Thursday, September 23, 2010

How To Spot A Bubble? (So you think you're a contrarian? Part Deux)

In re-hashing my for-profit education stance, I came across another element of being a contrarian: spotting bubbles

Case in point: Netflix- $165/share. Yes, the stock has risen 800% Year-over-year. Yes, I am a subscriber and love the service ( I would cancel cable before I would cancel netflix). The reason I am comfortable calling Netflix a bubble is based upon the level of hubris displayed by Netflix CEO Reed Hastings in a recent interview. Here is an excerpt from the interview with "The Hollywood Reporter",

"THR: American services when they enter the Canadian market typically charge the locals more than they charge stateside. Why the discount for Canadians?

Hastings: We want to provide an incredible value for Canadians, and it's the lowest price we have anywhere in the world for unlimited screenings. And anyone can try it for free for a month. It's pretty addictive.

THR: Are you concerned that American Netflix subscribers will look north and ask for the same discount Canadians get at $7.99?

Hastings: How much has it been your experience that Americans follow what happens in the world? It's something we'll monitor, but Americans are somewhat self-absorbed.

THR: How will you will measure success for Netflix Canada?

Hastings: I'm certain we'll succeed, so it's kind of a matter of degree. We're not quantifying that in terms of subscriber numbers or profitability. What we're focused on is getting out there. We've got to get out on all of the devices, get the word out, and we need to be such a good service that people not only stay with us but rave to their friends about it. "

I'm not so appalled by the fact that he views Americans as ignorant and self-absorbed, as the fact that he does not measure success in terms of subscribers and profitability. It should be no-big-secret that Netflix was cashflow negative under its traditional 3-out-at-a-time plan for $19 (due to high postage and DVD replacement costs) and only turned free-cashflow positive due to its streaming business (subscriber growth exploded under its $9, one-at-a-time, unlimited streaming plan- due largely to lower shipping and dvd replacement costs).

Netflix's existing streaming agreements were priced opportunistically as content-owners failed to envision the subscriber growth that Netflix would generate from being able to stream through newer DVD players/TVs/gaming systems. Unfortunately, those contracts do not run forever and Netflix will find itself in the same difficult position as cable companies in a few years (forced to pay much higher rates for streaming). The difference is, Netflix posesses no major barrier-to-entry or competitive advantage like the cable companies do.....

I am not short NFLX yet, but at $8.3Bln market capitalization (4.4x sales/16x Ebitda) I firmly believe that NFLX shareholders will have a "coming-to-Jesus" moment at some point over the next two years.

COCO a Go-Go....

Since my recommendation to buy COCO (Corinthian Colleges) and WAPO (Washington Post) on 08/16/2010, both stocks have increased in value by a substantial amount (+25%, vs +5% for the S&P 500). At its peak today, COCO was up more than 36% over the past month.

As it turns out, the Education Secretary Arne Duncan announced they were "keeping their options open" and that final DOE regulations could be delayed. This should lead to significantly more upside in both COCO and WAPO.

Previously, I laid out a number of potential problems with the bear-case, which included skepticism that: 1)Racially-divisive gainful-employment rules go into effect on schedule without any changes 2) Belief that upcoming Congressional elections might create uncertainty about final rule adoption (Republicans want to extend oversight of not-for-profits, not just for-profits) 3)Current valuations imply that COCO/WAPO shutter their entire programs overnight, giving zero credit to ancillary programs (Heald College) or foreign programs (17% of assets in Canada)

Essentially, if you priced a business at liquidation value (i.e- 2-3 earnings and below tangible book value then suddenly decide suddenly that the business will live a little bit longer... you will have made a huge mistake selling-out and materially underpriced the value of the franchise. There is uncertainty in all human endeavors and perhaps an above-average level of uncertainty in federal funding, but with 30% of the company's shares shorted and the forward business value priced near zero.... I believe the pessimists are over-confident in their analysis to the point of arrogance.

Remain long COCO ($6.50) and WAPO ($375), in spite of my disgust of for-profit education stocks.

Sunday, September 05, 2010

Update on Washington Post

Recently, I recommended Washington Post as a good contrarian investment that was considerably undervalued near $300/share. Since that post, the stock has rallied more than 25% to +$380/share. In the interest of full disclosure, I present my full valuation breakdown of Washington Post. My original WaPo valuation was published in Barron's (March 19, 2010 edition- Letters to the Editor). The analysis below updates that work and demonstrates where I come up with my $478/share sum-of-the-parts valuation (+60% upside from entry point).

Washington Post has 4 distinct business units and a significant pile of investments that comprise its value. The business units and my best-guess at valuations are as follows (in order of relevance):

1)Cash and Investments of $1.05 Bln= $660Mln cash + $392Mln stock (mostly Berkshire Hathaway shares). WaPo does have $400Mln Long-term debt, which doesnt mature until 2019.

2) Cable Television Business worth $2.0Bln= 1.4Mln subscribers (across cable, internet, telephony) in rural markets with limited competition. This unit generates EBITDA of $300Mln per annum and is likely worth at least a 7x multiple, based on below-average capital spending needs.

3) For-Profit Education Company Kaplan-worth at least $1Bln in= Annualized EBITDA for 2010 will be $425Mln, which suggests a low valuation multiple of 2.2x pre-tax operating profit. A significant portion of Kaplan's business involves recruiting minorities and unemployed individuals to go back to school and utilize available federal grants. Recently, the Department of Education has decided to crack-down on abuses in the for-profit space. They have proposed very stringent "gainful employment" requirements, which will be certain to shut-out minorities and at-risk unemployed persons from the higher education market. Virtually no college (non-profit or for-profit) will risk losing access to federal funding by "taking a chance" on someone with a high financial risk profile (i.e- low credit score, no job, no savings, medical problems, criminal record, etc.). I do not love the for-profit education business, but the ends do not appear to justify the means.

At a 2.2x multiple, Kaplan is priced to either be out-of-business within 2 years, or be severely distressed. By pricing for the worst-case, it leaves us a free upside catalyst in the event :1) Republicans win Congress and dilute for-profit clampdown 2) Kaplan alters its business model 3) Final regulations are delayed or otherwise watered down. 4) Washington Post steps up lobbying efforts. As Bill Clinton once said, "Never pick a fight with a guy that buys ink by-the-barrel", which is certainly the case given Washington Post controls the namesake newspaper!

4) Broadcast TV stations worth at least $500Mln- This unit is clearly on the decline, but is generating an annualized $110Mln in EBITDA in spite of overall ad-market weakness. Assigning a 5x multiple with a strong political ad-spending season ahead of us seems to make sense.

5) Washington Post newspaper worth at least $250Mln?- This is a total guess. Washington Post is one of several iconic newspapers that likely has staying power, although not as much clout as the NY Times/Wall-Street Journal. The Post is still important and holds some editorial sway in the epicenter of our fast-spending federal government. The Times is set to generate $700Mln revenue this year (-30% YoY), but a distressed valuation of 1/3rd times sales appears appropriate.

Summary- In total, my estimated enterprise value for Washington Post is $4.4Bln or $478 per-share(after subtracting $400Mln debt), with a free-call option on the Kaplan for-profit schools in the event that federal student-loan regulations are not altered. If Kaplan were worth absolutely zero, Washington Post would still be worth $3.4Bln or $370 per share under our analysis.