform. Money printing and a European TARP will only carry the markets so far as we learned via the US TARP and Quantitative easing programs, which led initially to huge stock market rise but then a significant pullback. 


Philip I. Frank, Ph.D.
President and Portfolio Manager,
Insight Asset Management LLC
Tel: 212-223-2715
e-mail: insight-asset@earthlink.net

Multidisciplinary Approach, Technology Revolution, and Ultra-Fast Information Flow

As a portfolio manager and analyst I believe it is important not only to focus on finance and accounting which are of course vital when conducting analysis, but to have a broad multidisciplinary approach which includes an understanding of business strategy, economics, geopolitics, history, demographics, and technology.  A distinguishing characteristic of today's world as compared to say ten years ago is how fast information moves today.  It’s not that the internet wasn’t around then, it’s just that the internet is so much more embedded now, and I think information moves much faster now. Arguably Facebook and Twitter have a lot to do with the change going on in the Middle East today. But I also wonder as to its effect on markets. Could it be that market cycles themselves are being accelerated by this  ultra-fast flow of information? That would make some sense, just as you could argue that the Middle East turbulence we see today was not necessarily caused by the internet, but that the internet accelerated the process. If market cycles are being accelerated that would help to explain both the US stock market's plunge in 2008 as well as the market’s huge bounce back since 2009.  This would bolster the view that the 2009-2011 advance isn't just a brief reprieve like the market’s recovery from the 1929 crash only to take a second leg down.  Rather, information is being digested and integrated more quickly as the markets "see" further ahead.  Today, markets may well be forecasting accelerating social development such as a Middle East moving toward democracy,and the beneficial effects this would have on global economic growth.  Faster information flow has been a hallmark of the world's development over the centuries, but the Internet technology revolution has accelerated it greatly, in Insight's view.

This ultra-fast flow of information could also be accelerating business development in general . There could be a virtuous cycle which develops such that accelerated information flow leads to faster corporate development  which in turn leads to research and development expenditures further enhancing information flow. This should enhance the present value of corporations, as well as providing a tailwind for continuing technological innovation. A wonderful book I’m reading now, Why the West Rules -For Now by Ian Morris expounds the argument that advances in social development (which includes energy capture, organization, war making and information technology) from 2000 to 2050 will rise two times as much as that which occurred in the previous 15,000 years.  Of course the author brings out that there are large risks to this scenario including war, famine, and disease. Still, the possibility of such an advancement is breathtaking, and it can be argued that the world is still in the early stages of the technology revolution heralded by the Internet.  Yes, the problems the financial world faces are very real including developed world debt, a continuing US housing problem, stubbornly high US unemployment, and Chinese inflation.  As clients know, Insight is not dogmatically bullish, having sold significant amounts of stock and raised cash during both 2002 and 2008, based on macroeconomic analysis.  Nevertheless,  the ongoing technology revolution is reason for bullishness, supported by a reasonably valued US stock market chastened by past excesses, and a US government intent on reflating the US stock market, in Insight's view.  Insight has positioned clients portfolios accordingly.

Philip Frank, PhD
President and Portfolio Manager,
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net